ECON 202

Introduction to Microeconomics

X- Perfect Competition
in Long Run
Dr. Mohamed El-Komi
 The Supply Curve for a Perfectly
Competitive Industry
•  Question
–  What does the short-run supply curve for the
individual firm look like?

•  Answer
–  The firm’s short-run supply curve in a
competitive industry is its marginal cost
curve at and above the point of intersection
with the average variable cost curve.
LONG-RUN COSTS AND OUTPUT DECISIONS

We begin our discussion of the long run by looking at firms in

three short-run circumstances:

(1)  firms earning economic profits,

(2)  firms suffering economic losses but continuing to operate to

reduce or minimize those losses, and

(3)  firms that decide to shut down and bear losses just equal to
fixed costs.
 Shutdown vs. Exit
•  Shutdown:
A short-run decision not to produce
anything because of market conditions.
•  Exit:
A long-run decision to leave the market.
•  A key difference:
–  If shut down in SR, must still pay FC.
–  If exit in LR, zero costs.

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A Firm’s Short-run Decision to Shut Down

•  Cost of shutting down: revenue loss = TR

•  Benefit of shutting down: cost savings =
VC
(firm must still pay FC)
•  So, shut down if TR < VC
•  Divide both sides by Q: TR/Q < VC/Q
•  So, firm’s decision rule is:
Shut down if P < AVC
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A Competitive Firm’s SR Supply Curve
The firm’s SR
supply curve is
the portion of Costs
its MC curve
MC
above AVC.
If P > AVC, then
ATC
firm produces Q
where P = MC. AVC

If P < AVC, then

firm shuts down
(produces Q = 0). Q

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The Irrelevance of Sunk Costs to Shutting
Down Decision
•  Sunk costs should be irrelevant to
decisions;
you must pay them regardless of your
choice.
•  FC is a sunk cost: The firm must pay its
fixed costs whether it produces or shuts
down.
•  So, FC should not matter in the decision to
shut down.
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 A Firm’s Long-Run Decision to Exit

•  Cost of exiting the market: revenue loss =

TR
•  Benefit of exiting the market: cost savings
= TC
(zero FC in the long run)
•  So, firm exits if TR < TC
•  Divide both sides by Q to write the firm’s
decision rule as: Exit if P < ATC

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A New Firm’s Decision to Enter Market

•  In the long run, a new firm will enter the

market if it is profitable to do so: if TR >
TC.
•  Divide both sides by Q to express the
firm’s entry decision as:
Enter if P > ATC

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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
breaking even The situation in which a
firm is earning exactly a normal rate of
return.

MAXIMIZING PROFITS

Example: The Blue Velvet Car Wash

TABLE 1 Blue Velvet Car Wash Weekly Costs (Price= $5)!

 TOTAL VARIABLE COSTS
 TOTAL COSTS
 
 

TOTAL FIXED COSTS (TFC)! (TVC) (800 WASHES)! (TC = TFC + TVC)! $! 3,600!

1." Normal return to investors" $" 1,000" 1.
 Labor
 $
 1,000
 Total revenue (TR)
 
 

2." Materials" " 600" at P = $5 (800 x $5)" $! 4,000!

2." Other fixed costs 
 
 $! 1,600! Profit (TR - TC)" $! 400!

(maintenance contract, 
 

insurance, etc.)" " 1,000"
$! 2,000!
SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
When washing 300 cars/week

FIGURE 2 Firm Earning Positive Profits in the Short Run

SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
MINIMIZING LOSSES

operating profit (or loss) or net

operating revenue Total revenue minus
total variable cost (TR - TVC).

In general,

■ If revenues exceed variable costs, operating profit is

positive and can be used to offset fixed costs and
reduce losses, and it will pay the firm to keep
operating.
■ If revenues are smaller than variable costs, the firm
suffers operating losses that push total losses above
fixed costs. In this case, the firm can minimize its
losses by shutting down.
SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
Producing at a Loss to Offset Fixed Costs:

TABLE 2 A Firm Will Operate If Total Revenue Covers Total Variable Cost!
CASE 1: SHUT DOWN! CASE 2: OPERATE AT PRICE = $3!

Total Revenue (q = 0)" $" 0" Total Revenue ($3 x 800)" $" 2,400"
Fixed costs
 
 $
 2,000
 Fixed costs
 
 $
 2,000

Variable costs
 +" 
 0
 Variable costs
 +" 
 1,600

Total costs" $" 2,000" Total costs" $" 3,600"

Profit/loss (TR - TC)" -

$" 2,000" Operating profit/loss (TR - TVC)" $" 800"
Total profit/loss (TR - TC)" -
$" 1,200"
SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
Washing 225 cars/week @ P=$3.5

FIGURE 3 Firm Suffering Losses but Showing an Operating Profit in the Short Run
SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
Remember that average total cost is equal to average fixed
cost plus average variable cost. This means that at every
level of output, average fixed cost is the difference between
average total and average variable cost:

ATC = AFC + AVC

or
AFC = ATC - AVC = $4.10 - $3.10 = $1.00

As long as price (which is equal to average revenue per unit) is sufficient to cover average
variable costs, the firm stands to gain by operating instead of shutting down.
SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
Shutting Down to Minimize Loss
TABLE 3 A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost!
CASE 1: SHUT DOWN! CASE 2: OPERATE AT PRICE = $1.50!

