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4.3. Using the Long-run Equilibrium Model
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From the course by University of Illinois at Urbana-Champaign
Microeconomics Principles
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From the lesson
Competitive Output
Welcome to your sixth week! This module we continue our discussion of the firm by focusing on those firms working in a perfectly competitive (or competitive) environment.
Meet the Instructors
Dr. José J. Vázquez-CognetClinical Professor
Department of Economics
[music] Very well. So now, let's, let's do some examples of
the long-run equilibrium model to see if we can get used to kind of using this
model and, and following the logic, okay, before we went, move into our next
section. Again let's try the diagram here.
But if, if, if the diagram doesn't help, I'm going to also try to follow the logic
without using the diagrams. And this is a perfectly competitive
industry. Let's continue for the time being by
saying that we're still in the same example, barbecue sandwiches.
One diagram gives you the market situation.
One diagram gives you the typical firm in that market and there's a lot of firms
selling exactly the same thing, barbecue sandwiches.
There's no difference between the different barbecue sandwiches.
So, on the vertical axis for both diagrams, we're going to have the price.
There's a demand in that market for barbecue sandwiches, there's a supply for
the market for barbecue sandwiches, and the firm will take that price as given.
And it'll try to do the best they can with that price, they cannot change the price.
Now, let's assume now the firm will produce whatever that price meets the
marginal cost because the price is also the marginal revenue for the perfectly
competitive firm. So, this firm will produce right here.
Whether this firm makes profits or not depends of what are the cost per unit.
So, let's assume that for the time being, this firm selling barbecue sandwiches is
making 0 profits, right? So, price is equal to the average total
cost, in this particular case, so their profits are 0, there is no incentive for
companies to enter, there is no incentive for companies to go out.
So, that's the way this company is operating on long-run equilibrium.
Now, let's assume that the demand for barbecue sandwiches, for some reason,
right, the demand for barbecue sandwiches increases.
They say that perhaps the cost of producing barbecue sandwiches is low, I
mean, perhaps the one of the compliments of barbecue sandwiches is lower.
For whatever reasons, let's assume that demand for barbecue sandwiches go up.
What will happen in this, in this market? Well, let's follow the model.
So, that is the change on the market level.
The demand for barbecue sandwiches increases, that increases the price for
barbecue sandwiches, so now, every industry that actually sell barbecue
sandwiches can sell at a higher price. They will sell at this price.
And since the price is higher, they will be able to produce more, at least in the
short term. Now in the short term, they are also
making profit, because now they're charging a price that is larger than the
cost per unit. So, because of the increase in demand for
barbecue sandwiches in that area, now all the barbecue sandwiches places are
actually making some profits. Now, as companies can enter or companies
can expand, right, and that might take, you know, a year, two years, whatever time
it takes for people to raise money to enter the industry or whatever time it
takes for companies that are operating to get new businesses.
As, as companies have time, they will enter this market, because now there are
profits to be made. And they will continue to enter this
market until those profits are eliminated, right?
When those profits are eliminated again, we a re back at the same equilibrium that
we were before price, because price again, is, is driven down to the lowest point of
the average total cost curve. And then, we can analyze what happened,
right? So, what happens here is that we were at
Q1, really, at the market level. The demand went up to Q2, a lot of
companies started to enter in this market. They drove, they drove down the prices and
the profits at the firm level down to, down to 0.
But at the market level, we end up, since there's more demand, with more firms and
higher number of barbecue sandwiches, alright?
So, this is kind of a way of using the model for that but then you can explain
this intuitively. The, the demand for barbecue sandwiches in
the area increases and now those, those firms, those stores, are operating saw
that as a positive. Now, they, since they were having a line
at their door, they increase their price in order to gain those, those, those
additional revenue or to get rid of the line.
Now as they did that, they were able to make a lot more profits than before and
entrepreneurs, actually in the long term know that and they will try to enter this
industry and as they enter the industry, the barbecue sandwich industry, they will
take way those profits at, for a short term, those companies that they were
making. They will have to split those profits with
those companies. When all this process settles down, what
do you have compared to what you had before?
