In the short run, the manager’s production decisions are limited because some of the inputs used by the firm are fixed for the short-run period of production. Typi- cally, the key input that a manager views as fixed in the short run is the amount of capital available to the firm in the form of plant or equipment. In the long run, all inputs are variable, and a manager can choose to employ any size plant—amount of capital—required to produce most efficiently the level of output that will maxi- mize profit. The choice of plant size is often referred to as the “scale of operation.”
The scale of operation may be fixed in the short run, but in the long run it can be altered as economic conditions warrant.
The long run can also be viewed as the planning stage, prior to a firm’s entry into an industry. In this stage the firm is trying to decide how large a production facility to construct: that is, the optimal scale of operation. Once the plans have congealed (a particular-size plant is built), the firm operates in a short-run situa- tion. Recall that a fundamental characteristic of perfect competition is unrestricted entry and exit of firms into and out of the industry. As you will see in this section, the entry of new firms, which is possible only in the long run, plays a crucial role in long-run analysis of competitive industries.
Profit-Maximizing Equilibrium for the Firm in the Long Run
Suppose that an entrepreneur is considering entering a competitive industry in which the firms already in the industry are making economic profits. The prospec- tive entrant, knowing the long-run costs and the product price, expects to make an economic profit also. Because all inputs are variable, the entrant can choose the scale or the plant size for the new firm. We examine the decision graphically.
In Figure 11.7, LAC and LMC are the long-run average and marginal cost curves. The firm’s perfectly elastic demand D indicates the equilibrium price ($17) and is the same as marginal revenue. As long as price is greater than long-run average cost, the firm can make a profit. Thus, in Figure 11.7, any output between 20 and 290 units yields some economic profit. As mentioned earlier, the points of output B and B9 are sometimes called the break-even points. At these two points, price equals long-run average cost and economic profit is 0.
Maximum profit occurs at 240 units of output (point S), where marginal reve- nue equals long-run marginal cost. The firm would want to select the plant size to produce 240 units of output. Note that the firm, under these circumstances, would not want to produce 140 units of output at point M, the minimum point of long- run average cost. At M, marginal revenue exceeds marginal cost, so the firm can gain by producing more output. As shown in Figure 11.7, at point S total revenue (price times quantity) at 240 units of output is equal to $4,080 (5 $17 3 240), which is the area of the rectangle 0TSV. The total cost (average cost times quantity) is equal to $2,880 (5 $12 3 240), which is the area of the rectangle 0URV. The total profit is $1,200 [5 ($17 2 $12) 3 240], which is the area of the rectangle UTSR.
Thus the firm would plan to operate at a scale (or plant size) such that long-run marginal cost equals price. This would be the most profitable situation under the circumstances. But, as we shall show, these circumstances will change. If the firm illustrated in Figure 11.7 is free to enter the industry, so are other prospective entrants.
And this entry will drive down the market price. We will now show how this occurs.
Long-Run Competitive Equilibrium for the Industry
While the individual firm is in long-run profit-maximizing equilibrium when MR 5 LMC (as shown in Figure 11.7), the industry will not be in long-run equilib- rium until there is no incentive for new firms to enter or incumbent firms to exit. The economic force that induces firms to enter into an industry or that drives firms out of an industry is the existence of economic profits or economic losses, respectively.
F I G U R E 11.7 Profit-Maximizing Equilibrium in the Long Run
Quantity 10
LMC
17
140 M
Price and cost (dollars)
B
240
12 R
290
D = MR = 17 S B'
LAC
T
U
V
0 20
Economic profits attract new firms into the industry, and entry of these new firms increases industry supply. This increased supply drives down price. As price falls, all firms in the industry adjust their output levels to remain in profit-maximizing equilibrium. New firms continue to enter the industry, price continues to fall, and existing firms continue to adjust their outputs until all economic profits are elimi- nated. There is no longer an incentive for new firms to enter, and the owners of all firms in the industry earn only what they could make in their best alternatives.
Economic losses motivate some existing firms to exit, or leave, the industry.
