28. Competition and Long Run Equilibrium
Essay:
- Describe the long run process by which the market system rids itself of economic profits or losses in the long run when firms produce identical (or nearly) identical products.
- Describe the long run process by which the market system rids itself of economic profits or losses in the long run when each firm produces a somewhat different product.
Entry
Entry is the term that describes another firm beginning to produce a product in competition with firms that were already producing the product. This could be a new firm or else a firm that was producing some other product. An industry is all the firms producing the same or similar products. Entry then, refers to a firm entering an industry.
Why would a firm enter an industry? A firm would enter an industry because it anticipates earning economic profits. Economic profits is revenues less total costs. Total cost include both explicit costs and implicit costs. Explicit costs are money expenditures. Implicit costs are the opportunity cost of owner-supplied inputs. For most firms that would be equity funding. So, to say a firm earns economic profits would be to say they that its business profits are greater than the opportunity cost of equity firms.
If many or most existing firms in an industry are earning persistent economic profits. Economists argue that firms will enter an industry to obtain some of the economic profits as well.
Exit
Exit is the term that describes a firm stopping its production of a particular product. It exits an industry. The firm could fail and go bankrupt. Or else the firm may stop producing the product and concentrate solely on one or more other products.
Why would a firm exit an industry? A firm would exit because it anticipates suffering economic losses. That would mean that it either suffers business losses or else its business profits fail to compensate the owners for the opportunity cost of their equity investment.
If many or most firms in an industry are suffering persistent economic losses. Economists argue that the weakest firms will exit the industry. They will get tired of suffering the losses. Eventually, firms suffering business losses will go bankrupt and close. But even if the problem is that business profits are too low to compensate the owners, eventually the owners will want to invest their funds elsewhere.
Long Run Perfect Competition
Long run perfect competition is a situation where firms can easily enter or exit an industry where all the firms produce a nearly identical product. For example, many farmers grow corn. All firms in the industry charge the “market price” for their product. Basic supply and demand analysis applies to this situation. Entry and exist impacts supply, the market price of the product, and the economic profits or losses of all the firms in the industry.
Suppose many or most of the firms in an industry are earning economic profits. Firms enter the industry. As new firms enter the industry, supply increases. The increase in supply leads to a lower price for the product. While the total output is higher, a larger number of firms each produce a smaller quantity. The lower price and the lower quantity per firm leads to lower economic profits. The process continues until there are no longer any economic profits, instead the business profits in the industry are just equal to the opportunity cost of the owners’ funds.
Suppose many or most firms in an industry are suffering economic losses. As firms exit the industry, the supply decreases. The decrease in supply leads to a higher price for the product. The total output falls, but a smaller of number of firms each produce a larger quantity. The higher price and the higher quantity per firm leads to smaller economic losses. The process continues until there are no longer any economic losses, instead the business profits in the industry are just equal to the opportunity cost of the owners’ funds.
Long Run Monopolistic Competition
Long run monopolistic competition is a situation where firms can easily enter or exist an industry where firms produce a variety of products that are close substitutes. For example, many restaurants sell fast food. The firms in the industry have a variety of products and charge a variety of prices. Basic supply and demand analysis applies poorly in this situation because there are a variety of prices and the quantity is tough to measure since there are many different goods really. (You can come up with a total number of bushels of corn, but adding whoppers, big macs, chicken fingers, and pan pizzas just gives you a bunch of stuff.) Entry and exit impact the demand for the firms’ products.
Suppose many or most of the firms in the industry are earning economic profits. Firms enter the industry. The demand for the products of all of the firms already in the industry decrease. They respond by lowering their prices. While the total output in the industry rises, there is a smaller amount of output for each different product. The lower prices and lower quantities for each product result in smaller economic profits for the firms. The process continues until there are no longer any economic profits and each firm just earns enough business profit to compensate for the opportunity cost of the owners’ funds.
Suppose many or most of the firms in the industry are suffering economic losses. Firms exist the industry. The demand for the products of all the remaining firms increase. They respond by raising their prices. While the total output in the industry falls, there is a larger amount of output of a smaller number of products. The higher prices and higher quantities of each product result in smaller economic losses. The process continues until there are no longer economic losses and each firm earns enough business profit to compensate for the opportunity cost of the owners’ funds.
Market Competition—The Big Picture
Considering the economy as a whole, the long run process by which firms enter industries with economic profits and exit industries with economic losses involves a tendency to equalize profits in all sectors of the economy. Firms exit from those sectors where there are economic losses and enter where there are economic profits. This tends to lower the losses and the profits leading to a situation where the returns to investors in various industries are equal. This is related to the concept of the opportunity cost of the owners’ funds. In any one industry, the opportunity cost of the owners’ funds is what they owners could earn if they had invested their funds in other industries.
When the firms exit and enter, they are also moving resources—inputs like labor and capital—from those parts of the economy where there are economic losses to those parts of the economy where there are economic profits. Firms that exit no longer purchase the resources, and firms that enter use more resources.
This is the process that Adam Smith described as the “invisible hand.” Suppose people demand more salsa and less ketchup. The higher demand for salsa leads to a higher price and economic profits for firms in the salsa industry. The lower demand for ketchup leads to lower ketchup prices and economic losses in the ketchup industry. Firms exit the ketchup industry and enter the salsa industry. The supply of salsa rises, the price of salsa falls, the quantity of salsa rises, and the salsa profits disappear. The supply of ketchup falls, the price of ketchup rises, the quantity of ketchup falls, and the ketchup losser disappear. The “carrot” of profits and the “stick” of losses causes even selfish business owners to respond to the change in the demand for salsa and ketchup by producing more salsa and less ketchup.
Later economists came to see that the cost of producing any one product is the opportunity cost of the resources used in producing that product. The opportunity cost is what buyers are willing to pay for the other goods that could have been produced instead.
In an industry with economic profits, buyers are willing to pay more for additional units of the good than they are willing to pay for the other goods that could be produced instead. More exactly, the goals or purposes they can achieve with additional units of that good are more important to them than the goals or purposes they could achieve with the other goods that could have been produced instead. Economists would use the term marginal utility. The marginal utility of the good where firms are earning economic profit is greater than the marginal utility of the other goods that could be produced instead.
In an industry with economic losses, buyers are willing to pay less for at least some of the good than they are willing to pay for the other goods that could be produced instead. More exactly, the goals or purposes they are achieving with that good are less important to them than the goals or purposes they could achieve with the other goods that could be produced instead. The marginal utility of the good where firms are suffering economic losses are less than the marginal utility of the other goods that could be produced instead.
When firms enter industries with economic profits and exist industries with economic losses they are moving resources away from the production of goods that help buyers achieve goals they consider less important and moving resources too the production of goods that help buyers achieve goals they consider more important.
Monopolistic Competition—The Big Picture
Over the years, economists have discovered many different ways in which the market system will fail to produce the goods and services that buyers want most. Some of those problems relate to monopolistic competition. In an industry with many different firms producing similar products, the condition of zero economic profits implies that there are many firms crowded into the industry so that each one just “breaks even.” (Business profits just compensate owners for the opportunity cost of funds.) As the firms are crowded into the industry, each firm produces less of its particular product. As a result, firms are less able to take advantage of increasing returns to scale and so end up with increasing long run average cost. As a result, buyers end up with higher prices than would be the situation if the many firms produced an identical product. Some economists have described this as a market failure. Other economists insist that if buyers all wanted identical products, firms would produce them and that monopolistic competition provides a desired variety of products.