Short-run vs. Long-run Equilibrium

Introduction

Key Concepts

Perfect Competition Overview

Perfect competition is a market structure characterized by numerous small firms, homogeneous products, free entry and exit, and perfect information. Firms in such markets are price takers, meaning they accept the market price determined by the intersection of industry supply and demand. The equilibrium in perfect competition can be analyzed in both the short run and the long run, each presenting different dynamics and outcomes.

Short-run Equilibrium

In the short run, firms operate under the assumption that at least one factor of production (typically capital) is fixed. This time frame allows firms to adjust some, but not all, production inputs to respond to changes in market conditions. The short-run equilibrium occurs where a firm's marginal cost (MC) equals its marginal revenue (MR), which, in perfect competition, is also the market price ($P$).

Key characteristics of short-run equilibrium include:

• Fixed Inputs: Firms cannot alter all production factors, limiting their ability to fully adjust to market changes.
• Profit Maximization: Firms aim to maximize profits where $MC = MR = P$.
• Possibility of Supernormal Profits: Firms may earn excess profits if the market price is above the average total cost (ATC).
• Potential for Losses: If the market price falls below the ATC but remains above the average variable cost (AVC), firms may continue operating in the short run despite losses.

Mathematically, short-run equilibrium can be represented as:

For example, suppose a firm has a fixed capital and faces a market price of $10 per unit. If the marginal cost of producing an additional unit is $10, the firm is in short-run equilibrium. If the price rises to $12, the firm can increase production to maximize profits, and vice versa if the price falls.

Long-run Equilibrium

In the long run, all factors of production are variable, allowing firms to adjust fully to changes in the market. The long-run equilibrium in perfect competition is achieved when firms earn zero economic profit, meaning that the price equals the minimum point of the average total cost curve ($P = ATC_{min}$). This adjustment process involves the entry and exit of firms in response to profit incentives.

Key characteristics of long-run equilibrium include:

• Variable Inputs: Firms can adjust all production factors, optimizing their scale of operations.
• Zero Economic Profit: $P = ATC_{min}$ ensures that firms are earning a normal profit, covering all opportunity costs.
• Efficiency: The market achieves both allocative and productive efficiency, maximizing societal welfare.
• No Incentive for Entry or Exit: Since firms earn zero economic profit, there is no motivation for new firms to enter or existing firms to exit the market.

Mathematically, long-run equilibrium is represented as:

For instance, if firms in a perfectly competitive market are earning supernormal profits in the short run, new firms will enter the market, increasing supply and driving down the price until only normal profits are achievable. Conversely, if firms are incurring losses, some will exit, reducing supply and increasing the price until the remaining firms break even.

Adjustments from Short-run to Long-run Equilibrium

The transition from short-run to long-run equilibrium involves adjustments in the number of firms and their scale of operations in response to profit signals:

1. Supernormal Profits: If existing firms are earning supernormal profits in the short run, new firms are incentivized to enter the market due to the absence of barriers. This increases market supply, reducing the price until profits are eliminated.
2. Losses: If firms are suffering losses, some will exit the market, decreasing supply and causing the price to rise until the remaining firms can cover their average total costs.

These adjustments ensure that in the long run, firms operate at the most efficient scale, producing at the minimum point of their ATC curves, and the industry supply aligns with consumer demand at the equilibrium price.

The Role of Economies of Scale

Economies of scale refer to the cost advantages that firms experience as their production increases, leading to a lower average cost per unit. In the long run, firms can achieve economies of scale by optimizing their production processes, investing in better technology, and expanding their operations. This often results in the downward-sloping portion of the long-run average cost (LRAC) curve.

However, economies of scale are limited and may give way to diseconomies of scale if firms become too large, leading to inefficiencies and increased average costs. In perfect competition, the LRAC curve is typically U-shaped, reflecting both economies and diseconomies of scale, and firms operate where the LRAC is minimized to ensure zero economic profit.

Graphical Analysis

Graphically, short-run and long-run equilibriums can be depicted using cost curves:

• Short-run Equilibrium: Illustrated where the MC curve intersects the MR (price) line. The ATC curve in the short run may not be at its minimum, indicating potential for adjustment.
• Long-run Equilibrium: Illustrated where the MC curve intersects the MR (price) line at the minimum point of the LRAC curve. This ensures firms are producing at the lowest possible cost.

These graphs help visualize how firms respond to changes in market conditions and adjust their production to achieve equilibrium over different time horizons.

Implications for Firms and Consumers

The distinctions between short-run and long-run equilibrium have significant implications:

• Firm Decisions: In the short run, firms may experience profits or losses and make decisions based on fixed factors. In the long run, firms adjust all inputs to achieve zero economic profit, ensuring sustainable operations.
• Market Supply: Entry and exit of firms in the long run ensure that market supply adjusts to meet consumer demand at a price level where firms break even.
• Consumer Welfare: Long-run equilibrium ensures allocative and productive efficiency, maximizing consumer surplus and overall welfare by producing the optimal quantity of goods at the lowest possible cost.

Understanding these dynamics is essential for analyzing real-world markets and predicting how firms and industries respond to economic changes over time.

Comparison Table

Summary and Key Takeaways