Long Run Competitive Equilibrium

Let's go through some diagrammatic analysis to visualize it!

Figure 1 below shows how the entry of new firms in a perfectly competitive market in the short run eventually establishes the long-run competitive equilibrium.

Fig. 1 - Entry of new firms and the establishment of the long-run competitive equilibrium

Figure 1 above shows the entry of new firms and the establishment of the long-run competitive equilibrium. The graph on the left-hand side shows the individual firm view, whereas the graph on the right-hand side shows the market view.

Initially, the price in the market in the short run is P_SR, and the total quantity sold on the market is Q_SR. Firm A sees that at this price, it can enter the market as it evaluates that it can make supernormal profits, shown by the rectangle highlighted in green in the graph on the left-hand side.

Several other firms, similar to Firm A, decide to enter the market. This results in the market supply increasing from S_SR to S'. The new market price and quantity are correspondingly P' and Q'. At this price, some firms find that they cannot remain in the market as they are making losses. The loss area is represented by the red rectangle in the graph on the left-hand side.

The exit of firms from the market shifts the market supply from S' to S_LR. The established market price is now P_LR, and the total quantity sold on the market is Q_LR. At this new price, all individual firms earn only normal profits. There is no incentive for firms to enter or leave the market anymore, and this establishes the long-run competitive equilibrium.

Long-Run Competitive Equilibrium Price

What is the price that the firms charge in the long-run competitive equilibrium? When the long-run competitive equilibrium is established in a perfectly competitive market, there is no incentive for any new firms to enter the market or any existing firms to exit the market. Let's take a look at Figure 2 below.

Fig. 2 - Long run competitive equilibrium price

Figure 2 above shows the long-run competitive equilibrium price. In panel (b) on the right-hand side, the market price is located where the market supply intersects the market demand. As all firms are price takers, each individual firm is able to charge only this market price - not above nor below it. The long-run competitive equilibrium price is located at the intersection of the marginal revenue \((MR)\) and average total cost \((ATC)\) for an individual firm, as shown in panel (a) on the left-hand side of the graph.

The Long-Run Competitive Equilibrium Equation

What's the long-run competitive equilibrium equation? Let's find out together!

As the firms in long-run competitive equilibrium in perfect competition only make normal profits, then they are operating at the intersection of the marginal revenue \((MR)\) and average total cost \((ATC)\) curves. Let's take a look at Figure 3 below to evaluate further!

Fig. 3 - Long-run competitive equilibrium equation

As can be seen from Figure 3 above, a firm in a perfectly competitive market that is in long-run equilibrium operates at P_M, which is the price as dictated by the market. At this price, a firm can sell any quantity it wants to sell, but it cannot deviate from this price. Therefore the demand curve D_i is a horizontal line that passes through the market price P_M. Each additional unit sold yields the same amount of revenue, and therefore marginal revenue \((MR)\) is equal to average revenue \((AR)\) at this price level. Thus, the equation for the long-run competitive equilibrium in a perfectly competitive market is as follows:

\(MR=D_i=AR=P_M\)

Conditions of Long-Run Competitive Equilibrium

What conditions should hold for the long-run competitive equilibrium to persist? The answer is the same conditions that hold for a perfectly competitive market. These are as follows.

• Conditions of long-run competitive equilibrium:
  • A large number of buyers and sellers - there are infinitely many on both sides of the market
  • Identical products - firms produce homogeneous or undifferentiated products
  • No market power - firms and consumers are "price takers," so they have no impact on the market price
  • No barriers to entry or exit - there are no setup costs for sellers entering the market and no disposal costs upon exit

In addition, the equation for the long-run competitive equilibrium in a perfectly competitive market should hold.

\(MR=D_i=AR=P_M\)

Monopolistic Competition Long-Run Equilibrium

What does the long-run equilibrium look like in monopolistic competition?

Monopolistic competition long-run equilibrium occurs when such equilibrium is characterized by firms making normal profits. At the equilibrium point, no firm in the industry wants to leave, and no potential firm wants to enter the market. Let's take a look at Figure 4 below.

Fig. 4 - Monopolistic competition long-run equilibrium

Figure 4 above shows a long-run equilibrium in a monopolistically competitive market. A firm would operate by the profit-maximizing rule where \((MC=MR)\), which is shown by point 1 on the diagram. It reads off its price from the demand curve represented by point 2 in the graph above. The price that the firm charges in this scenario is \(P\) and the quantity it sells is \(Q\). Note that the price is equivalent to the average total cost \((ATC)\) of the firm. This indicates that only normal profits are being made. This is the long-run equilibrium, as there is no incentive for new firms to enter the market, as no supernormal profits are being made. Note the difference with the long-run competitive equilibrium in perfect competition: the demand curve is downward-sloping as the products sold are slightly differentiated.