• 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.