Perfect Competition: Long-Run Adjustments

We have seen that perfectly competitive firms can earn economic profits, normal profits, or losses in the short run because their plant size is fixed, and they cannot exit the industry. We now turn our attention to the long run. In the long run, firms can adjust all factors, even to the point of leaving an industry. And if the industry looks attractive, other firms can enter it in the long run. Why are some industries (such as medical marijuana) thriving while others (such as photo developing) declining? The answer is tied to economic profits and losses.

Adjusting to Profits and Losses in the Short Run

If firms in the industry are earning short-run economic profits, new firms can be expected to enter the industry in the long run, or existing firms may increase the scale of their operations. Figure 9 illustrates one such possible adjustment path when the firms in an industry are earning short-run economic profits. To simplify the discussion, we will assume there are no economies of scale in the long run.

Long-Run Adjustment with Short-Run Economic Profits Panel A shows a market initially in equilibrium at point a. Industry supply and demand equal S₀ and D₀, and equilibrium price is P₀. This equilibrium leads to the short-run economic profits shown in the shaded area in panel Short-run economic profits lead other firms to enter the industry, thus raising industry output to Q_L in panel A, while forcing prices down to P_L. The output for individual firms declines as the industry moves to long-run equilibrium at point b. In the long run, firms in perfectly competitive markets can earn only normal profits, as shown by point b in panel B.

In panel A, the market is initially in equilibrium at point a, with industry supply and demand equal to S₀ and D₀, and equilibrium price equal to P₀. For the typical firm shown in panel B, this translates into a short-run equilibrium at point a. Notice that, at this price, the firm produces output exceeding the minimum point of the ATC curve. The shaded area represents economic profits.

These economic profits (sometimes called supernormal profits) will attract other firms into the industry. Remember that in a perfectly competitive market, entry and exit are easy in the long run; therefore, many firms decide to get in on the action when they see these profits. As a result, industry supply will shift to the right, to S₁, where equilibrium is at point b, resulting in a new long-run industry price of P_L. For each firm in the industry, output declines to q_L and is just tangent to the minimum point on the ATC curve. Thus, all firms are now earning normal profits and keeping their investors satisfied. There are no pressures at this point for more firms to enter or exit the industry.

Consider the opposite situation—that is, firms in an industry that are incurring economic losses. Figure 10 depicts such a scenario. In panel A, market supply and demand are S₀ and D₀, with equilibrium price at P₀. In panel B, firms suffer economic losses equal to the shaded area. These losses cause some firms to reevaluate their situations and some decide to leave the industry, thus shifting the industry supply curve to S₁ in panel A, generating a new equilibrium price of P_L. This new price is just tangent to the minimum point of the ATC curve in panel B, expanding output for those individual firms remaining in the industry. Firms in the industry are now earning normal profits, therefore the pressures to leave the industry dissipate.

Long-Run Adjustment with Short-Run Losses Panel A shows a market initially in equilibrium at point a. Industry supply and demand equal S₀ and D₀, and equilibrium price is P₀. This equilibrium leads to the short-run economic losses shown in the shaded area in panel B, thus inducing some firms to exit the industry. Industry output contracts to Q_L in panel A, raising prices to P_L and expanding output for the individual firms remaining in the industry, as the industry moves to long-run equilibrium at point b. Again, in the long run, firms in perfectly competitive markets will earn normal profits, as shown by point b in panel B.

Notice that in Figures 9 and 10, the final equilibrium in the long run is the point at which industry price is just tangent to the minimum point on the ATC curve. At this point, there are no net incentives for firms to enter or leave the industry.

If industry price rises above this point, the economic profits being earned will induce other firms to enter the industry; the opposite is true if price falls below this point. A simple way to remember this is with the elimination principle: In a competitive industry in the long run with easy entry and exit, profits are eliminated by firm entry, and losses are eliminated by firm exit.

