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Fig.XXI The Short and Logn Run Impact of a Demand Increase






profits. Because barriers to entry by new firms are absent under pure compeddon, these profits will attract entrants into the industry in the long run. As these firms enter, the industry supply curve shifts to the right firom Si to S2, as we saw in Secdon III. Industry output will therefore begin to expand above Q2 and the price will begin to fall below Pg.

At what point will this process terminate? If new entrants to the industry have the same (stable) average total cost curves as existing sellers, the price must eventually return to its original level Pj where long nm average total cost is at a minimum and profits equal zero. Otherwise entry by new firms will continue to be profitable. The output of indiridual firms will likewise retum to qj. Industry output, however, will have expanded from Qi to Q3 ; the entire increase in market output represents the contribudon of new firms. Therefore, prorided new firms face unchanged cost condidons, the long run supply curve is infinitely elasdc at a price equal to minimum long run average total cost ( ). Such a supply curve has been derived from Figure XXJ and is pictured in Figure XXII. Because in Figure XXII output can be expanded from Qi to Qs without a permanent increase in the price of P], the long run supply is perfecdy elastic at Pi Such an industry is termed a constant cost industr) and all problems in this secdon assume constant costs.

We can reverse the same process as follows. Suppose in Figure XX\ demand decreases fi-om Di to Dj. At the new price of Pg, price-taking firms are experiencing losses and will start to leave the industry. As these firms exit, the industry supply starts to decrease, thereby raising the price back toward ]. The whole process again terminates when price returns to the min-

imum of the long run average total cost ( ) Once there, profits are zero and firms no longer the incendve to leave the industry. Price returns to but now fewer firms make up the industry. Again dii is no permanent decrease in the price below Pi, so have a constant cost industry as in Figure XXII.

Nonetheless, you should also be acquaini with the supply curves generated from increasii industries and from decreasing cost industries. The: mer is pictured back in Figure XXIII and the latta Figure XXIV. Although we shall leave the derivauons these curves to intermediate price theory, you shoi note that the supply curve in the decreasing cost slopes downward. While such supply condidons yet to be conclusively sighted in the real world, the represent a theoredcal possibility which is often 1 fused with diminishing retums. Do not allow yoi to become confused. Diminishing returns mean the marginal cost (MC) of producdon in a single must rise as variable factors are added to fixed Decreasing cost condiUons mean the long run indi supply cur\e slopes downward.


The fact diat the relevant pordon of thej curve is the supply curve has an important impu don: Price-taking industries operate so as to minii the total cost of producing the industry or Reconsider Figure IX of Secdon III. Note diat in < librium the MC of producing the last unit is the : for all price-taking firms. This means that total > producing exactly Q widgets cannot be reduce increasing production at one firm and decreasmgl another. If it were possible to achieve the same ou

Q and still have a greater output of other goods, soci-etv would be inefficiendy producing inside its production possibilides curve. To see that equality of marginal costs among producing funis niimmizes total cost, we use our now familiar technique of showing the inferiority of alternatives. Suppose that two Hi ms have the following marginal cost schedules, and let firm A produce 7 units at a MC of $5 and let firm pioduce 11 units at the lower MC of $3.


6 $4

7 $5


g MC

$3 $4

Then we can get the same tolal output of 18 units from these two firms at a lesser total cost as follows. Let firm A decrease its producdon by 1 unit, causing its total cost to fall by the MC ofthe 7th unit. So. Now let firm increase its producdon by a unit, causing its total cost to rise by MC of the I2th unit, S4. The decrease in Firm As producdon isjust offset by the increase in Bs; so the total Q is constant at 18 units. But total cost has now decreased by $1 ($5 - $4). This illustrates the following crucial general principle: total cost of producing a given output is at a minimum when the MC of production is the ssime for all producing firms, S4 in this example. If the MC is not the same, we can have the same output at a smaller total cost or - what is the same thuig - we can have a larger output at the same total cost.

Since all price-taking firms face the same product price, P, and maximize profit by producing the output at which MC = P, it follows that in equilibrium MC is the same for all price-taking firms automatically. For

example, if the price of output is $4 in a competitive industry, the MC of the last unit is $4 in every firm. This means we cannot reshuffle producdon from high marginal cost firms to low cost ones as we did above. Thus, once again the self-interests of producers have led to the socially desirable goal of efficient resource use: The total cost of producing the industrys output is as small as possible. Perfect competition is in this respect efficient.


Although in everyday speech we take the term compeddon to mean head-on rivalry, such as aggressive price-cutdng, sales drives, advertising, design innovations, and other practices designed to take business away from other sellers, the term has a specialized -almost opposite - meaning in economics. Under pure competition all such business tacdcs are ruled out. Since products are perceived as identical, advertising and distinctive product designs would be futile. For example, corn is not advertised and no farmer suggests that his corn is any different from that of anyone else. Non-price forms of rivalry occur neither in agricultural nor in other compedtive markets. Moreover, under pure competition, sellers can trade any quantity they like at the going price. As such, they do not resort to price-cutting tactics in order to attract business away from others. We vdll consider rivalrous tacdcs in Section VII.


Firms may be organized in any number of ways: as single proprietorships, as partnerships, and as corporations. Of these three basic types by far the most

Fig.XXl (Repictured)










important is the modern corporation. Co oradons are legal entities that raise their initial operating funds from the sale of stock, i.e., certificates of ownership in the firm. "Whether such ownership will be valuable depends upon the net income stream which the corporation may generate from its fijture sales. In the event the firm does well, ownership will be valuable; but if it does poorly, ownership will not be worth much. If it fails altogether, ownership will be worth nothing. Nonetheless, stockholders have limited liability for the debts of their corporations; the most a stockholder can lose is the money put up to buy the stock in the first place. Thus, if a firm should go bankrupt, its assets will be sold off to repay its creditors and the stock in this case will become worthless. But once the assets are sold, the creditors will have no further

claim on the wealth of the stockholders.

Limited liabilit)- comes at a price, however: The 1 profits of stockholders are taxed at an extra ordinarily high rate. For example, suppose a corpora tion in which you have stock earns a dollar. Forty-six cents of that dollar will be taken by the federal gov ernment in 1 income taxes and another five or six cents by the state. Already the govemment has appropriated over half the profits. Moreover, youi remaining forty-nine cents are then subject to addi tional personal taxation. Should you find yourself in the 30% personal income tax bracket, the personal income tax will then take an additional fifteen cents Already two-kinds of the benefits of ownership have been expropriated without e\en counting the impac of propert}, local, and sales taxes. Although dema







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