No Such Thing as a Free Lunch: Principles of Economics (Part 44)

"I find that because of modern technological evolution and our global economy, and as a result of the great increase in population, our world has greatly changed: it has become much smaller. However, our perceptions have not evolved at the same pace; we continue to cling to old national demarcations and the old feelings of 'us' and 'them'."

Dalai Lama

Long-Run Costs and Output Decisions

(Part F)

by

Charles Lamson

Long-Run Adjustments to Short-Run Conditions

Firms can be operating at a profit or suffering economic losses; they can be shut down or producing. The industry is not in equilibrium if firms have an incentive to enter or exit in the long run. Thus, when firms are earning economic profits (profits above normal) or are suffering economic losses (profits below normal, or negative), the industry is not at an equilibrium, and firms will change their behavior. What they are likely to do depends in part on costs in the long run.

In this post we discuss the actual long-run adjustments that are likely to take place in response to short-run profits and losses.

Short-Run Profits: Expansion to Equilibrium

We begin our analysis of long run adjustments with a perfectly competitive industry in which firms are earning positive profits. We assume that all firms in the industry are producing with the same technology of production, and that each firm has a long-run average cost curve that is U-shaped. A U-shaped long-run average cost curve implies that there are some economies of scale to be realized in the industry, and that all firms ultimately begin to run into diseconomies at some scale of operation.

As capital flows into the industry, the supply curve in Figure 7(a) shifts to the right and price falls. The question is: Where will the process stop? In general, firms will continue to expand as long as there are economies of scale to be realized, and new firms will continue to enter as long as positive profits are being earned. 

In Figure 7(a), final equilibrium is achieved only when price falls to P* = $6 and firms have exhausted all the economies of scale available in the industry. At P* = $6, no profits are being earned and none can be earned by changing the level of output.

Short-Run Losses: Contraction to Equilibrium

Firms that suffer short-run losses have an incentive to leave the industry in the long run, but cannot do so in the short run. As we have seen, some firms incurring losses will choose to shut down and bear losses equal to fixed costs. Others will continue to produce in the short run in an effort to minimize their loss.

Once again the question is: How long will this adjustment process continue? In general: as long as losses are being sustained in an industry, thus reducing supply---shifting the supply curve to the left. As this happens, price rises. This gradual price rise reduces losses for firms remaining in the industry until those losses are ultimately eliminated.

The Long-Run Adjustment Mechanism: Investment Flows toward Profit Opportunities

The central idea in our discussion of entry, exit, expansion, and contraction is this: In inefficient markets, investment capital flows toward profit opportunities. The actual process is complex and varies from industry to industry.

In inefficient markets, profit opportunities are quickly eliminated as they develop. To illustrate this point, imagine driving up to a toll booth. Shorter-than-average lines are quickly eliminated as cars shift into them. So too, are profits in competitive industries eliminated as new competing firms move into open slots, or perceived opportunities, in the industry.

In practice, the entry and exit of firms in response to profit opportunities usually involves the financial capital market. In capital markets, people are constantly looking for profits. When firms in an industry do well, capital is likely to flow into that industry in a variety of forms. Entrepreneurs start new firms, and firms producing entirely different products may join the competition to break into new markets. It happens all around us. The tremendous success of premium ice cream makers Ben & Jerry's and Haagen-Dazs spawned dozens of competitors. In one Massachusetts town of 35,000, a small ice cream store opened to rave reviews, long lines, and high prices and positive profits. Within a year there were four new ice cream/yogurt stores, no lines, and lower prices. Magic? No: just the natural functioning of competition.

Many believe that part of the explosion of technology-based dot-com companies is due to the very low barriers to entry. All it takes to start a company is an idea, a terminal, and web access. The number of new firms entering the industry is so large that statistical agencies cannot even keep pace.

When there is promise of positive profits, investments are made and output expands. When firms end up suffering losses, firms contract, and some go out of business. It can take quite a while, however, for an industry to achieve long-run competitive equilibrium, the point at which P = SRMC = SRAC = LRAC and profits are zero. In fact, because costs and taste are in a constant state of flux, very few industries ever really get there. The economy is always changing. There are always some firms making profits and some firms suffering losses.

This, then, is a story about tendencies. Investment in the form of new firms and expanding old firms will over time tend to favor those industries in which profits are being made, and over time industries in which firms are suffering losses will gradually contract from disinvestment. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 185-188*

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