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EQUILIBRIUM, LONG-RUN AGGREGATE MARKET: The state of equilibrium that exists in the long-run aggregate market when real aggregate expenditures are equal to full employment real production with no imbalances to induce changes in the price level or real production. The opposing forces of aggregate demand (the buyers) and long-run aggregate supply (the sellers) exactly offset each other. Equilibrium in the long-run aggregate market also involves simultaneous equilibrium in the aggregated financial and resource markets. Long-run price flexibility ensures that all three aggregate markets are in equilibrium.

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PERFECT COMPETITION, LONG-RUN EQUILIBRIUM CONDITIONS:

The long-run equilibrium of a perfectly competitive industry generates six specific equilibrium conditions, including: (1) economic efficiency (P = MC), (2) profit maximization (MR = MC), (3) perfect competition (MR = AR = P), (4) breakeven output (P = AR = ATC), (5) minimum production cost (MC = ATC), and (6) minimum efficient scale (MC = ATC = LRAC = LRMC).
In the long-run equilibrium of a perfectly competitive industry, the market price, the number of firms in the industry, and each firm's scale of production adjust such that each firm produces at the lowest point on its long-run average cost curve--which is its minimum efficient scale. At this production scale the following multivariable equilibrium condition is achieved:

P = AR = MR = MC = LRMC = ATC = LRAC

This overall equilibrium condition can be divided into the six specific conditions: (1) economic efficiency (P = MC), (2) profit maximization (MR = MC), (3) perfect competition (MR = AR = P), (4) breakeven output (P = AR = ATC), (5) minimum production cost (MC = ATC), and (6) minimum efficient scale (MC = ATC = LRAC = LRMC).

For a closer look at these six conditions, consider the hypothetical perfectly competitive Shady Valley zucchini growing industry. While zucchini growing in the real world does not match all of the conditions of perfect competition, it comes close enough to serve as a illustration for this analysis. The hypothetical Shady Valley zucchini growing industry contains a large number of relatively small firms (gadzillions of zucchini growers, each producing a handful of zucchinis each day), identical products (one zucchini is the same as every other zucchini), freedom of entry and exit (anyone can grow zucchinis with no up front cost or legal restriction), and perfect knowledge of prices and technology (ever grower knows how to grow zucchinis and they know all relevant prices). Not absolutely perfect, but close.

Economic Efficiency

P = MC
The condition that price equals marginal cost (P = MC) is the standard condition for economic efficiency. This condition means that resources are being used to produce goods that generate the greatest possible level of satisfaction.

If the price that a hypothetical zucchini grower named Phil (as well as ever other perfectly competitive zucchini grower) receives for his zucchinis is equal to the marginal cost of producing zucchinis, then it is not possible to produce more zucchinis or fewer zucchinis and improve society's overall satisfaction.

Suppose, for example, that in long-run equilibrium the zucchini price and the marginal cost of zucchini production are $4 per pound.

  • From the buyers viewpoint, this $4 price means that they receive $4 worth of satisfaction from consuming a pound of zucchinis. If buyers do not enjoy $4 worth of satisfaction, then they are not willing to pay $4. As such, the good produced by the perfectly competitive zucchini growers (that would be zucchinis) generates $4 of satisfaction.

  • From the sellers viewpoint, marginal cost is the opportunity cost of producing zucchinis. This is the value of other goods NOT produced when resources are used to produce zucchinis. If the marginal cost of producing a pound of zucchinis is $4, then the resources that Phil uses to produce zucchinis could have been used to produce another good, such as kumquats or cucumbers. And the value of the other good NOT produced is $4. In other words, kumquat buyers are willing to pay $4 for the kumquats that could have been produced with the resources that are used to produce the zucchini.
Efficient exists because both values, the value of the good produced and the value of the good NOT produced, are the same. It is not possible to increase total satisfaction by producing more of one good and less of another.

  • Suppose, for example, that the zucchini price ($4) is greater than the marginal cost of zucchini production (only $3). In this case, the value of the good produced, zucchinis, is greater than the value of the good not produced, kumquats. Using resources to produce zucchinis rather than kumquats means that zucchini consumers obtain more satisfaction than kumquat consumers give up. This is a net gain of satisfaction for society. And because society is able to increase satisfaction by producing more zucchinis and fewer kumquats, then society must not be efficiently allocating resources.

