7.3 Producer Theory in the Long Run
Learning Objectives
By the end of this section, you will be able to:
- Understand why positive and negative profits entice entry and exit.
- Differentiate between accounting and economic profits.
- Explain what happens in the long-run after shocks to supply and demand.
So far we have looked at The Clip Joint in the short-run, while eluding to some of the actions The Clip Joint may take in the LR including:
- If the price is below The Clip Joint’s break-even price, it will continue to operate in the short-run but exit in the long run.
- If the price is below The Clip Joint’s shut-down price, it will shut down in the short-run.
In our example in Topic 7.2, when price was $7.50, we showed The Clip Joint making positive profits in the short run. To begin our discussion of long-run, we must first remember that The Clip Joint is a price-taker who is receiving price cues from the competitive market. This means that the price that The Clip Joint faces is equal to the equilibrium price in the aggregate market. In Figure 7.3a, the competitive market is shown with an equilibrium price of $7.5, and an equilibrium quantity of 5,500 haircuts. Assuming every firm is identical to The Clip Joint, we can determine how many firms are in the market by the equation Q/q, dividing the 5,500 haircuts produced in the market, by the 110 haircuts each firm produces at the market price. This shows us that in this market, there are 5,500/110 = 50 firms.
In this situation, cutting hair is an attractive industry. Each firm is able to pay all variable costs (which include opportunity costs) and fixed costs and make $210 in profit after economic expenses! In the long run, this is unsustainable – other businesses will see the profitable market and decide to join the industry. This activity will cause supply to increase.
In Figure 7.3b, our supply has increased from S1 to S2, causing price to fall from $7.5 to $6.5 and creating a new equilibrium quantity of 6,600. Consider what this has done for The Clip Joint’s profits. Now, with the market change, The Clip Joint is making only $52.50 in profits – a significant decrease from before. Notice that the amount of firms has increased from 50 to 6,600/105 = 63 firms.
Although the number of firms has increased and the equilibrium price has fallen, there is still incentive in the market for firms to enter. Since profits are positive, supply will continue to increase.
Supply continues to increase until Price = $5.8, which is the break-even price for the market. At this point, The Clip Joint is making no profits and there is no incentive for other firms to enter.
In this analysis, we have shown that when a firm is making positive profits in the short-run, in the long run, this will cause more firms to enter, decreasing price until it is at the break-even point once more. If price is below break-even, the reverse will occur as firms leave the market to seek opportunities elsewhere. The important take away