Dr. Gary Stone, Winthrop University

Dr. Gary Stone, Winthrop University

The Adjustment of a Perfectly Competitive Firm from

Short-Run Equilibrium to Long-Run Equilibrium

(This analysis is based on a given level of market demand, D1, for the industry’s good.)

A perfectly competitive firm is a price-taker which means it charges the price determined by demand and supply in the overall industry or market. No firm acting alone can affect the market price. A shift in the market supply or demand curve, however, will affect the market price. If the market price changes, each firm in the perfectly competitive market will charge the new market price. A firm is in a position of short-run equilibrium (SRE) when it produces its optimal output where marginal revenue equals marginal cost (MR = MC). In its SRE position a firm can earn a positive total profit, a negative total profit, or break even. In its long-run equilibrium (LRE) position, a perfectly competitive firm must break even. The move from a SRE position to a LRE position is explained below.

Graph Set #1 The market price is P1 as determined by the intersection of the industry demand and supply curves at point A. A perfectly competitive firm (a PCF) will charge P1 for its product so its demand curve is horizontal at P1. We see in the graph for a PCF that the firm is earning positive total profit (T > $0) at price P1 because its average revenue curve is above its average total cost curve (AR > ATC) at Q1*, the firm’s optimal output where MR = MC at point A1.

Graph Set #2 The presence of positive total profit in this industry attracts other firms to the industry. As more and more firms enter, the market supply curve begins to shift to the right. The shift from S1 to S2 indicates such an increase in the market supply. The increase in the market supply drives down the market price to P2 at point B. The fall in the market price means the PCF’s demand curve shifts down to the new, lower price P2.

Note that at this lower price each firm reduces its output from Q1* to Q2* (at point B1) but still earns a positive total profit.

Graph Set #3 Since there still is positive total profit in the industry at price P2, more firms enter the industry. This expansion of the industry continues until the market price has fallen to a level where each perfectly competitive firm breaks even (T = $0). This happens when the market supply has shifted to S3 and created market price of P3 at point C. The PCF’s demand curve drops again to P3. Note that a PCF breaks even at its optimal output of Q3* (point C1). Since there now is no total profit in the industry, firms quit entering the industry. This is a position of long-run equilibrium for the industry and for each firm.

Questions:

1. Why does the market supply curve shift to the right?

2. What happens to each firm’s output level as the market price falls?

3. How can the industry output increase as the market price falls?

4. In its LRE position, the total profit of a PCF = $0. Is this firm earning a normal profit

in LRE?