  • Alternatively, suppose the zucchini price ($4) is less than the marginal cost of zucchini production (say $5). In this case, the value of the good produced, zucchinis, is less than the value of the good not produced, kumquats. Using resources to produce kumquats rather than zucchinis means that kumquat consumers obtain more satisfaction than zucchini consumers give up. This also is a net gain of satisfaction for society. And because society is able to increase satisfaction by producing more kumquats and fewer zucchinis, then society must not be efficiently allocating resources.

Only by satisfying the condition (P = MC) is economic efficiency achieved. This condition is satisfied by a perfectly competitive industry in the long run.

Profit Maximization

MR = MC
The condition that marginal revenue equals marginal cost (MR = MC) is the standard condition for profit-maximization by a firm. This condition means that, given existing price and cost conditions, a firm is producing the quantity of output that generates the highest possible level of economic profit.

Phil, the hypothetical zucchini grower, maximizes his economic profit by producing the quantity of zucchinis that equates the marginal revenue received for selling zucchinis ($4) with the marginal cost of producing zucchinis (also $4). It is not possible for Phil to generate any greater economic profit by producing more or fewer zucchinis.

Marginal revenue is the extra revenue that Phil receives for producing zucchinis. Marginal cost is the extra cost Phil incurs when producing zucchinis. When the production of a pound of zucchinis results in a change of revenue that is exactly the same as the change in cost, economic profit does not change, profit its at its maximum.

To see why, consider how profit is affected if marginal revenue and marginal cost are NOT equal.

  • Suppose, for example, that marginal revenue (at $4) is greater than marginal cost (only $3). When Phil receives $4 for producing an extra pound of zucchinis that incurs a cost of only $3, then his economic profit rises by $1. Any time Phil can sell zucchinis for more than the cost, profit goes up. But if profit can be increased by producing and selling more zucchinis, it must not be maximized.
  • Alternatively, suppose that marginal revenue (at $4) is less than marginal cost ($5). When Phil receives $4 for producing an extra pound of zucchinis that incurs a cost of $5, then his economic profit falls by $1. Any time Phil sells zucchinis for less than the cost, profit goes down. But if profit goes down by producing MORE in goes up by producing LESS. And if profit can be changed by changing by production, it must not be maximized.
Only by satisfying the condition (MR = MC) is profit maximized. This condition is satisfied by a perfectly competitive firm in the long run.

Perfect Competition

P = AR = MR
The condition that price equals both average revenue and marginal revenue (P = AR = MR) is the standard condition for a perfectly competitive firm. This condition means that a firm is a price taker with no market control and faces a perfectly elastic demand curve equal to the market price.

The key to this condition is that a perfectly competitive firm has NO market control. The price the firm receives for its output is determined in the market by the combined forces of demand and supply. The firm can then sell any or all of its production at this going market price.

Phil, for example, can sell all of his zucchini production for $4 per pound of zucchinis. There is no way he can receive more and no reason to accept less. If Phil sells one pound of zucchinis, then he receives $4. If he sells 20 pounds, he receives $4 for per pound.

The going market price is also Phil's average revenue. In fact, average revenue and price are really just two terms for the same thing. Average revenue is the revenue Phil receives per pound of zucchinis. Price is the revenue Phil receives per pound of zucchinis. So price is almost always equal to average revenue, whether or not a firm is perfectly competitive.

Perfect competition, however, is indicated because price and average revenue are also equal to marginal revenue. Because Phil is a perfectly competitive zucchini grower who can sell all of his output at the going $4 market price, each EXTRA pound of zucchinis he sells generates the same EXTRA revenue as ever other pound. The first pound of zucchinis Phil sells adds $4 to his total revenue. The second pound of zucchinis Phil sells adds $4 to his total revenue. The tenth pound of zucchinis Phil sells adds $4 to his total revenue. The twentieth pound of zucchinis Phil sells adds $4 to his total revenue. Because the price is constant, marginal revenue is constant and equal to the price.

A perfectly competitive firm is the ONLY type of firm that satisfies the condition (P = AR = MR). Of course, this condition holds for a perfectly competitive firm in long-run equilibrium.

Breakeven Output

P = ATC = LRAC
The condition that price equals both short-run average total cost and long-run average cost (P = ATC = LRAC) indicates that a firm is producing breakeven output, earning exactly a normal profit. The perfectly competitive firm is not receiving an economic profit nor incurring an economic loss.

This condition further means that firms have no incentive to enter or exit the industry. If no firms IN the perfectly competitive industry receive above-normal economic profit, then there is no incentive for other firms to enter the industry. If no firms in the perfectly competitive industry incur economic loss or receive below-normal profit, then there is no incentive for any firms to exit the industry.