Well, you have each company making exactly the same profits which is 0, but we have a
lot more barbecue sandwich stores, in essence, that's what we have.
So, this is a kind of a good way of asking you to continue to do examples and you
should be able to learn how to use this model a lot better.
So, what my goals are in the next few, few minutes is to give you a couple of
questions in which you have to use the model to answer so you got used to, to
actually using the model. So, let's do a couple more samples so you
can use this model. Let's switch from barbecue sandwiches and
talk for something that is not so appetizing.
Let's talk out haircuts, right? So, suppose that a market for haircuts in
a community, could be your community, is perfectly competitive, and that the market
is initially in long-run equilibrium, alright?
So, that means long-run equilibrium means that companies are making 0 profits.
Now, at this point, a decrease in population decreases the demand for
haircuts. My question is, in the short-run, why
would we expect what happened to the price and to the output of the typical firm in
that market in the short-run? Now, in order to answer that question,
again, we can answer intuitively without the diagrams and we can answer with the
diagrams. Let's try to answer it intuitively first.
Today every haircut industry or every hair salon is making 0 profits.
Demand for haircuts go up because an increase in population, what's going to
happen in the short term? Well, in the short term, those hair salons
that were there are going to reap those profits, as for those, because there's a
line at the door for haircuts. So, they will probably increase the price
for the haircuts. And if they increase the price, they will
actually make more profits. Now, when other companies, or other
entrepreneurs see that there's profits to be made in the haircut industry, they will
actually try to take, try to take some of that action.
As that happens, as time progresses and it gives time to other entrepreneurs to enter
that industry, and establish new hair salons, they're going to eliminate the
profits of those hair salons that were there before, because they're going to
have to share some of those customers with the new ones.
So, I ask that, as long as there's profits to be made in the industry, people will
continue to open new hair salons. When that process stop, we have a lot more
hair salons, we have a lot more hair cuts, but hair, the hair cuts that are, the hair
salons that are there are making no profits anymore and the price is, again,
driven down to whatever it was when we started.
Let's look at how that looks in a diagram. This is the market here, and we have a
supply and the demand for haircuts. Now, the firm will take that price, the
typical firm will take that price from the market and they will try to do the best
thing they can with that. They will maximize profits.
They will produce a quantity of output where the marginal cost equals the price.
So, they will produce this much output. And we said that the initial point is a
situation in which there is no profits, so that means that whatever the price is, the
average total cost is the same. Price equals average total cost, so
there's no profits to be made in this industry, right?
Alright, now at that point, what happens? Now, we have a change.
The demand curve shifted to the right, that drives the price up.
Now, the companies who are in the industry are going to be able to increase the
price, to get rid of the line. And that means, that they will be able to
make some profits by increasing the quantity of haircuts that they sell at a
higher price, right? This difference between price and, and
average total cost. Now, the price is higher than the average
total cost, well, there's profits to be made here.
As that con, as that continues through time, other industries are going to try to
reap those profits so the supply curve would shift to the right as companies try
to get some of those profits from the, from the companies that were there
originally. That pro, process will continue until the
price is, again, driven down to the lowest point of the average total cost curve.
And at that point, we're back to the original equilibrium point.
But in the short term, the typical, the, the, the average firm will make more
units, will make more haircuts, charging a higher price.
But what's going to happen in the long term?
Well, in the long term, the price is driven down to the [unknown] point, and we
have more hair salons and more haircuts generally.
So this is the user model to answer something that we, that we can answer
intuitively, but on account of the model, allows you to see this in a more organized
way. And keep trying and there's more examples
in the quizzes and more examples in the discussion.
The more you use the model, the more you actually understand how to use it and
you'll see that eventually, you'll see that it's, it's not that difficult, it
looks a lot more difficult than what it really is.
We have one more thing to answer here and that is this question, actually two more
thing. One is why would anyone staying in, in the
industry, they are making 0 profits? And second, we have been assuming that
when the companies enter, the average total cost stay the same.
And that's a strong assumption, we're going to [unknown] that assumption in the
next section. [music] Produced by OCE Atlas Digital
Media at the University of Illinois, Urbana-Champaign.
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