The Partial Equilibrium Competitive Model

Chapter 15
THE PARTIAL EQUILIBRIUM

COMPETITIVE MODEL
MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS
EIGHTH EDITION
WALTER NICHOLSON
Copyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved.
CONTENTS
• Partial Equilibrium Analysis
• Timing of the Supply Response
• Pricing in the Very Short Run
• Short-Run Price Determination
• Shifts in Supply and Demand Curves
• Mathematical Model of Supply and Demand
• Long-Run Analysis
• Shape of the Long-Run Supply Curve
• Comparative Statics Analysis of Long-Run
Equilibrium- industry structure
• Producer Surplus in the Long Run
Timing of the Supply Response
• In the analysis of competitive pricing, the
time period under consideration is important
– very short run
• no supply response (quantity supplied is fixed)
– short run
• existing firms can alter their quantity supplied, but no
new firms can enter the industry
– long run
• new firms may enter an industry
Long-Run Analysis
• In the long run, a firm may adapt all of its
inputs to fit market conditions
– profit-maximization for a price-taking firm
implies that P is equal to long-run MC
• Firms can also enter and exit an industry
in the long run
– perfect competition assumes that there are
no special costs of entering or exiting an
industry
Long-Run Analysis
• New firms will be lured into any market
for which economic profits are greater
than zero
– entry of firms will cause the short-run market
supply curve to shift outward
– market price and profits will fall
– the process will continue until economic
profits are zero
Long-Run Analysis
• Existing firms will leave any industry for
which economic profits are negative
– exit of firms will cause the short-run market
supply curve to shift inward
– market price will rise and losses will fall
– the process will continue until economic
profits are zero
Long-Run Competitive
Equilibrium
• A perfectly competitive industry is in
long-run equilibrium if there are no
incentives for profit-maximizing firms to
enter or to leave the industry
– this will occur when the number of firms is
such that P = MC = AC and each firm
operates at minimum AC
Long-Run Competitive
Equilibrium
• We will assume that all firms in an
industry have identical cost curves
– no firm controls any special resources or
technology
• The equilibrium long-run position
requires that each firm earn zero
economic profit
Long-Run Equilibrium:
Constant-Cost Case
• Assume that the entry of new firms in an
industry has no effect on the cost of
inputs
– no matter how many firms enter or leave
an industry, a firm’s cost curves will remain
unchanged
• This is referred to as a constant-cost
industry
Constant-Cost Case
This is a long-run equilibrium for this industry
P = MC = AC
SMC MC
S
AC
P1
D
q1 Quantity Q1 Quantity
A Typical Firm Total Market
Constant-Cost Case
Suppose that market demand rises to D’
Market price rises to P2
SMC MC
S
AC
P2
P1
D’
D
q1 Quantity Q1 Q2 Quantity
Constant-Cost Case
In the short run, each firm increases output to q2
Economic profit > 0
SMC MC
S
AC
P2
P1
D’
D
q1 q2 Quantity Q1 Q2 Quantity
Constant-Cost Case
In the long run, new firms will enter the industry
Economic profit will return to 0
SMC MC
S
S’
AC
P1
D’
D
Constant-Cost Case
The long-run supply curve will be a horizontal line
(infinitely elastic) at P1
SMC MC
S
S’
AC
P1 LS
D’
D
Shape of the Long-Run
Supply Curve
• The zero-profit condition is the factor that
determines the shape of the long-run cost
curve
– if average costs are constant as firms enter,
long-run supply will be horizontal
– if average costs rise as firms enter, long-run
supply will have an upward slope
– if average costs fall as firms enter, long-run
supply will be negatively sloped
Increasing-Cost Case
• The entry of new firms may cause the
average costs of all firms to rise
– prices of scarce inputs may rise
– new firms may impose “external” costs on
existing firms
– new firms may increase the demand for
tax-financed services
Suppose that we are in long-run equilibrium in this industry
P = MC = AC
SMC MC
S
AC
P1
D
A Typical Firm (before entry) Total Market
Market price rises to P2 and firms increase output to q2
SMC MC
S
AC
P2
P1
D’
D
Positive profits attract new firms and supply shifts out
Entry of firms causes costs for each firm to rise
SMC’ MC’
S
S’
AC’
P3
P1
D’
D
A Typical Firm (after entry) Total Market
The long-run supply curve will be upward-sloping
SMC’ MC’
S
S’
AC’
LS
P3
P1
D’
D
A Typical Firm (after entry) Total Market
Decreasing-Cost Case
• The entry of new firms may cause the
average costs of all firms to fall
– new firms may attract a larger pool of
trained labor
– entry of new firms may provide a “critical
mass” of industrialization
• permits the development of more efficient
transportation and communications networks
Suppose that we are in long-run equilibrium in this industry
P = MC = AC
SMC MC
S
AC
P1
D
Market price rises to P2 and firms increase output to q2
SMC MC
S
AC
P2
P1
D’
D
Positive profits attract new firms and supply shifts out
Entry of firms causes costs for each firm to fall
SMC’ S
MC’
S’
AC’
P1
P3 D’
D
The long-run industry supply curve will be downward-sloping
SMC’ S
MC’
S’
AC’
P1
P3
D D’ LS
Classification of Long-Run
Supply Curves
• Constant Cost
– entry does not affect input costs
– the long-run supply curve is horizontal at
the long-run equilibrium price
• Increasing Cost
– entry increases inputs costs
– the long-run supply curve is positively
sloped
Classification of Long-Run
Supply Curves
• Decreasing Cost
– Entry reduces input costs
– the long-run supply curve is negatively
sloped
Long-Run Elasticity of Supply
• The long-run elasticity of supply (eLS,P)
records the proportionate change in long-
run industry output to a proportionate
change in price
% change in Q QLS P
eLS ,P   
% change in P P QLS
• eLS,P can be positive or negative

– the sign depends on whether the industry
exhibits increasing or decreasing costs

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Chapter 15

THE PARTIAL EQUILIBRIUM

• eLS,P can be positive or negative

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