Market Equilibrium

CHECK STATION 2 The typical firm in a perfectly competitive market has a cost structure described by the equation

C 25 4Q Q2 ,

where Q is measured in thousands of units. Using the profit-maximizing condition,

P MC,write an equation for the firm’s supply curve. If 40 such firms serve the mar-

ket, write down the equation of the market supply curve.

LONG-RUN EQUILIBRIUM Perfectly competitive markets exhibit a third important condition: In the long run, firms can freely enter or exit the market. In light of this fact, it is important to recognize that the profit opportunity shown in Figure 7.3a is temporary. Here the typical firm is earning a positive economic profit that comes to ($8.00 $6.50)(6,000) $9,000. But the existence of positive economic profit will attract new suppliers into the industry, and as new firms enter and produce output, the current market price will be bid down. The competitive price will fall to the point where all economic profits are eliminated.

Figure 7.3b depicts the long-run equilibrium from the firm’s point of view. Here the firm faces a market price of $6 per unit, and it maximizes profit by producing 5,000 units over the time period. At this quantity, the firm’s marginal cost is equal to the market price. In fact, long-run equilibrium is characterized by a “sublime” set of equalities:

In equilibrium, we observe the paradox of profit-maximizing competition:

P MR LMC min LAC.

The simultaneous pursuit of maximum profit by competitive firms results in zero economic profits and minimum-cost production for all.5

In short, the typical firm produces at the point of minimum long-run average cost (LAC) but earns only a normal rate of return because P LAC.

Let’s shift from the typical firm’s point of view to that of the market as a whole. Figure 7.4 provides this marketwide perspective. The current equilibrium occurs at E, where the market price is $6 per unit (as in Figure 7.3b) and the industry’s total quantity of output is 200,000 units. This output is supplied by exactly 40 competitive firms, each producing 5,000 units (each firm’s point of

5Remember that a zero economic profit affords the firm a normal rate of return on its capital investment. This normal return already is included in its estimated cost.

Cost and Revenue per Unit

D D′

$8

P = $6

$4

0 100

minimum LAC). The market is in equilibrium. Industry demand exactly matches industry supply. All firms make zero economic profits; no firm has an incentive to alter its output. Furthermore, no firm has an incentive to enter or exit the industry.

Supply curve before entry

E′

E E* Supply curve after entry

FIGURE 7.4

Competitive Price and Output in the Long Run

An increase in demand from D to D has two effects. In the short run, the outcome is E ; in the long run (after entry by new firms), the outcome is E*.

D D′

280240200 Output (Thousands of Units)

In the perfectly competitive market described in Check Station 2, what is the equilibrium price in the long run? (Hint: Find the typical firm’s point of minimum average cost

by setting AC MC.) Find the output level of the typical firm. Let industry demand be given by the equation QD 320 20P. Find total output in the long run. How many

firms can the market support?

Now consider the effect of a permanent increase in market demand. This is shown as a rightward shift of the demand curve (from DD to D D ) in Figure 7.4. The first effect of the demand shift is to move the market equilibrium from E to E . At the new equilibrium, the market price has risen from $6 to $8 and

CHECK STATION 3

CHECK STATION 4

industry output has increased to 240,000 units. The higher level of output is supplied by the 40 incumbent firms, each having increased its production to 6,000 units. (According to Figure 7.3a, this is precisely the firm’s profitmaximizing response to the $8 price.) The equilibrium at E is determined by the intersection of the new demand curve and the total supply curve of the 40 firms currently in the industry. This supply curve also is shown in Figure 7.4 and is constructed by summing horizontally the individual firms’ supply curves (i.e., marginal cost curves) in Figure 7.3. (Check Station 4 will ask you to derive the market equilibrium by equating demand and shortrun supply.)

The shift in demand calls forth an immediate supply response (and a move from E to E ). But this is not the end of the story. Because the firms currently in the market are enjoying excess profits, new firms will be attracted into the industry. Price will be bid down below $8 and will continue to be bid down as long as excess profits exist. In Figure 7.4, the new long-run equilibrium result is at E*. Price is bid down to $6 per unit, its original level. At this price, total market demand is 280,000 units, a 40 percent increase above the 200,000 units sold at equilibrium E. In turn, industry supply increases to match this higher level of demand. How is this output supplied? With the price at $6 once again, each firm produces 5,000 units. Therefore, the total output of 280,000 units is supplied by 280,000/5,000 56 firms; that is, 16 new firms enter the industry (in addition to the original 40 firms). In the long run, the 40 percent increase in demand has called forth a 40 percent increase in the number of firms. There is no change in the industry’s unit cost or price; both remain at $6 per unit.

Starting from the long-run equilibrium in Check Station 3, suppose market demand

increases to QD 400 20P. Find the equilibrium price in the short run (before new

firms enter). (Hint: Set the new demand curve equal to the supply curve derived in Check Station 2.) Check that the typical firm makes a positive economic profit. In the long run— after entry—what is the equilibrium price? How many firms will serve the market?

LONG-RUN MARKET SUPPLY The horizontal line in Figure 7.4 represents the case of a constant-cost industry. For such an industry, the long-run market supply curve is a horizontal line at a level equal to the minimum LAC of production. Recall that any long-run additions to supply are furnished by the entry of new firms. Furthermore, in a constant-cost industry, the inputs needed to produce the increased industry output can be obtained without bidding up their prices. This is the case if the industry in question draws its resources from large, well-developed input markets. (If the industry is a “small player” in these input markets, an increase in its demand will have a negligible effect on the inputs’ market prices.) For instance, the market for new housing exhibits a nearly horizontal long-run supply curve. In the long run, the industry’s two main inputs—

building materials and construction labor—are relatively abundant and provided by nationwide markets.6

For an increasing-cost industry, output expansion causes increases in the price of key inputs, thus raising minimum average costs. Here the industry relies on inputs in limited supply: land, skilled labor, and sophisticated capital equipment. For instance, if U.S. drilling activity increased by 30 percent (perhaps due to increases in world oil prices), the typical oil company’s average cost per barrel of oil could be expected to rise, for a number of reasons. First, the increase in drilling would bid up the price of drilling rigs and sophisticated seismic equipment. Second, skilled labor (such as chemical engineering graduates), being in greater demand, would receive higher wages. Third, because the most promising sites are limited, oil companies would resort to drilling marginal sites, yielding less oil on average. For an increasing-cost industry, the result of such increases in average costs is an upward-sloping long-run supply curve.

MARKET EFFICIENCY

You might be familiar with one of the most famous statements in economics— Adam Smith’s notion of an “invisible hand”:

Every individual endeavors to employ his capital so that its produce may be of greatest value. He generally neither intends to promote the public interest, nor knows how much he is promoting it. He intends only his own security, only his gain. And he is in this led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of society more effectively than when he really intends to promote it.7

One of the main accomplishments of modern economics has been to examine carefully the circumstances in which the profit incentive, as mediated by competitive markets, promotes social welfare.8 Although economists are fond of proving theorems on this subject, the present approach is more pragmatic. Our aim is to examine the following proposition: Competitive markets provide efficient amounts of goods and services at minimum cost to the consumers who are most willing (and able) to pay for them. This statement is one expression of the notion of market efficiency. Of

6Here it is important to distinguish between long-run and short-run supply. In the short run, an increased local demand for new housing can bid up the wages of construction labor (and, to some extent, materials) until additional workers are attracted into the market. In addition, if available land is limited in rapidly growing metropolitan areas, its price may increase significantly. 7Adam Smith, The Wealth of Nations (1776). 8The study of the relationship between private markets and public welfare is referred to as welfare economics.