Principles of EconomicsEC 201California State Polytechnic University, PomonaDr. BresnockFall, 2002ReCap for Purely Competitive FirmP = MB = MCPrinciples of EconomicsEC 201California State Polytechnic University, PomonaDr. BresnockFall, 2002Lecture 12 Long Run Price and Output Determination: Pure CompetitionRemember: Firms can alter all inputs, and can “enter” or “exit” the industryif “economic profits” or “economic losses” are present.Assume Initially:(1) “Entry” and “Exit” constitutes the long run adjustment to changingmarket circumstances.(2) Costs are identical for each firm. This is a simplifying assumption sothat we can regard the firm as a “representative firm” of all the otherpurely competitive firms.(3) Constant-cost industry is assumed for simplicity so that entry and exitwill not affect cost schedules of the individual firms nor resource prices.Long Run Equilibrium (Pure Competition)For the purely competitive firm, the long run equilibrium is found at the QwhereP = AR = MR = MC = min ATCThus, entry and exit drive “economic profits” and “economic losses” to zero inthe long run. In the long run, all purely competitive firms break even, or justearn “normal profits”.Graph 1 Long Run Equilibrium: Entry (Pure Competition) INDUSTRY FIRMEC 201 Lecture 12Fall, 2002 A. BresnockGraph 2 Long Run Equilibrium: Exit (Pure Competition) INDUSTRY FIRM Long Run Industry Supply (Pure Competition)(1) Constant Cost Case – entry and exit of firms does not affect: (a)resource prices, or (b) other production costs. Ex. manufacturingindustries.Graph 3 Constant Cost Industry 2EC 201 Lecture 12Fall, 2002 A. Bresnock3EC 201 Lecture 12Fall, 2002 A. Bresnock(2) Increasing Cost Case – entry and exit of firms causes: (a) resourceprices to rise when demand increases, and visa versa, and (b) otherproduction costs to rise when demand increases and visa versa. Ex.agriculture, forestry, extractive industries such as minerals, petroleum.Graph 4 Increasing Cost Industry (3) Decreasing Cost Case – entry and exit of firms causes: (a) resourceprices to fall when demand increases, and visa versa, and (b) otherproduction costs to fall when demand increases and visa versa. Ex. firmsexperiencing “economies of scale” in production as a result of volumediscounts in purchasing materials, volume shipping discounts, preferredinterest rates for borrowing, i.e. “prime rate”Graph 5 Decreasing Cost Industry 4EC 201 Lecture 12Fall, 2002 A. BresnockReCap for Purely Competitive Firm(1) Short-Run EquilibriumP = MR = AR = MC or P = MC(2) Long – Run EquilibriumP = MR = AR = MC = min ATC orP = MC = min ATCEvaluation of Competitive Pricing(1) Productive Efficiency is Achieved -- goods are produced at least-cost in the long run, or where P = min ATC.(2) Allocative Efficiency is Achieved -- goods are produced where P =MC. This allocation provides what consumers want most with theavailable resources. Recall from Ch. 2 that allocative efficiency meansthat theValue of the Last Unit = Value of Alternative GoodsSacrificed or or P = MB = MCwhere MB = marginal benefit and MC = marginal cost. Thus, P = MC isthe allocative efficiency criterion. Note that if…P > MC or MB > MC  Underallocation of Resources  Q so as to  Total Economic Profits P < MC or MB < MC  Overallocation of Resources  Q so as to  Total Economic Profits(3) Dynamic Adjustments -- the “invisible hand” of the competitivesystem leads consumers and producers toward efficiencies inconsumption and production so long as government plays a minimal rolein economic decision-making, “laissez faire”. Self-interest on the part ofboth consumers and producers directs the market as though an“invisible hand” is guiding it toward the best allocation decisions. Suchdirection occurs in a dynamic way, or over time.5EC 201 Lecture 12Fall, 2002 A. BresnockShortcomings of the Price System(1) Income Distribution -- the price system does not alter the status quodistribution of income (or wealth for that matter). If income is unequallydistributed in an economy, the price system will not change that.Whether this is a “shortcoming” or not remains a point of debate amongeconomists. (2) Market Failures: (a) Externalities and (b)Public Goods -- (a)sometimes demand does not fully reflect all of the benefits to societyfrom consumption of a good or service. In that case, positiveexternalities exist. Sometimes supply does not fully reflect all of thecosts to society from production of a good or service. In that case,negative externalities exist. (See your text pp. 86 – 87, and pp. 344 –351 for an expanded discussion of these types of externalities). (b)Finally, there are some circumstances when the market does not provideat all, or does not provide enough of some goods or services for avariety of reasons, i.e. the exclusion principles does not exist, significantpositive externalities exist. Each of these circumstances is explained inmore detail below. First, a no externalities case will be presented forcomparative purposes.(a) No Externalities -- all costs and benefits are private. No marketfailure. The market correctly allocates resources to their bestusage.PP = Private Optimum PriceQP = Private Optimum QuantityPP, QP = Private Optimum6EC 201 Lecture 12Fall, 2002 A. Bresnockwhere MCP = Marginal Private Costs = direct, unavoidable, easily quantified, accrue to producer MBP = Marginal Private Benefits = direct, easily quantified, accrue to purchaser Private Optimum = MCP = MBP7EC 201 Lecture 12Fall, 2002 A. Bresnock(b) Positive