Long run price and output under perfect competition

The Long Run Adjustment Process

If most firms are making abnormal profits in the short run there will be an expansion of the output of existing firms and we expect to see the entry of new firms into the industry. Firms are responding to the profit motive and supernormal profits act as a signal for a reallocation of resources within the market. The addition of new suppliers causes an outward shift in the market supply curve. This is shown in the diagram below.

Making the assumption that the market demand curve remains unchanged, higher market supply will reduce the equilibrium market price until the price = long run average cost. At this point each firm is making normal profits only. There is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established.

The entry of new firms shifts the market supply curve to MS2 and drives down the market price to P2. At the profit-maximising output level Q3 only normal profits are being made. There is no incentive for firms to enter or leave the industry. Thus a long-run equilibrium is established.

Does perfect competition lead to economic efficiency?

Perfect competition is used as a yardstick to compare with other market structures (such a monopoly and oligopoly) because it displays high levels of economic efficiency. In both the short and long run, price is equal to marginal cost (P=MC) and therefore allocative efficiency is achieved – the price that consumers are paying in the market reflects the factor cost of resources used up in producing / providing the good or service.

Productive efficiency occurs when price is equal to average cost at its minimum point. This is not achieved in the short run – firms can be operating at any point on their short run average total cost curve, but productive efficiency is attained in the long run because the profit maximising output is achieved at a level where average (and marginal) revenue is tangential to the average total cost curve. The long run of perfect competition, therefore, exhibits optimal levels of static economic efficiency.

There is of course another form of economic efficiency – dynamic efficiency – which relates to aspects of market competition such as the rate of innovation in a market, the quality of output provided over time.

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One Response to “Long run price and output under perfect competition”

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