Competition and the Public Interest

Competitive processes dominate modern life. You and your friends compete for grades, concert tickets, spouses, jobs, and many other benefits. Competitive markets are simply an extension of the competition inherent in daily life. Figure 11 illustrates the long-run equilibrium for a firm in a competitive market. Market price in the long run is P_LR; it is equal to the minimum point on both the short-run average total cost (SRATC) curve and the long-run average total cost (LRATC) curve. At point e, the following is true:

This equation illustrates why competitive markets are the standard (benchmark) by which all other market structures are evaluated. First, competitive markets exhibit productive efficiency. Products are produced and sold to consumers at their lowest possible opportunity cost. For consumers, this is an excellent situation: They pay no more than minimum production costs plus a profit sufficient to keep producers in business, and consumer surplus shown in panel A is maximized. When we look at monopoly firms in the next chapter, consumers do not get such a good deal.

Long-Run Equilibrium for the Perfectly Competitive Firm Market price in the long run is P_LR, corresponding to the minimum point on the SRATC and LRATC curves. At point e, P = MR = MC = SRATC_min = LRATC_min. This is why economists use perfectly competitive markets as the benchmark when comparing the performance of other market structures. With competition, consumers get just what they want because price reflects their desires, and they get these products at the lowest possible price (LRATC_min). Further, as panel A illustrates, the sum of consumer and producer surplus is maximized. Any reduction in output reduces the sum of consumer and producer surplus.

Can Businesses Survive in an Open-Source World?

Open-source software can be downloaded free, used free, and altered by anyone, provided that any changes made can also be freely used and altered by anyone else. Open-source systems such as Linux and Apache server software are used to run many of the Internet’s biggest sites. Other types of software, including word processing, spreadsheets, and photo manipulation programs, are now becoming open source. Digital formats allow the cost of downloading, using, and duplicating this software to approach zero. Making a profit selling open-source software, even with enhanced features, is therefore a difficult process.

But now there is a movement to open-source hardware: products and plans that are available free, which anyone can duplicate, alter if they wish, and sell. What happens when open-source software is followed by open-source hardware?

Cory Doctorow, in his novel Makers, imagines a world in which the “system makes it hard to sell anything above the marginal cost of goods unless you have a really innovative idea, which can’t stay innovative for long, so you need continuous invention and reinvention, too.” This sounds eerily similar to the battles going on today with smart phones, televisions, video games, eBooks, and other high-tech products. As soon as one company presents a game-changing product (think iPod, iPhone, and iPad), other firms work feverishly to clone it and competition pushes prices and margins down to lower levels. Imagine what would happen if these products were both hardware and software open source.

Makers presents a world in which two engineers make three-dimensional (3D) desktop printers that can produce any product consumers want from inexpensive “goop.” In Makers, the economy collapses, department stores vanish, and unemployment approaches depression levels of more than 20%. Coming up with a continuous stream of clever innovative ideas that initially make high short-run profits is the only way to stay ahead, because the transition to the long run happens so fast. Worse, people use their own 3D printers to duplicate products or designs for virtually nothing (just the cost of the goop).

James Leynse/Corbis

Technology of the kind we are seeing now has the possibility of driving markets to these kinds of levels at which marginal cost and profit margins are low. Many companies have thousands of employees that make products from toothbrushes to plasticware to nearly everything you see at dollar stores. If households had the capability to produce their own products from some inexpensive substance, many companies we know today would disappear. Cory Doctorow explores what happens when the printers can produce other printers and other open-source machines. Although Makers is science fiction, the prototypes of 3D printers available today suggest it is not so far-fetched.

Sources: Cory Doctorow, Makers (New York: Tom Doherty Associates), 2009; L. Gordon Crovitz, “Technology Is Stranger Than Fiction,” Wall Street Journal, November 23, 2009, p. A19; and Justin Lahart, “Taking an Open-Source Approach to Hardware,” Wall Street Journal, November 27, 2009, p. B8.

Second, competitive markets demonstrate allocative efficiency. The price that consumers pay for a given product is equal to marginal cost. Because price represents the value consumers place on a product, and marginal cost represents the opportunity cost to society to produce that product, when these two values are equal, the market is allocating the production of various goods according to consumer wants.

