Question

Suppose that the pen-making industry is perfectly competitive. Also suppose that each current firm and any potential firms that might enter the industry all have identical cost curves, with minimum ATC \(=\$ 1.25\) per pen. If the market equilibrium price of pens is currently \(\$ 1.50,\) what would you expect it to be in the long run? \(L O 11.2\) a. \(\$ 0.25\) b. S1.00. c. S1.25. d. S1.50.

Short answer

The long-run price will be \( \$ 1.25 \), option c.

Step-by-step solution

Understanding Perfect Competition

In a perfectly competitive market, all firms are price takers, meaning they sell their product at the market equilibrium price. Any firm earning a profit will attract new entrants since products are homogeneous and entry/exit barriers are low.

Current Market Conditions

The current market price is given as \( \\( 1.50 \), and firms incur a minimum average total cost (ATC) of \( \\) 1.25 \) per pen. Therefore, they are currently earning a profit of \( \\( 1.50 - \\) 1.25 = \$ 0.25 \) per pen.

Long-Run Market Adjustments

In the long run, new firms will enter the market attracted by the profit opportunities. This will increase the market supply of pens, causing the price to decrease. Entry continues until firms earn zero economic profit.

Equilibrium in the Long Run

The long-run equilibrium price will equal the minimum ATC because firms only earn normal profit. Therefore, the market price will adjust to \( \$ 1.25 \), where firms cover their costs including a normal rate of return.

Key concepts

Market Equilibrium

When we discuss market equilibrium in the context of perfect competition, it revolves around the idea that the market price is determined by the interaction of supply and demand.
In a perfectly competitive market, each firm is a price taker. This means they have no power to influence the price of the product – the market sets the price.
Firms can sell as much as they want at this price, but increasing the price would mean selling nothing, as buyers have plenty of alternative suppliers.

To identify the equilibrium price, we look at where the quantity demanded by consumers matches the quantity supplied by all firms in the market.
At this point, neither surplus nor shortage prompts a price change, ensuring that the market "clears." This equilibrium price is vital because it guides firms on production and helps ensure economic stability in the market.

Long-Run Adjustments

In the long run, perfectly competitive markets undergo natural adjustments that impact prices and profits.
Initially, if firms are making economic profits, new firms are enticed to enter, as barriers to entry are low.

This influx of new firms increases the total supply of the good, driving down its market price.
As the price falls, profits begin to evaporate. The entry of firms continues until economic profits drop to zero, ensuring firms are only covering their costs, including a normal profit – no more, no less.

Similarly, if firms are yielding losses initially, some will exit the market, reducing supply and raising prices until the remaining firms cover their costs.
This dynamic keeps the market efficient and resources allocated effectively over time, reflecting changes in demand and supply.

Average Total Cost

Average Total Cost (ATC) is a measure that combines all of the firm's costs divided by the quantity produced.
This includes both fixed costs (like rent) and variable costs (like materials). ATC indicates the cost per unit, showing how economically efficient a firm is.

In perfect competition, firms strive to produce output at the minimum point of the ATC curve, optimizing cost efficiency.
This occurs because any price below the ATC leads to losses, while achieving the minimum ATC ensures competitive pricing.
Thus, in the long-run equilibrium, prices tend to settle at the minimum ATC, where firms make zero economic profits but cover all costs, surviving even in highly competitive environments.

Economic Profit

Economic profit exists when a firm's total revenue exceeds the total costs, including opportunity costs, which imply the earnings from the next best alternative.
In perfect competition, however, economic profits due to a higher-than-needed price attracts new entrants.
This competitive pressure ensures these profits are temporary.

Over time, the entrance of new firms raises supply and reduces prices until only a normal profit remains.
Economic profits influence firm decisions and market dynamics significantly.
For instance, they drive innovation and efficiency improvements as firms seek to sustain profitability even under competitive pressure.
Recognizing these aspects helps students understand why certain changes happen in competitive markets, keeping economic profits as a self-reforming mechanism.