Pure Competition: Long-Run Equilibrium

In the long run, firms can enter or exit a purely competitive market easily. Pure competition also assumes that firms and resources can be easily reallocated in response to demand. Hence, if economic profits are being made by the firms within the industry, then more firms will enter the market, thereby lowering the market price to the equilibrium price and quantity that allows only normal profits. If the firms are suffering losses, then some firms will leave the market, reducing the market supply, thereby increasing prices, which will allow the existing firms to earn a normal profit. The long-run market price equals the minimum average total cost (ATC) of producing the product. And since suppliers will produce until marginal cost = market price, the long-run equilibrium in a purely competitive market can be summarized thus:

Average Total Cost = Marginal Cost = Market Price

2 diagrams showing the effect of an increase in market demand for both the individual firm and for the industry as a whole, with market supply increasing and market prices moving back down to their former equilibrium.

A firm maximizes profit when it's marginal revenue (MR) equals its marginal cost (MC) equals the average total cost (ATC). For a competitive firm, MR equals the market price. When market demand increases, prices rise, causing the MR to exceed ATC, allowing the firms to earn an economic profit proportional to the increased demand. However, the increased profit will attract other firms in the industry, thereby increasing the supply, which will decrease prices, until the firms are, again, earning a normal profit.

An industry at equilibrium will earn 0 economic profits, but if the market demand increases from D1 to D2, then firms within the industry will be able to make economic profits, causing other firms to enter the industry, increasing supply from S1 to S2, causing lower prices until the economic profits are again reduced to 0.

2 diagrams showing the effect of a decline in market demand for both the individual firm and for the industry as a whole, with the consequence of market supply declining and market prices moving back up to their former equilibrium.

When market demand declines, MR declines below MC, which causes firms to suffer temporary losses, because they must lower their prices below their ATC, causing less efficient producers to exit the market. Consequently, the supply declines and market prices rise again, until MR = MC = ATC.

If market demand suddenly declines from D1 to D2, then firms in the industry will experience temporary losses, until a few less efficient firms exit the market, causing the supply to move from S1 to S2, thereby causing prices to rise until economic profits are again 0. Remember that when economic profits are 0, the owners of the firm are still making a normal profit.

For a constant-cost industry, the supply curve is completely elastic, because any change in the market demand will cause either an entry or an exit of firms until the price returns to the industry's lowest average total cost. A constant-cost industry can only exist if there are ample supplies of inputs required to produce the product that will satisfy the entire market; otherwise, increased demand for the product will increase demand for the inputs, which will raise the prices of both the inputs and the product.

For an increasing-cost industry, the long run supply curve slopes upward because average total costs increase as new firms enter the market. This occurs because there are limited quantities of inputs in relation to the market demand for the product. Therefore, input prices rise as demand increases, so a greater quantity will only be supplied if the market price for the product is higher, which is in contrast to the constant-cost industry, where the market price remains horizontal at any quantity. Most industries are an increasing-cost industry.

For a decreasing-cost industry, the long run supply curve is downward sloping, because the price of inputs declines with increasing quantity. This usually occurs when the inputs themselves are manufactured and benefit from economies of scale, where increased quantities decreases the average total cost of the inputs, and therefore, their prices. The best example of this type of industry is the computer industry, since an increase in demand for computers also increases the demand for components. However, since the fixed costs of producing computer components are substantial, the average total cost of manufacturing the components greatly declines with increasing quantity. Therefore, the price of personal computers declines as the quantity increases. Software is another example, since once the software is produced, the cost of making additional copies is minimal.

Productive And Allocative Efficiency Under Pure Competition

Productive efficiency requires that products be produced for the minimum cost. When productive efficiency is achieved, price equals minimum average total costs. Therefore, any firm that cannot produce at the minimum ATC will be forced to leave the industry. If a firm is more productive in producing a certain product, with average total costs lower than the industry average, then they can increase output continually until either other firms achieve similar efficiency or they are forced out. Hence, firms that use the best technology and methods will achieve the lowest average total costs, thereby providing the lowest possible price for the product.

Allocative efficiency requires that resources be apportioned among firms and industries so as to yield the best combination of products and services most desired by society. The greatest allocative efficiency has been achieved when there is no other combination of goods and services that would be more desired by society.

Allocative efficiency is achieved because suppliers supply the product at the lowest average total cost, which allows them to supply the product at a quantity desired by the consumers as reflected in the price that they are willing to pay. The lowest market prices that are achieved under a purely competitive market allow the greatest number of consumers to enjoy the product, and for those consumers that do enjoy the product, their consumer surplus is maximized.