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Keith Siilats R11

5. Explain how long-run equilibrium under perfect competition depends of the free entry and exit of the firms.


Perfect competition is an economic model which assumes that consumers aim to maximize satisfaction, producers aim to maximize profits, all firms sell a homogeneous product, there is a perfect knowledge and multiplicity of buyers and sellers in the market and all the factors of production are perfectly mobile, so there is free entry to and exit from all markets. Researches have shown, that in the case of perfect competition the long-run equilibrium is situated where firm's average revenue(AR) equals average cost(AC), marginal cost(MC) and marginal revenue(MR). So there are no losses or abnormal profits made, all the firms earn normal profit.

In this essay I am going to discuss over this equilibrium related to last assumption above - the free exit and entry of the firms.

As there is a multiplicity of buyers, so none of them can change the market price. They must accept it and can sell as much as they want with that price. So the demand curve(Dd.) for individual firm is horizontal. From that we can assume, that MR is horizontal as well, because it is in that case the same as Dd. And as MR does not change with output, TR is quantity times MR. AR is TR divided by quantity, so from previous equation MR times quantity divided by quantity equals AR, so MR=AR=Dd. It is most profit maximizing to produce where MR=MC as the firm can earn exactly its normal profits on the last unit and it would lose money with its next unit. I assumed that the firm produces at the output where AR=MR=AC=MC. MC cuts the AC curve at its lowest point and AC curve is U-shaped because of the diminishing returns of scale. All this data is shown in the graph below:


The firm produces where MC=MR so at output q and price p.

But it can also happen that the price of the factors of production drops or any other thing occurs, which would lead to the decrease in AC. The short run equilibrium for firm will then look like this:


Now the firm's AR>AC, so the firm is making extra profit, called abnormal profit. The following is to prove that this could not happen in long - run.

As there is a perfect knowledge in markets all the firms will now that immediately. In real life they could not find it out and even when they could in most cases they could not use it, because it would be too expensive to change the industry. But now there is a perfect mobility of factors, so the firms in other industries will change their industry to this profitable one. Because they have varied their capital, this is no more short - run, but already long - run. When other firms enter the industry then to things happen:

a.The supply increases

b.The price of factors of production is bid up (because new firms might offer the suppliers more money).

It is argued how exactly do the cost curves behave, I think, that as MC and AC are related to each other, MC curve must change as well. Usually other firms bid up the price of raw - material etc. which are variable costs, when variable cost increase, the AC graph will move exactly upwards and as MC must cut it in its lower point, it must increase as well. Below is graphically showed the new equilibrium to industry and to one particular firm:


New firms enter the industry until no abnormal profits are made, because there is no reason to enter afterwards.

Exactly the same thing as above happens when the demand increases due to increase in incomes etc.


The existing firms make again abnormal profits and new firms will enter the industry until only normal profits are made.

It may also happen that the conditions of demand or supply move against the firms' interest (increase in the cost of production or the price of complements etc.). When it happens the firm will start making abnormal losses. It is shown in the graph below:


Now again if it would happen in some other market with no perfect mobility of factors the firms could not change the industry and  must bear those losses. The firms can leave the industry always in perfect competition markets. It is not always the case, because AC curve consists of average variable costs(AVC) and average fixed costs(AFC). Now if the firm would produce 0 units, it still has to pay its fixed costs. As long as the price is above AVC the profit is less when producing, than it is when finishing the production. So the firms will continue producing, usually decreasing their maintenance costs for fixed factors until one of them (or the most expensive) needs replacing and leave the industry then. They could also hope that other firms will leave the industry, decreasing the supply curve and so increasing the price.

When the price drops below AVC firms will leave at once.

All this is described below:


As seen the long - run equilibrium depends on the perfect mobility of factors. In perfect competition it is always at the point AR=MR=AC=MC=Dd, where only normal profits are made.

In loss-making and especially in profit making circumstances without the perfect mobility the situation could last for ever. In reality it usually does not in loss making situation, because it is always possible to stop production. But in profit making situation the perfect mobility is very important. If there would be no perfect mobility (e.g., in monopoly) the abnormal profits will last forever. That is why firms aim to monopoly to earn as much abnormal profits as possible.

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