Long-run refers to a period long enough to change the size of the plant, the number of machines or even the techniques of production so as to increase the production capacity in response to a change in demand.
If the demand for a product increases, new firms can enter the industry (raising its size) or the existing firms can increase the scale of production (raising their sizes) to adjust output completely to changes in demand and price.
On the contrary, the firms can contract output by reducing their capital equipment through sales or otherwise, in the long run. Moreover, the firms can leave the industry in the long-run. In fact, all the resources can be varied in the long-run making entire total costs variable. Firms attain long-run equilibrium, when they produce profit maximising output by using long-run cost functions.
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We have explained in the previous section that the firms in short-run equilibrium may enjoy profits or suffer losses or these may be just breaking even. When the firms break-even, there is no incentive for new potential firms to enter the industry, neither will there be any inducement for the existing firms to leave the industry.
However, when firms earn supernormal profits in the short-run (i.e., Price > SAC), new firms will be tempted to enter in the industry and compete with the already established firms by producing the same homogenous product. (The assumption of free entry guarantees that these new firms will also possess the same complete information as the old firms).
The existing or new firms will add their supplies to the already existing supply. The increased product supply will reduce the price of product. Further, the increased supply in the industry results in increase in demand for the scarce factors, which will bid up their prices. On account of the reduced price and increased cost, the profits will tend to be squeezed down toward zero, until no additional firms find it worth moving in.
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Consequently, the supply curve continues to shift to the right, till SS in Fig. 18.6, so that, its intersection with the demand curve DD determines a price for which price is equal to long-run average cost (LAC). Thus in the long-run, the supernormal profits are wiped out and only normal profit accrue to the firms (Fig. 10.6).
Similarly, when existing firms make losses (i.e., Price < SAC), some (inefficient) firms will be induced to leave the industry or reduce their supply. Some firms may even try to attract the efficient factors of production to reduce the cost.
Consequent fall in the industrial output will lead to a leftward shift of the supply curve, which will raise the price of the product. Cost may also fall due to decline in the demand for certain specialised factors of production. Firms will continue to leave the industry until the intersection of the demand curve with the supply curve determines a price for which losses (or profits) are reduced to zero. In other words, the firms remaining in the field enjoy only normal profits and cover only their costs of production (i.e., price = LAC).
Fig. 10.6: Long-Run Equilibrium of a Competitive Firm
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Thus, we observe that the free entry and free exit feature of the perfect competition eliminates excess profits or losses as the case may be, by driving down or up the market price through variation in the supply of the industry.
Ultimately, profits or losses disappear and the firms earn only normal profits, profits just sufficient to keep the entrepreneur in that business. These profits are included in the costs. That is why, firms continue to produce, despite the fact that they only cover their costs of production (i.e., no profit-no loss situation).
Fig. 10.6 shows how firms adjust to their long-run equilibrium position, when there are excess profits in the short run. (Similar explanation could be given if the firms suffer losses in the short- run, as discussed above).
According to this figure, a typical competitive firm makes excess profits in the short-run (shown by the shaded area), since, the prevailing market price (determined by the intersection of the aggregate demand (DD) and aggregate supply (SS) curves of industry) is greater than the average cost of the firm.
The firm under consideration is operating with the plant, whose cost is denoted by short-run average cost curve (SAC), which is tangent to the falling portion of the long-run average cost (LAC) curve. The excess profits will induce this firm to expand its output and move along its LAC curve to build new capacity.
The excess profits will also attract new firms to enter the industry. Consequent increased supply of the product (by the increased production of expanding old firms and by the newly established ones) will shift the supply curve rightward. This will lead to a fall in price (a downward shift in the firm’s demand curve) and an upward shift of the cost curves due to the increase in the prices of factors on account of expansion of the industry.
These changes will continue, until the firm is able to adjust its plant so as to produce at the minimum point of the LAC curve and earns only normal profits or breaks even. The U-shaped LAC curve will be tangent to a horizontal demand curve at its minimum point.
“The reason is that only if the unit costs were everywhere higher than price, every output would be unprofitable, and firms would leave the industry, thus shifting the curves toward tangency by raising price and possibly, lowering the cost curves as well.
Similarly, if the average cost curve were to intersect the demand curve, there would be some output at which profits could be earned and an influx of new firms would soon shift the cost and revenue curves sufficiently to wipe out these profits“.
The new supply curve in the figure is SS, while the new equilibrium price is OP. Long run equilibrium is established at point ‘E’, where price (P) is equal to long-run average cost (LAC) at the minimum point of the latter. With the equilibrium condition of the marginal analysis, the long- run equilibrium of the competitive firm requires that the long run marginal cost (LMC) should be equal to the price (P = AR = MR) and to the long run average cost (LAC). That is,
P = AR = MR = LMC = LAC
Now, since in the long run, the firm has adjusted its plant so as to produce at the minimum point of its LAC at the equilibrium, SMC is equal to LMC and SAC is equal to LAC. Thus, from the above equilibrium condition, we have the impressive set of equalities
P = AR = MR = LMC = SMC = LAC = SAC
With U-shaped costs curves, equality of marginal cost and average cost (in the short as well as long-run) in the above equilibrium condition implies that marginal cost curves (in the short-run and long-run, i.e., SMC and LMC) cut the common minimum point of short-run and long-run average cost curves (i.e., SAC and LAC).
This means that at the minimum point of the LAC, the corresponding short-run plant is worked at its optimal capacity, such that the minima of the LAC and SAC coincide. Thus, in the long-run, the firm produces at its most efficient level of output, where average costs are minimised.
It signifies that the firm is of optimum size and has no excess capacity (the corresponding price is called the reservation price, below which the firm will not sell its product.) Since such firm utilises the resources in the most efficient way, the consumers get the product at the least possible price.
Corresponding to long-run equilibrium, the equilibrium output is OQ. At this output level, the typical firms as well as all other firms in the industry make only zero economic profits. Therefore, there will be no tendency for new potential firms to enter the industry or for existing firms to leave the industry, i.e., industry is neither expanding nor contracting.
Hence, the whole industry is in equilibrium, when a price is reached at which all the firms are producing at the minimum points of their respective long-run average cost curves, earning only normal profits, thereby satisfying the equilibrium conditions
(i) MR = LMC (first order condition),
(ii) Price (AR) = LAC (second order condition)
It is important to note that all the competitive firms under the perfect competition may be producing at the minimum points of their respective LAC curves, yet they may have different equilibrium outputs in accordance with their efficiency levels and hence their sizes. A more efficient firm is expected to have a larger equilibrium output than a less inefficient one.