Slide 1Econ 410: Micro TheoryCompetitive Markets in the Long RunFriday, November 16th, 2007Slide 2Recall from last time… We’ve learned how firms maximize profit in the short run. By looking at how a group of firms maximize profit, we can create a short run supply curve. But, how do these decisions change as an industry transitions from the short to long run? How do firms choose output? Maximize profit? How does this affect supply?Slide 3Long Run Competitive Output Remembering what we’ve learned so far, what changes between the short run and long run? In the long run, a firm can alter all its inputs, including the size of the plant We assume free entry and free exit No legal restrictions or extra costs In the short run, the ATC curve can be low enough for the firm to make positive economic profits. Why does economic profit matter?Slide 4 However, in the long run, no firms in a competitive industry will make economic profit. Why? Firms enter the market seeking positive economic profits. Increased quantity shifts the market supply curve rightward. Price decreases until firms no longer have incentive to enter. What is true about a competitive market long run equilibrium?Long Run Competitive OutputSlide 5Long Run Competitive OutputS1OutputOutput$ per unit ofoutput$ per unit ofoutputLACLMCDS2$40 P1Q1Firm IndustryQ2P2q2$30Suppose firms are earning positive economic profits. What happens?Slide 6 Why would firms stay in a market where they’re earning zero economic profit? Zero economic profit implies that a firm is earning a normal return on its investment Doing as well as it could by investing its money elsewhere A normal return is the firm’s opportunity cost of using money to buy capital instead of investing elsewhere What should a firm’s decision rule be in the long run?Long Run Competitive OutputSlide 7Long Run Competitive Supply How does the long run supply curve differ from one in the short run? The shape of the long-run supply curve depends on the extent to which changes in industry output affect the prices firms must pay for inputs.  Long-run supply can be characterized by three industry types: Constant-Cost Increasing-Cost Decreasing-CostSlide 8Constant Cost Industries A constant cost industry is one whose long-run supply curve is horizontal Any changes in output will have no impacts on input costs –w and l remain constant To see this, assume a firm is initially in equilibrium Demand increases, causing price to increase Firms earn positive profits initially Supply increases, causing market price to decrease Economic profit always moves back to zero.Slide 9Constant Cost IndustriesACMCq1D1S1Q1P1D2P2P2q2S2Q2OutputOutput$$P1SLIncrease in demand increases market price and firm output.Positive profits cause market supply to increase and price to fall.In a constant-cost industry, long-run supply is a horizontal line at a price that is equal to the minimum average costof productionSlide 10Increasing Cost Industries In an increasing cost industry, the price of some or all of the inputs rise as Qincreases As before, if demand increases, prices and production will increase and firms entering the market will cause an increased demand for inputs But, unlike the previous case, costs of inputs will increase, causing an upward shift in the supply curve As a result, market supply increases by less than in the constant cost caseSlide 11Increasing Cost IndustriesOutput Output$$D1S1q1P1Q1P1SSLLSMC1LAC1SMC2LAC2P3S2P3Q3q2P2D2Q2P2Due to the increase in input prices, long-run equilibrium occurs at a higher price.Long Run Supply is upward SlopingSlide 12Decreasing Cost Industries A decreasing cost industry has a downward sloping long-run supply curve “Lauren, you’re ridiculous. How could supply be downward sloping?” Increase in size allows firms to take advantage of this to get inputs cheaper Increased production may lead to better efficiencies or quantity discounts Costs shift down and market price falls Not a common caseSlide 13Decreasing Cost IndustriesS2SLP3Q3P3SMC2LAC2Output Output$$P1D1S1P1Q1q1SMC1LAC1q2P2D2Q2P2Due to the decreasein input prices, long-runequilibrium occurs at a lower price.Long Run Supply is Downward SlopingSlide 15Sample Exam QuestionI. If the cost of producing each unit of output falls $5, then the short run market price falls $5.II. If the cost of producing each unit of output falls $5, then the long run market price falls $5.a) I and II are true.b) I is true, and II is false.c) I is false, and II is true.d) I and II are false.Slide 16For next time… We’ll begin using our knowledge of competitive markets to analyze policy Please read sections 8.7, 8.8, and 9.1 of your textbook. Reminders The optional paper assignment is due at the beginning of class on Monday Your problem set will be due the Monday after