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Long Run Production

what happens in the long run? There are three different possibilities: The firm could make a profit, make a loss, or break even. The first is called excess profit or supernormal profit, and the last is called normal profit. No firm can allow itself to make a long-run loss.

In the long run, a firm in a perfectly competitive market will make normal profits, i.e. break even. To see that, look at Figure 9.3. Since the firm makes a profit, this market will attract new firms. Moreover, since there are no barriers to entry, new firms will establish themselves as soon as possible; i.e. in the long run. As more and more producers establish themselves in the market, larger and larger quantities will and the market supply curve will shift to the right, from S1 towards S2. Consequently, the price will be pushed down, from p1* towards p2*.

For the individual firm, the decrease in the price means that it will reduce the quantity it produces, from q1* to q2*. Remember that the firm chooses to produce the quantity where MR (= p) = MC. This process, with new firms and reductions in prices, continues as long as there are any profits to be made in the market. When the price reaches p2*, and the firm produces the quantity q2*, we are exactly at the point where the MC curve intersects the ATC curve. In the
previous section, we showed that π = q*(MR - ATC), and a quick look at that expression gives that if MR = ATC then the profit must be zero, regardless of the quantity produced.

When the price has reached p2*, there are no longer any excess profits to be made in the market. No more firms establish themselves and the downward push on the price stops. The market is then in long-run equilibrium. Note that the individual firm reduces the quantity it produces, while the total quantity produced in the market increases. The reason for this is that enough many new firms establish themselves to counterweight the reduction in production for the individual firm.
In the short run, we can also have the opposite case: The individual firms can make short-run losses. That will cause some firms to leave the market in the long run and total supply decreases, which causes the equilibrium price to rise.
That process will continue until no firm makes a loss, and the end point of that process is the same as before: p2* and Q2*.

Many people find the result that firms in a perfectly competitive market make zero profits, hard to accept. Remember, however, that by a cost in this context we mean opportunity cost. Therefore, the revenues are as large as the opportunity costs. In the opportunity costs, we include what the firm loses by not investing in the best alternative. If the best alternative is a very good one, the situation here will also be good for the firm. Also, remember that, there are very few real-life examples of a perfectly competitive market, so it might be difficult to have a good intuition for this result.

The Long-Run Supply Curve

For the individual firm, the long-run supply curve is found in exactly the same way as the short-run, only with long-run marginal cost, LRMC, and average cost, LRAC, instead. The supply curve is, consequently, that part of LRMC that lies above LRAC. When it comes to the whole market’s long-run supply curve, the situation is much more complicated. Remember that, for the short run we found the market’s supply by summing up all existing firms’ supply curves. That was possible because in the short run the number of producers is constant. This is not the case in the long run. If the price changes, then, in the long run, the number of producers also changes. The market long-run supply curve instead depends on how the cost of production changes with the size of production for the whole market.

  • Constant production cost. If it is possible to establish new firms and they will have exactly the same cost of production as existing firms, then the industry has constant costs. If this is the case, the long-run supply curve will be a horizontal line. The reason for that is that, if the price would be higher at some quantity, new firms would establish themselves. Moreover, the cost for the new firms is the same as for the old firms, so this will push down the price to the marginal cost.
  • Increasing production cost. If it costs more and more to produce more units, the industry has increasing costs. To produce more, the firms have to increase the price per unit. The supply curve will therefore slope upwards (i.e. in the opposite direction of any of the supply curves in this book).
  • Decreasing production cost. In the opposite case, if it costs less and less to produce more units, the supply curve will slope downwards.

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