The exit of these firms decreases industry supply. The reduction in supply drives up market price. As price is driven up, all firms in the industry must adjust their output levels to continue maximizing profit. Firms continue to exit until economic losses are eliminated, and economic profit is zero.
Long-run competitive equilibrium, then, requires not only that all firms be maximizing profits, but also that economic profits be zero.8 These two conditions are satisfied when price equals marginal cost (P 5 LMC), so that firms are maxi- mizing profit, and price also equals average cost (P 5 LAC), so that no entry or exit occurs. These two conditions for equilibrium can be satisfied simultaneously only when price equals minimum LAC, at which point LMC 5 LAC.
Figure 11.8 shows a typical firm in long-run competitive equilibrium.9 The long-run cost curves in Figure 11.8 are similar to those in Figure 11.7. The differ- ence between the two figures is that in Figure 11.7 the firm is maximizing profit, but the industry is not yet in 0-profit equilibrium. In Figure 11.8, the firm is maxi- mizing profit (P equals LMC), and the industry is also in long-run competitive equilibrium because economic profit is zero (P 5 LAC).
Long-run equilibrium occurs at a price of $10 and output of 140, at point M.
Each (identical) firm in the industry makes neither economic profit nor loss.
There is no incentive for further entry because the rate of return in this industry is the normal rate of return, which is equal to the firm’s best alternative. For the same reason, there is no incentive for a firm to leave the industry. The number of firms stabilizes, and each firm operates with a plant size represented by short-run marginal and average cost, SMC and ATC, respectively. We can now summarize long-run competitive equilibrium with a principle:
Principle In long-run competitive equilibrium, all firms are maximizing profit (P 5 LMC ), and there is no incentive for firms to enter or exit the industry because economic profit is zero (P 5 LAC ). Long-run competi- tive equilibrium occurs because of the entry of new firms into the industry or the exit of existing firms from the industry. The market adjusts so that P 5 LMC 5 LAC, which is at the minimum point on LAC.
Now try Technical Problem 6.
long-run competitive equilibrium
Condition in which all firms are producing where P 5 LMC and economic profits are zero (P 5 LAC ).
8Economists, regulators, and policy analysts sometimes refer to the implicit cost of owner- supplied resources as “normal profit.” Total economic costs of production equal explicit costs plus normal profit. Thus when economic profit is zero, the owners are making just enough accounting profit (total revenue minus explicit costs) to pay themselves an amount equal to what they could have earned by using their resources in their best alternative use. When economic profit is zero, we can say the firm is earning just a normal profit or normal rate of return.
9We will assume that all firms in the industry have identical cost curves. For example, Figures 11.7 and 11.8 show the cost curves of a typical firm. While it is not necessary to assume identical costs for all firms, this assumption substantially simplifies the theoretical analysis without affecting the conclusions.
Long-Run Supply for a Perfectly Competitive Industry
In the short run when the amount of capital in an industry is fixed, as well as the number of firms, an increase in price causes industry output to increase.
This increase is accomplished by each firm’s using its fixed capital more intensively; that is, each firm hires more of the variable inputs to increase output.
In the long run, when entry of new firms is possible, the industry’s response to an increase in price takes on a new dimension: The industry’s supply adjustment to a change in price is not complete until entry or exit results in zero economic profit. This means that for all points on the long-run industry supply curve, economic profit must be zero.
To derive the industry supply curve in the long run, we must differentiate between two types of industries: (1) an increasing-cost industry and (2) a constant-cost industry. An industry is an increasing-cost industry if, as all firms in the industry expand output and thus input usage, the prices of some inputs used in the industry rise. For example, if the personal computer industry expands production by 15 percent, the price of many specialized inputs (such as microprocessor chips, RAM boards, disk drives, and so on) will increase, caus- ing marginal and average cost for all firms to shift upward. An industry is a constant-cost industry if, as industry output and input usage increase, all prices
increasing-cost industry
An industry in which input prices rise as all firms in the industry expand output.
constant-cost industry An industry in which input prices remain constant as all firms in the industry expand output.