Total Revenue (q = 0)" $" 0" Total revenue ($1.50 x 800)" $" 1,200"
Fixed costs
 
 $
 2,000
 Fixed costs
 
 $
 2,000

Variable costs
 +" 
 0
 Variable costs
 +" 
 1,600

Total costs" $" 2,000" Total costs" $" 3,600"

Profit/loss (TR - TC):" -

$" 2,000" Operating profit/loss (TR - TVC)" -
$" 400"
Total profit/loss (TR - TC)" -
$" 2,400"

Any time that price (average revenue) is below the minimum point on the average variable
cost curve, total revenue will be less than total variable cost, and operating profit will be
negative—that is, there will be a loss on operation. In other words, when price is below all
points on the average variable cost curve, the firm will suffer operating losses at any
possible output level the firm could choose. When this is the case, the firm will stop
producing and bear losses equal to fixed costs. This is why the bottom of the average
variable cost curve is called the shut-down point. At all prices above it, the marginal cost
curve shows the profit-maximizing level of output. At all prices below it, optimal short-run
output is zero.
SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS

shut-down point The lowest point on the

average variable cost curve. When price
falls below the minimum point on AVC, total
revenue is insufficient to cover variable
costs and the firm will shut down and bear
losses equal to fixed costs.

The short-run supply curve of a competitive firm is that portion of its marginal cost
curve that lies above its average variable cost curve (Figure 9.3).
SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS

FIGURE 4 Short-Run Supply Curve of a Perfectly Competitive Firm

 Example: Industry Demand and Supply Curves and the
Individual Firm Demand Curve (Secure digital cards firm)

•  Given Pe, firm produces qe where MC = MR

§  If AC = AC1, break-even
•  If AC = AC2, losses
•  If AC = AC3, economic profit
SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
THE SHORT-RUN INDUSTRY SUPPLY CURVE
short-run industry supply curve The
sum of the marginal cost curves (above
AVC) of all the firms in an industry.

FIGURE 6 The Industry Supply Curve in the Short Run Is the Horizontal Sum of
the Marginal Cost Curves (above AVC) of All the Firms in an Industry
SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
LONG-RUN DIRECTIONS: A REVIEW

TABLE 4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and
Short Run!
SHORT-RUN
 SHORT-RUN
 LONG-RUN

CONDITION! DECISION! DECISION!

Profits" TR > TC" P = MC: operate" Expand: new firms enter"

Losses" 1. With operating profit" P = MC: operate" Contract: firms exit"
(TR > TVC)" (losses < fixed costs)"
2. With operating losses" Shut down:" Contract: firms exit"
(TR < TVC)" losses = fixed costs"
Exercise 1 (Solve at home)
Identifying a firm’s profit
A competitive firm
Determine
this firm’s Costs, P
total profit. MC

Identify the P = $10 MR

area on the ATC
graph that
$6
represents
the firm’s
profit.
Q
50
Exercise 1
Answers
A competitive firm
Costs, P
Profit per unit MC
= P – ATC
P = $10 MR
= $10 – 6
profit ATC
= $4
$6

Total profit
= (P – ATC) x Q
= $4 x 50 Q
50
= $200
Exercise 2
Identifying a firm’s loss
Determine A competitive firm
this firm’s Costs, P
total loss, MC
assuming
AVC < $3.
ATC
Identify the
area on the $5
graph that P = $3 MR
represents
the firm’s
Q
loss. 30
Exercise 2
Answers
A competitive firm
Costs, P
Total loss MC
= (ATC – P) x Q
= $2 x 30 ATC
= $60
$5
loss loss per unit = $2
P = $3 MR

Q
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 Entry & Exit in the Long Run
•  In the LR, the number of firms can change
due to entry & exit.
•  If existing firms earn positive economic
profit,
–  new firms enter, SR market supply shifts right.
–  P falls, reducing profits and slowing entry.
•  If existing firms incur losses,
–  some firms exit, SR market supply shifts left.
–  P rises, reducing remaining firms’ losses.

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 The Zero-Profit Condition
•  Long-run equilibrium:
The process of entry or exit is complete –
remaining firms earn zero economic profit.
•  Zero economic profit occurs when P = ATC.
•  Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
•  Recall that MC intersects ATC at minimum
ATC.
•  Hence, in the long run, P = minimum ATC.
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Why Do Firms Stay in Business if Profit = 0?

