Profits in Long Run Pure Competition

In the long run, producers are able to alter their scale of plant. TheLRAC or envelope curve was constructed from a series of short runperiods with different plant sizes. In the long run the firm is essentiallyable to select the scale of plant (or a specific set short run productionand cost functions associated with a specific fixed (in the short run)input). The is essentially the meaning of “relative ease of exit andentry from the market.

Another crucial aspect of long run pure competition is that the demandfaced by the firm is perfectly elastic at the market price. The AR andMR functions coincide with the firm’s demand function. Because thefirm’s demand function is perfectly elastic, they cannot raise their priceabove the market price. If they do, their sales will fall to 0. There is noreason to lower their price below the market price because they cansell all they want to a the market price. The firms in pure competitionhave no “ market power. ”

Market power, in microeconomics, refers tothe ability of an agent to raise the price and not have their sales fall to0. A quick review of price elasticity suggests that market power isinfluenced by a firm’s demand function. Purely competitive firms areprice takers. These firms have no incentive to advertise. The largestproducer in a purely competitive market can sell all they can produceor none at all and the market price will be unaltered.

The process of long run equilibrium in pure competition can be shown inFigure. Both the market and an individual firm’s demand and cost (supply)functions are shown in Figure. The market demand an supply functions (in Panel A) are initially DM and SM.Given thess demand and supply functions, the market equilibrium is at point EM resultingin an equilibrium price (PEM) and quantity (QEM). When the market price is PEM, the firmreacts to that price (The firm is a price taker.). If the firm’s objective is to maximizeprofits, it will operate at the point where MR = MC.

This equality of MR and MC occurs atpoint at Point B in panel B. Note that the short run MC will lie to the right of the LRMC atthis point, so short run output would be greater. The firm will select plant size SRAC2 sinceit will minimize the cost per unit at that output level (QB). This SRAC2 is not the mostefficient size plant (SRAC*). The AR is greater than the AC at this point. The firm can earn“ economic profits ” under these conditions. Remember “ normal profits ” are included inthe cost functions.Since entry is relatively free, other entrepreneurs will desire to capture some of theseeconomic profits and enter the industry. The supply function will increase (shift to theright) causing the equilibrium price to fall from PEM to P*. The equilibrium quantity in themarket rises but there are more firms. The firm represented in Panel B must adjust to thelower market price, P*.The new demand and revenue functions faced by the firm is D*,AR* and MR*.MR* = MC at point C. The firm reduces output to QC and adjusts plant size toSRAC*.

The firm now is operating where:

• the plant that has allows the lowest cost per unit (most efficient size plant),

• they operate that plant at the level of output that has the lowest cost per unit,

• they earn a normal profit,

• They are maximizing their profits given circumstances (They have no incentive to change output or plant size, they are in equilibrium.),

• The price is equal to the MC (This is the condition to optimize the welfare of the individuals in society given the income distribution.)

P_x

MC

LAC

Е

P* d d

0 q* Q_x

At the point of long run equilibrium in Figure VII.6 at point C, the following conditions will exist:

• AR = AC; Firms earn a normal profit. There is no incentive for firms to enter or leave the market.

• LRMC = LRAC; the firm is operating with the plant size that results in the lowest cost per unit, i.e. the fewest resources per unit of output are used.

• MR =LRMC; the firm has no incentive to alter output or plant size.

• P = MR =MC; the price reflects the marginal value of the good to the buyers and the marginal cost to the producer/seller.

Long run equilibrium in pure competition results in an optimal allocation of resources. The price reflects the marginal benefits of the buyers and the marginal cost of production. The user of the last unit of the good places a value (the price they are willing and able to pay) on the good equal to the cost of producing that unit of the good. Units of the good between 0 and the equilibrium quantity have a greater value than the cost of production.

The purely competitive model provides a benchmark or criteria to evaluate the performance of a market; MB = P = MC. The marginal benefit (MB) to the buyer is suggested by the price they are willing and able to pay. The MB to the seller is the marginal revenue (MR) they earn. The marginal cost (MC) reflects the opportunity cost to society.