The flip side of these observations is that if a market falls out of equilibrium, the public interest will suffer. If, for instance, output falls below equilibrium, marginal cost will be less than price. Therefore, consumers place a higher value on that product than it is costing firms to produce. Society would be better off if more of the product were put on the market. Conversely, if output rises above the equilibrium level, marginal cost will exceed price. This excess output costs firms more to produce than the value placed on it by consumers. We would be better off if those resources were used to produce another commodity more highly valued by society.

Long-Run Industry Supply

Economies or diseconomies of scale determine the shape of the long-run average total cost (LRATC) curve for individual firms. A firm that enjoys significant economies of scale will see its LRATC curve slope down for a wide range of output. Firms facing diseconomies of scale will see their average costs rise as output rises. The nature of these economies and diseconomies of scale determines the size of the competitive firm.

Long-run industry supply is related to the degree to which increases and decreases in industry output influence the prices firms must pay for resources. For example, when all firms in an industry expand or new firms enter the market, this new demand for raw materials and labor may push up the price of some inputs. When this happens, it gives rise to an increasing cost industry in the long run.

Globalization and “The Box”

When we think of disruptive technologies that radically changed an entire market, we typically think of computers, the Internet, and cellular phones. Competitors must adapt to the change or wither away. One disruptive technology we take for granted today, but one that changed our world, is “the box”—the standardized shipping container. As Dirk Steenken reported, “Today 60% of the world’s deep-sea general cargo is transported in containers, whereas some routes, especially between economically strong and stable countries, are containerized up to 100%.”

Before containers, shipping costs added about 25% to the cost of some goods and represented over 10% of U.S. exports. The process was cumbersome; hundreds of longshoremen would remove boxes of all sizes, dimensions, and weight from a ship and load them individually onto trucks (or from trucks to a ship if they were going the other way). This process took a lot of time, was subject to damage and theft, and was costly and inconvenient for business.

Youssouf Cader

In 1955, Malcom McLean, a North Carolina trucking entrepreneur, got the idea to standardize shipping containers. He originally thought he would drive a truck right onto a ship, drop a trailer, and drive off. Realizing that the wheels would consume a lot of space, he soon settled on standard containers that would stack together, but would also load directly onto a truck trailer. Containers are 20 or 40 feet long, 8 feet wide, and 8 or 8½ feet tall. This standardization greatly reduced the costs of handling cargo. McLean bought a small shipping company, called it Sea-Land, and converted some ships to handle the containers. In 1956 he converted an oil tanker and shipped 58 containers from Newark, New Jersey, to Houston, Texas. It took roughly a decade of union bargaining and capital investment by firms for containers to catch on, but the rest is history.

Longshoremen and other port operators thought he was nuts, but as the idea took hold, the West Coast longshoremen went on strike to prevent the introduction of containers. They received some concessions, but containerization was inevitable. Containerization was so cost effective that it could not be stopped. It set in motion the long-run adjustments we see in competitive markets. Ports that didn’t adjust went out of business, and trucking firms that failed to add containers couldn’t compete. The same was true for oceanic shipping companies.

Much of what we call globalization today can be traced to “the box.” Firms producing products in foreign countries can fill a container, deliver it to a port, and send it directly to the customer or wholesaler in the United States. The efficiency, originally seen by McLean, was that the manufacturer and the customer would be the only ones to load and unload the container, keeping the product safer, more secure, and cutting huge chunks off the cost of shipping. Today, a 40-foot container with 32 tons of cargo shipped from China to the United States costs roughly $5,000 to ship, or 7 cents a pound! This efficient technology has facilitated the expansion of trade worldwide and increased the competitiveness of many industries.

Sources: Based on Tim Ferguson, “The Real Shipping News,” Wall Street Journal, April 12, 2006, p. D12, and on Mark Levinson, The Box (Princeton, NJ: Princeton University Press), 2006. Dirk Steenken et al., “Container Terminal Operation and Operations Research,” in Hans-Otto Gunther and Kap Hwan Kim, Container Terminals and Automated Transport Systems (New York: Springer), 2005, p. 4. Christian Caryl, “The Box Is King,” Newsweek International, April 10–17, 2006. Larry Rather, “Shipping Costs Start to Crimp Globalization,” New York Times, August 3, 2008, p. 10.