•  Recall, economic profit is revenue minus

all costs – including implicit costs, like the
opportunity cost of the owner’s time and
money.
•  In the zero-profit equilibrium,
–  firms earn enough revenue to cover these
costs
–  accounting profit is positive

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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE

increasing returns to scale, or economies of

scale An increase in a firm’s scale of
production leads to lower costs per unit
produced.
constant returns to scale An increase in a
firm’s scale of production has no effect on costs
per unit produced.

decreasing returns to scale, or diseconomies

of scale An increase in a firm’s scale of
production leads to higher costs per unit
produced.
LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
INCREASING RETURNS TO SCALE
The Sources of Economies of Scale

Most of the economies of scale that immediately

come to mind are technological in nature.

Some economies of scale result not from technology but from

sheer size.
LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
Example: Economies of Scale in Egg Production
TABLE 5 Weekly Costs Showing Economies of Scale in Egg Production!
JONES FARM! TOTAL WEEKLY COSTS!
15 hours of labor (implicit value $8 per hour)" $120"
Feed, other variable costs" 25"
Transport costs" 15"
Land and capital costs attributable to egg production" 17"
$177"
Total output" 2,400 eggs"
Average cost" $.074 per egg"

CHICKEN LITTLE EGG FARMS INC.! TOTAL WEEKLY COSTS!

Labor" $ 5,128"
Feed, other variable costs" 4,115"
Transport costs" 2,431"
Land and capital costs" 19,230"
$30,904"
Total output" 1,600,000 eggs"
Average cost" $.019 per egg"
LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE

Graphic Presentation

long-run average cost curve (LRAC) A graph

that shows the different scales on which a firm
can choose to operate in the long run.
LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE

FIGURE 9.5 A Firm Exhibiting Economies of Scale

LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
CONSTANT RETURNS TO SCALE

Technically, the term constant returns means that the

quantitative relationship between input and output stays
constant, or the same, when output is increased.

Constant returns to scale mean that the firm’s long-run

average cost curve remains flat.
LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
DECREASING RETURNS TO SCALE

FIGURE 7 A Firm Exhibiting Economies and Diseconomies of Scale

All short-run average cost curves are U-shaped, because we assume a fixed scale of plant
that constrains production and drives marginal cost upward as a result of diminishing
returns. In the long run, we make no such assumption; instead, we assume that scale of
plant can be changed.
LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE

It is important to note that economic efficiency requires taking

advantage of economies of scale (if they exist) and avoiding
diseconomies of scale.

optimal scale of plant The scale of plant

that minimizes average cost.
LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
SHORT-RUN PROFITS: EXPANSION TO
EQUILIBRIUM

FIGURE 8 Firms Expand in the Long Run When Increasing Returns

to Scale Are Available
LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
Firms will continue to expand as long as there are economies of scale
to be realized, and new firms will continue to enter as long as positive
profits are being earned.

In the long run, equilibrium price (P*) is equal to long-run average

cost, short-run marginal cost, and short-run average cost. Profits are
driven to zero:

P* = SRMC = SRAC = LRAC

where SRMC denotes short-run marginal cost, SRAC denotes short-
run average cost, and LRAC denotes long-run average cost. No other
price is an equilibrium price. Any price above P* means that there are
profits to be made in the industry, and new firms will continue to
enter. Any price below P* means that firms are suffering losses, and
firms will exit the industry. Only at P* will profits be just equal to zero,
and only at P* will the industry be in equilibrium.
 Long-Run Equilibrium
•  In the long run, the firm can change the
scale of its plant, adjusting its plant size in
such a way that it has no further incentive
to change; it will do so until profits are
maximized.
•  In the long run, a competitive firm
produces where price, marginal revenue,
marginal cost, short-run minimum average
cost, and long-run minimum average cost
are equal.
LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS

long-run competitive equilibrium When

P = SRMC = SRAC = LRAC and profits are
zero.

Investment—in the form of new firms and expanding old firms—will over time tend
to favor those industries in which profits are being made, and over time industries in
which firms are suffering losses will gradually contract from disinvestment.
Graphic Example: Long-Run Firm
Competitive Equilibrium
 CONCLUSION:
The Efficiency of a Competitive Market
•  Profit-maximization: MC = MR
•  Perfect competition: P = MR
•  So, in the competitive eq’m: P = MC
•  Recall, MC is cost of producing the marginal unit.
P is value to buyers of the marginal unit.
•  So, the competitive eq’m is efficient, maximizes
total surplus.

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 CHAPTER SUMMARY

§  For a firm in a perfectly competitive market,

price = marginal revenue = average revenue.
§  If P > AVC, a firm maximizes profit by producing
the quantity where MR = MC. If P < AVC, a firm
will shut down in the short run.
§  If P < ATC, a firm will exit in the long run.
§  In the short run, entry is not possible, and an
increase in demand increases firms’ profits.
§  With free entry and exit, profits = 0 in the long run,
and P = minimum ATC.
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