Consider the $4 price that Phil receives for his zucchinis. Because this price is equal to the short-run average total cost and the long-run average cost of producing zucchinis, Phil earns exactly a normal profit. Note that normal profit is included as a cost of production. Because Phil is earning a normal profit, he has no incentive to switch from zucchini production to an alternative industry, such as kumquat production.

The normal profit is the profit that Phil could earn in another activity, such as kumquat production. Because this is equal to the profit he earns in zucchini production, there is no reason to change. There is no reasons to leave the zucchini industry in search of greener vegetables on the other side of the fence. Dan the kumquat producer reaches the same conclusion. His kumquat profit is the same as Phil's zucchini profit. He has no incentive to leave the kumquat industry and enter the zucchini industry.

What happens, however, if the price is not equal to average cost?

  • Suppose, for example, that the zucchini price ($4) is greater than the average total cost of producing zucchinis (say $3). In this case, Phil receives $1 of economic profit for each pound of zucchinis sold. Because this exceeds the zero economic profit earned by Dan the kumquat grower, Dan is induced to leave kumquat production and take up zucchini production.

  • Alternatively, if the zucchini price ($4) is less than the average total cost of producing zucchinis (say $5), then Phil incurs an economic loss of $1 for each pound of zucchinis sold. Because he would much prefer NOT to incur an economic loss, he is attracted to the zero economic profit (that is, normal profit) earned by Dan the kumquat grower. Phil is induced to leave zucchini production and take up kumquat production.
Only when the condition (P = ATC = LRAC) is satisfied do firms earn exactly a normal profit, receiving neither an economic profit nor incurring an economic loss. And only when this condition is satisfied are there no incentives for firms to enter or exit an industry. This condition is satisfied by a perfectly competitive industry in the long run.

Minimum Production Cost

MC = ATC
The condition that marginal cost equals short-run average total cost (MC = ATC) means that a firm is operating at the minimum point of its short-run average total cost curve. This condition means a firm is producing output at the lowest possible per unit cost and that the capital (or factory) is being used in the most technically efficient manner possible.

When the average cost and marginal cost of Phil's zucchini production are both equal at, say $4, then Phil is producing at the minimum point on his short-run average total cost curve. Phil cannot produce zucchinis at a lower per unit cost, given his existing capital (the current size of his backyard plot and his array of tools and equipment). Should Phil try to produce one more pound of zucchinis, then his short-run average total cost increases to perhaps $4.01. Should Phil try to produce one fewer pound of zucchinis, then his short-run average total cost also increases to perhaps $4.01.

Long-run equilibrium for a perfectly competitive industry achieves the condition (MC = ATC) and ensures that firms produce output at the lowest per unit cost possible.

Minimum Efficient Scale

MC = LRMC = ATC = LRAC
The condition that marginal cost equals short-run average total cost which equals long-run average cost and long-run marginal cost (MC = LRMC = ATC = LRAC) means that a firm is operating at the minimum point of its long-run average cost curve, which is the minimum efficient scale of production. This condition means that a firm has constructed the most technically efficient factory and is using this factory in the most technically efficient manner possible. The end result is that the firm is producing output at the lowest possible long-run per unit cost.

When the average cost and marginal cost of Phil's zucchini production are simultaneously equal in both the long-run and short-run, then Phil is producing at the minimum point on his long-run average cost curve. Phil cannot produce zucchinis at any lower per unit cost in the long run. Should Phil try to produce one more pound of zucchinis, then his short-run average total cost increases. Should Phil try to produce one fewer pound of zucchinis, then his short-run average total cost also increases. Moreover, should Phil use a slightly smaller plot of land and less equipment, or a slightly larger plot of land and more equipment, then per unit cost is also higher.

Long-run equilibrium for a perfectly competitive industry achieves the condition (MC = LRMC = ATC = LRAC) and ensures that firms produce output at the lowest per unit cost possible.

<= PERFECT COMPETITION, LONG-RUN ADJUSTMENTPERFECT COMPETITION, LONG-RUN PRODUCTION ANALYSIS =>


Recommended Citation:

PERFECT COMPETITION, LONG-RUN EQUILIBRIUM CONDITIONS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: October 31, 2014].


Check Out These Related Terms...

     | perfect competition, long-run production analysis | perfect competition, long-run adjustment |


Or For A Little Background...

     | perfect competition | perfect competition, characteristics | perfect competition, efficiency | long-run, microeconomics | long-run production analysis | minimum efficient scale | long-run average cost | economies of scale | breakeven output |


And For Further Study...

     | long-run industry supply curve | increasing-cost industry | decreasing-cost industry | constant-cost industry |


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