To illustrate, panel A of Figure 12 shows two sets of short-run supply and demand curves. Initially, demand and supply are D₀ and S₀, and equilibrium is at point a. Assume demand increases, shifting to D₁. In the short run, price and output will rise to point b. As we have seen earlier, economic profits will result and existing firms will expand or new firms will enter the industry, causing product supply to shift to S₁ in the long run. Note that at the new equilibrium (point c), prices are higher than at the initial equilibrium (point a). This is caused by the upward pressure on the prices of industry inputs, notably raw materials and labor that resulted from industry expansion. Industry output has expanded, but prices and costs are higher. This is an increasing cost industry.

Long-Run Industry Supply Curves Panel A shows an increasing cost industry. Demand and supply are initially D₀ and S₀, with equilibrium at point a. When demand increases, price and output rise in the short run to point b. As new firms enter the industry, they drive up the cost of resources. Supply increases in the long run to S₁ and the new equilibrium point c reflects these higher resource costs. In constant cost industries (panel B), firms can expand in the long run without economies or diseconomies, therefore costs remain constant in the long run. In decreasing cost industries (panel C), expansion leads to external economies and thus to a long-run equilibrium at point c, with lower prices and a higher output than before.

Alternatively, an industry might enjoy economies of scale as it expands, as suggested by panel C of Figure 12. In this case, price and output initially rise as the short-run equilibrium moves to point b. Eventually, however, this industry expansion leads to lower prices; perhaps suppliers enjoy economies of scale as this industry’s demand for their product increases. The semiconductor industry seems to fit this profile: As the demand for semiconductors has risen over the past few decades, their price has fallen dramatically. In the long run, therefore, a new equilibrium is established at point c, where prices are lower and output is higher than was initially the case. This illustrates what happens in a decreasing cost industry.

Finally, some industries seem to expand in the long run without significant change in average cost. These are known as constant cost industries and are shown in panel B in Figure 12. Some fast-food restaurants and retail stores, such as Wal-Mart, seem to be able to clone their operations from market to market without a noticeable rise in costs.

Summing Up

This chapter has focused on markets in which there is perfect competition—that is, in which industries contain many sellers and buyers, each so small that they ignore the others’ behavior and sell a homogeneous product. Sellers are assumed to maximize the profits they earn through the sale of their products, and buyers are assumed to maximize the satisfaction they receive from the products they buy. Further, we assume that buyers and sellers have all the information necessary for informed transactions, and that sellers can sell as much of their products as they want at market equilibrium prices.

These assumptions allow us to reach some clear conclusions about how firms operate in competitive markets. In the long run, firms will produce the efficient level of output at which LRATC is minimized, and profits are enough to keep capital in the industry. This output level is efficient because it gives consumers just the goods they want and provides these goods at the lowest possible opportunity costs. Competitive market efficiency represents the benchmark for comparing other market structures.

Competitive markets as we have described them might seem to have such restrictive assumptions that this model only applies to a few industries, such as agriculture, minerals, and lumber. Most businesses you deal with don’t look like the assumptions of these competitive markets. This is true, but most businesses you encounter, such as bars, restaurants, coffee shops, fast-food franchises, cleaners, grocery stores, and shoe and clothing stores, do share some of the characteristics of perfectly competitive markets such as earning normal profits over the long run. In the chapter after next, we examine those markets where consumers see products as differentiated and see how that industry’s behavior is different from a perfectly competitive market.

Because perfect competition is so clearly in the public interest and is the benchmark for comparing other market structures, we can ponder the answer to the following question: Do firms seek the competitive market structure? The answer is: Generally, no. Why? Recall the profit equation. In perfectly competitive markets, firms are price takers. They can achieve economic profits in the short run but find it almost impossible to have long-run economic profits. Most firms instead want to achieve long-run economic profits. To do so, they must have some ability to control price. In the next chapter, we will see what firms do to achieve this market power.