Question

Perfect Competition In the lecture I defined the long run market supply as being determined by the quantity demanded at the break-even price. Including any necessary graphs, explain what I meant by and how an upward sloping (increasing cost industry) long run supply curve is generated.

Answer 1

Break even price is simply the price necessary to make a normal profit.Normal profit is a situation in which a firm earns revenue that is sufficient enough to cover the total costs incurred.That is at break even price a firm makes neither a loss nor a profit.In a perfect competition a firm is said to be in equlibrium in long run when the price is equal marginal cost and the average cost .Because if the price is greater than or less than the average cosat then the firms will have a tendency to enter or leave the industry.

If the price is greater than the average cost, the firms will earn supernormal profits (more than normal profit) which will attract new firms into the industry .The entry of new firms in the industry will cause  the price of the product to go down as a result of the increase in supply of output and also the cost to go up as a result of more intensive competition for factors of production. The firms will continue entering the industry until the price is equal to average cost so that all firms are earning only normal profits.Instead if the price is lower than the average cost, the firms would incur losses that  will induce some of the firms to leave the industry. As a result, the output of the industry will fall which will raise the price.On the other hand with the firms leaving the industry the cost may go down as a result of fall in the demand for factors of production. The firms will continue leaving the industry until the price is equal to average cost such that the firms remaining in the field are making only normal profits.

Hence it is said that in a perfect competition ,long run market supply is determined by the quantity demanded at the break even price.

In the above figure long run equilibrium is at the point S where the firms earns normal profit, at the break even price.

We know that, in the long run, firms enter the industry only when pure profit exists. Thus, pure profit is an incentive to join the industry. In Fig. 4.8(a) we have shown equilibrium of a firm before entry is made. Fig. 4.8(b) shows equilibrium of a newly entrant firm and Fig. 4.8(c) demonstrates long run industry equilibrium.

Let us assume that, initially, the competitive industry is in equilibrium at point ‘M’. The industry produces and sells OQ output at the price OP. As income increases, demand curve temporarily rises to D1D1 and short run equilibrium price rises to OP2.

Each firm now produces and sells OQ1 output at the price OP2 (panel a). Firms are now making abnormal profit (as shown in figure). This attracts new firms to join. In an increasing cost industry, as firms enter, demand for input rises, price of input rises, cost rises. This leads to an upward shift in the LMC and LAC curves as shown in panel (b). Costs will rise till excess profit vanishes.

At the new price OP3, the firm earns normal profit after producing OQ3 output. Further, entry of new firms in the industry leads to a rightward shift in the supply curve to S1S1. Finally, equilibrium is achieved at point W. The industry output is now OQ3 and equilibrium price is OP3. Now by joining these equilibrium points (‘M’ and ‘N’), we get an upward rising long run industry supply curve, labelled as LRS.