Examples of rising and falling industries

• Beef• chicken• bagel stores• smoothies• video rental stores• drive-in movies

Long Run vs. Short Run in an Industry

• Long run for an industry– Firms have either entered or exited the industry

• Short run for an industry – Firms have neither entered nor exited the industry

• Contrast: long run vs. short run for a firm– Long run: can adjust all inputs– Short run: can adjust some but not all inputs

The Long Run Competitive Equilibrium Model

• It’s Dynamic!• It has three key ingredients

– Two we have seen before– The third is new

(1) Each firm has the typical MC, ATC, AVC graph

08_05

DOLLARS

QUANTITY

MC

ATCAVC

(2) Each firm is competitive, and the Market demand curve is

downward sloping09_05

PRICE

Demand curve from the perspective of a typical firm

Price is constant because the single seller cannot affect the price.

QUANTITY PRODUCED BY SINGLE FIRM

PRICE

Demand

Demand

Market demand curve

QUANTITY PRODUCED BY ALL FIRMS IN THE MARKET

Market Single Firm

(3) Free entry and exit

• Firms can enter the industry or exit the industry– firms exit the industry if profits are negative

(losses)– firms enter the industry if profits are positive

• Note that the definition of profits is economic profits– Opportunity costs are part of total costs

The Typical Firm and the Market09_06

PRICE PRICE

MC

ATC

P

FIRM QUANTITY

Supply

Demand

MARKET QUANTITY

Typical Firm Market

Market price determined by intersection

Zero profit because P = ATC

Firm produces this amount.

What happens if there is an increase in demand?

• First, look at short run effects• Then, look at what happens over time as

firms enter or exit• Finally, check out the new long run

equilibrium

09_07A

PRICE PRICE

FIRM QUANTITY MARKET QUANTITY

Typical Firm Market

MC

ATC

S

SHORT RUN

D’

P’

D

1. Demand increases, causing the price to rise.

3. These profits bring more firms into the industry...

2. Higher price raises profits from zero to area of shaded rectangle.

P

09_07B

PRICE PRICE

FIRM QUANTITY MARKET QUANTITY

4. increasing supply and lowering prices.

MarketTypical Firm

MC

ATC

SS’

D

LONG RUN

5. Profits are eventually driven back to zero because P = ATC.

P’

D’

Now let’s do it by hand to see how the curves change over time

Using the Model to explain the real world. Consider an example:

09_03

PRICE(DOLLARSPER TON)

700

500

300

100

1986 1988 1990

Price of grapes

09_04

NUMBER OF ACRES

4,000

3,000

2,000

1,000

1985 1986 1987 1988 1989 1990 1991

New vineyards

Now consider a decrease in demand

– Short run effects– dynamics over time – new long run equilibrium

09_08A

2. The lower price brings losses to the firms shown in this rectangle.

1. Demand declines, lowering the price.

3. These losses cause firms to leave the industry...

MC

ATC

S

D’

P’

D

PRICE PRICE

FIRM QUANTITY MARKET QUANTITY

Typical Firm Market

SHORT RUN

P

09_08B

5. The lower price eventually brings profits back to zero in the long-run equilibrium.

4. causing supply to decline and the price to rise.

D’ D

S’S

MC

ATC

PRICE PRICE

FIRM QUANTITY MARKET QUANTITY

MarketTypical Firm

LONG RUN

P

•

Another nice feature of competitive markets

• Since profits are zero in long run equilibrium, P = ATC

• Thus, in long run industry equilibrium ATC is at a minimum

• In other words, cost per unit is a low as you can go

What if there is a shift in costs?

Shift down both the ATC and the MC curves

Watch what happens

External Economies of Scale

• When a whole industry expands, the firms’ costs may shift down even though the scale at each firm does not expand

• Contrast with (internal) economies of scale at a single firm

To illustrate external economies of scale shift both the demand

curve and the cost curves. Let’s look at a hand sketch again:

Look more carefully at market supply and demand

09_11

PRICE

S1

S2

S3

D1 D2 D3

QUANTITY

Market

Short-run industry supply curves

Long-run industry supply curve

Can also have external diseconomies of scale

09_10

PRICE

S1S2

S3

QUANTITY

Market

D1D2

D3

Long-run industry supply curve

Short-run industry supply curves