F I G U R E 11.8
Long-Run Equilibrium for a Firm in a Competitive Industry
Quantity 10
SMC
Price and cost (dollars) M D= MR= 10
LMC LAC
ATC
0 140
I L L U S T R AT I O N 1 1 . 2 Government Bailouts Threaten Recovery of
Global Semiconductor Marketa
Semiconductors are essential components for ev- erything electronic and digital in today’s world:
iPhones, BlackBerrys, MP3 players, cell phones, digital cameras, solid state drives for PCs, as well as new technologies dealing with smart infrastructure and control systems for electric cars. As a real-world example of a nearly perfectly competitive industry, the global semiconductor industry is accustomed to boom-and-bust cycles. After enjoying the most profit- able period for memory and logic chips in history—
from 2002 until early 2007—the global semiconductor industry found itself saddled with huge excess ca- pacity at the end of 2008. Semiconductor demand dropped sharply, as did chip prices. The economic losses in 2007 and 2008 were the largest in the history of the industry.
In early 2009, as the industry continued to bleed, many CEOs and industry analysts were alarmed by the failure of chipmakers to reign in supply. In past bust cycles, the industry behaved just like the theory of perfect competition predicts: Many chip fabrication companies were forced into bankruptcy and exited the industry and those firms that survived continued to cut production until chip prices climbed back to profit- able levels. The bust cycle could be expected to take 6 to 18 months, but it always worked in the past to clear the market of excess capacity.
Some industry analysts worried that the bust of 2007 was somehow different from past downturns, and might not go away on its own. The situation has become “desperate” according to Daniel Heyler, head of global semiconductor research for Merrill Lynch in Hong Kong, in late 2008. A different expert estimated that every chipmaker in Taiwan (25 percent of world chip supply) could shut down and there would still be oversupply.
And so the government bailouts began. China’s biggest chipmaker received $170 million. The state of Saxony, Germany, supplied Qimonda with
$206 million in support. In Korea, Hynix Semicon- ductor got close to $600 million in new “loans” from
consortium state-owned banks. Bruce Einhorn offered his assessment in BusinessWeek: “If others keep giving financial support to local companies, chipmakers elsewhere will be faced with a tough decision: They can either compete on an uneven playing field or cede the terrain.”
In this Illustration, we will apply the theory of long- run competitive equilibrium set forth in this chapter to address two questions: (1) What, if anything, went wrong in 2007/2008 to prevent the semiconductor in- dustry from adjusting on its own to end the longest bust cycle in the industry’s history? and (2) Will gov- ernment bailouts of failing chip manufacturers help or hinder the recovery of the global semiconductor industry?
The answer to the first question is “probably noth- ing.” The losses were indeed large and long-lasting because the previous boom period attracted large amounts of new capital in the form of new fabrica- tion plants and foundries. When the bust hit, semi- conductor manufacturers had no better choice than to continue producing chips at deeply depressed prices because they could earn enough revenue to cover their (avoidable) variable costs of operation. Unfortunately, chip prices can fall well below average total cost before semiconductor firms will shut down because fixed costs make up a large fraction of total chip cost—up to 70 percent.
Consider the nearby figure showing a typical set of short-run cost curves for a fabrication plant and the firm’s demand curve when the market- determined price of a semiconductor wafer is $200 per wafer. In the short run the firm does not shut down, but rather continues to produce at a rate of 2,000 wafers per day to minimize its loss. At 2,000 wafers per day, the average total cost is $500 per unit, so the firm loses $300 on every chip it produces and total losses amount to $600,000 (5 $300 3 2,000) per day. While this is certainly a large loss, it is none- theless a smaller loss than would be incurred in the short run if the wafer plant shut down and lost all of its fixed cost—that is, lost $700,000 (5 $350 3 2,000) per day.
Notice the relatively large proportion of fixed costs in the plant’s total cost structure, as is typical of semi- conductor firms. Total cost is $1 million, which is the sum of its total variable cost ($300,000 per day) plus its total fixed cost ($700,000 per day). As you can see in the figure, fixed costs are so large relative to vari- able costs that chip prices must fall a long way below minimum ATC (the break-even price is $350) before reaching minimum AVC (the shutdown price is $135).
