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Long Run Competitive Equilibrium In An

Economy With Production


• Theoretically, in the long run firms can enter and exit the industry.
• A situation is a long run equilibrium if
• no firm in the industry wants to leave
• no potential firm wants to enter.
Assuming that the technology (and
hence cost functions) of every firm
are the same, and ignoring the
discrete change that may occur in the
firms' maximal profits when a firm
enters, the theory thus implies that
in a long run equilibrium every firm's
maximal profit is zero
or, equivalently,
price is equal to minimum average
cost.

The output at which LAC is minimal is the efficient


LAC - Long-Run Average Cost scale of production. LAC at the efficient scale of
LMC - Long-Run Marginal Cost production is thus the minimum average cost. In the
following figure, y* is the efficient scale of
production and p* is the minimum average cost.
• Given this terminology, another implicaton of the theory is:
every firm produces at the efficient scale of production.
• What determines the equilibrium number of firms? Given the
equilibrium price (minimum average cost), the aggregate demand
function Qd gives us the total amount Y* = Qd(p*) that must be
produced in equilibrium. We know how much each firm produces in
equilibrium (y*, the output equal to its efficient scale of production),
so if we divide Y* by this amount we obtain the equilibrium number
of firms.
Short-Run Equilibrium

• A short run competitive equilibrium is a


situation in which, given the firms in the
market, the price is such that that total
amount the firms wish to supply is
equal to the total amount the
consumers wish to demand.
• More precisely, a short run competitive
equilibrium consists of a price p and an
output yi for each firm i such that, given
the price p, the amount each firm i
wishes to supply is yi and the sum iyi of
all the firms outputs is equal to the total
amount Qd(p) demanded.
• Now suppose that there are n firms, all with the same cost function,
and hence the same short run supply function, say ys. Then a short
run competitive equilibrium is a price p and an output y for each firm
such that:

y = ys(p) and ny = Qd(p).


Efficiency Of Short-Run Equilibrium
• In a competitive equilibrium, price is equal to short run marginal cost,
so no firm can sell an extra unit at a price that covers its short run
marginal cost.
• Short run marginal cost is the market value of the variable inputs
needed to produce the extra unit of output, so in an equilibrium it is
not possible to sell another unit at a price that covers the market
value of the inputs needed to produce that unit.
• If the market value of the variable inputs needed to produce an extra
unit of output measures their social cost and the price at which a unit
can be sold measures the social value of the unit, then in an
equilibrium the socially optimal amount of the good is produced.
• A rough measure of the consumers'
gains from trade is the area under the
demand curve and above the price,
indicated by the light purple area in
the figure at the right. This area is
called the consumers' surplus. A
measure of the gain to the producers is
the difference between their revenue
and their variable cost (since fixed cost
is fixed!); this measure is called
the producers' surplus. The total
variable cost is the area under the
supply function (which is the marginal
cost function) up to the equilibrium
output; so the producers' surplus is
equal to the area between the supply
function and the price, indicated by
the pink area in the following figure.