Long-Run Equilibrium
In microeconomic theory, long-run equilibrium occurs when all inputs can be adjusted by firms, there is free entry and exit in the market, and no firm has any incentive to change its output. Long-run equilibrium under perfect competition is characterized by firms producing at the lowest point on their long-run average cost curves. This point reflects the most efficient scale of production.
For wheat farmers operating under perfect competition, long-run equilibrium is reached when the price of wheat equals the minimum average cost of production, and each farm produces at an output level where the average cost is minimized, typically represented by a U-shaped average cost curve. If market conditions change, as with a shift in demand, the number of firms will adjust over time until a new long-run equilibrium is established, ensuring all firms once again earn normal profits.
Perfect Competition
Perfect competition is a market structure characterized by several conditions: many buyers and sellers, homogeneous products, no barriers to entry or exit, perfect information, and no buyer or seller large enough to influence market price.
In such a market, individual firms are price takers, meaning they accept the market price as given and have no power to set their own prices. Profits in a perfectly competitive market will be driven to zero in the long run as firms enter and exit the market in response to profit opportunities, moving the market toward a long-run equilibrium.
Demand Curve Shifts
Demand curve shifts refer to the movement of the demand curve to the left (decrease in demand) or to the right (increase in demand) in a price-quantity space. Shifts may be caused by changes in consumer preferences, incomes, prices of related goods, or expectations for the future, among other factors.
An outward shift means that consumers are willing to buy more of the commodity at each price, which, in the short run, can lead to higher prices and increased profits for firms. Over time, in the long run, the entry of new firms in response to these profits will shift the supply curve to the right, returning prices to the minimum average costs and profits to normal levels.
Average Cost Curves
Average cost curves are graphical representations that show how the cost per unit of output changes with varying levels of production. The long-run average cost (LRAC) curve is U-shaped, reflecting economies and diseconomies of scale. Initially, as firms increase production, they benefit from economies of scale, leading to lower average costs.
After reaching a minimum point, diseconomies of scale set in, and the average cost begins to rise. The minimum point of the LRAC curve is significant since it identifies the production level at which a firm achieves the most efficient scale.
Short-Run Market Adjustments
Short-run market adjustments occur when firms face changes in demand or costs that affect their production and profit levels, but they cannot immediately adjust all inputs due to fixed factors. For instance, if demand increases, firms will see higher prices and profits in the short run.
However, since not all firms can instantly change their production levels, the market price can temporarily exceed the minimum average cost, allowing firms to earn above-normal profits. Eventually, these short-run adjustments lead to changes in output levels, prices, and the number of firms until a new long-run equilibrium is reached.
Profit Maximization
Profit maximization is the process by which firms determine the price and output level that returns the most substantial possible profit. Under perfect competition, this occurs when the firm's marginal cost equals the market price, which reflects the point of profit maximization because no additional profit can be made by increasing or decreasing production.
However, in the short run, if the market price is above the average cost, firms will earn supernormal profits, while in the long run, new firms will enter, increasing supply and driving down prices, hence profits will be reduced to a normal level.
Supply and Demand Analysis
Supply and demand analysis is a framework for understanding the determination of the prices of goods and services in a market economy. The intersection of supply and demand curves determines the market equilibrium, where the quantity supplied equals the quantity demanded.
Changes in the determinants of supply and/or demand will cause shifts in the respective curves, leading to a new equilibrium. In the example of wheat farming, the market responds to a demand shift by changing the price in the short run and by adjusting the number of firms and production quantities in the long run.