Because the unprecedented strength of the 2002–2007 boom pushed chip prices to record high levels, it is not surprising that it took longer than usual for prices to fall far enough to warrant shutting down fabrication plants.b
Turning to the second question, you can probably see that government bailouts are not necessary to help the surviving firms achieve profitability. Although it will take longer than usual for excess capacity to exit the industry, which will lead chip prices up along with profits, there is no particular reason to believe the equilibrating process is not working just fine. If the semiconductor market is indeed moving toward a new long-run equilibrium, then government bail- outs will slow, rather than speed, the wringing out of excess capacity. Avi Cohen, chief research analyst at Avian Securities in Boston, makes this point perfectly
well, stating that no one wants “governments rescuing less-competitive companies. The supply never goes away.”
As our theory predicted, worldwide sales of semi- conductors made a sharp turn around in 2010 with global chip sales rising 32 percent in 2010. Competi- tive market forces worked in their usual, predictable way to move the semiconductor industry out of its slump into a period of profitability. Had govern- ments held back their subsidies to chip manufacturers in 2008, the recovery might well have started in 2009.
In any case, we can be certain that the boom and bust cycle will repeat itself—as long as the global market for semiconductors remains a perfectly competitive industry.
aThis illustration draws heavily from Bruce Einhorn,
“ Chipmakers on the Edge,” BusinessWeek, January 5, 2009, pp. 30–31; and Evan Ramstad, “Memory Chips Signal Sector Getting Set for Recovery,” The Wall Street Journal, April 27, 2009, p. B1.
bBust periods in the semiconductor business are generally longer than for many other industries because the highly specialized nature of the capital equipment sharply limits the number of alternative uses in other industries. This extends the period of time it takes for capital to move out of semiconductor manufacturing, and lengthens the time to reach a new long-run competitive equilibrium.
200 500
150
0 2,000
t s
v
u r
Price and costs of semiconductor wafers (dollars per wafer)
Quantity (wafers per day)
SMC ATC
AVC D: P 5 MR 5 2$600,000
min ATC 5 $350
min AVC 5 $135
of inputs used in the industry remain constant.10 For example, the rutabaga indus- try is probably so small that its usage of inputs such as fertilizer, farm labor, and machinery have no effect on the prices of these inputs. This industry is therefore probably a constant-cost industry.
Figure 11.9 shows the relation between a typical firm in a constant-cost industry (Panel A) and the long-run industry supply curve, SLR, for a constant-cost industry (Panel B). Note that the supply price in the long run is constant and equal to $10 for all levels of industry output. This result follows from the long-run equilibrium condition that economic profit must be zero. The long-run supply price, $10, is equal to minimum long-run average cost (LACmin) for every level of output pro- duced by the industry because the entry of new firms always bids price down to the point of zero economic profit (point M in Figure 11.9). Because the industry is a constant-cost industry, expansion of industry output does not cause minimum LAC (point M) to rise. Therefore, long-run supply price is constant and equal to both minimum LAC and LMC. Because supply price is constant, SLR is flat or per- fectly elastic for constant-cost industries.
For example, if industry output expands from 28,000 units to 105,000 units through the entry of new firms, each firm (old and new) ends up producing 140 units of output at the minimum LAC (and LMC) of $10. No single firm expands
F I G U R E 11.9
Long-Run Industry Supply for a Constant-Cost Industry
LAC
Firm's output (q) 10
140 M
Price and cost (dollars)
Industry output (Q = nq)
10 A
105,000 B
140,000
C SLR=LACmin n = 1,000
n = 750 n = 200
0 0 28,000
Panel A — A typical firm in long-run equilibrium Panel B — The industry in long-run equilibrium
10Theoretically it is possible that input prices might fall as industry output rises, in which case there is a decreasing-cost industry. Decreasing-cost industries are so extremely rare that we will not consider them in this text.