Choosing Output in the Long

In the long run, a firm can alter all its inputs, including the size of the plant. It can decide to shut down (i.e., to exit the industry) or to begin to produce a product for the first time (i.e., to enter an industry). Because we are concerned here with competitive markets, we allow for free entry and free exit. In other words, we are assuming that firms may enter or exit without any legal restriction or any special costs associated with entry.6

In Chapter 10 we discuss examples of barriers to entry in an industry.

Price

S

($ per

unit of

output)

p*

\ Producer

Surplus

0 Q" Output

FIGURE 8.11 Producer Surplus for a Market. The producer surplus for a market is the area below the market price and above the market supply curve, between 0 and output Q*.

Figure 8.12 shows how a competitive firm makes its long-run, profit-maximizing output decision. As in the short run, it faces a horizontal demand curve. (In Figure 8.12 the firm takes the market price of $40 as given.) Its short-run average (total) cost curve SAC and short-run marginal cost curve SMC are low enough for the firm to make a positive profit, given by rectangle ABCD, by producing an output of qi where SMC = P = MR. The long-run average cost curve LAC reflects the presence of economies of scale up to output level qz and diseconomies of scale at higher output levels. The long-run marginal cost curve LMC cuts the long-run average cost from below at qi the point of minimum long-run average cost.

If the firm believes the market price will remain at $40, it will want to increase the size of its plant to produce an output q3 at which its long-run marginal cost is equal to the $40 price. When this expansion is complete, the firm's profit margin will increase from AS to EF, and its total profit will increase from ABCD to EFGD. Output q3 is profit-maximizing for the firm because at any lower output, say q2 the-marginal revenue from additional production is greater than the marginal cost, so expansion is desirable.But at any output greater than q3 marginal cost is greater than marginal revenue, so additional production would reduce profit. In summary, the long-run output of a profit-maximizing competitive firm is where long-run marginal cost is equal to price.

Note that the higher the market price, the higher the profit that the firm can earn. Correspondingly, as the price of the product falls from $40 to $30, so does the profit of the firm. At a price of $30, the firm's profit-maximizing

FIGURE 8.12 Output Choice in the Long Run. The firm maximizes its profit by choosing the output at which price is equal to long-run marginal cost LMC. In the diagram, the firm increases its profit from AB CD to EFGD by increasing its output in the long run.

output is qi, the point of long-run minimum average cost. In this case, since P = ATC, the firm earns zero economic profit. As we show below, this means that investors in the firm earn a competitive return on their investment.

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