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Unformatted text preview: C H A P T E R 14 Competitive Market Equilibrium Until now, we have only proceeded through the first two of three steps of the “eco- nomic way of thinking” — the crafting of a model and the process of optimizing within that model. We now proceed to the final step: to illustrate how an equilib- rium emerges from the optimizing behavior of individuals — how the “economic environment” that individuals in a competitive setting take as given emerges from their actions. In the process, we begin to get a sense of how order can emerge “spontaneously” — an idea introduced briefly in the introduction as one of the big ideas that we should not loose as we dive into technical details of economic models. Chapter Highlights The main points of the chapter are: 1. An equilibrium arises in an economic model when no individual has an in- centive to change behavior given what everyone else is doing. In a competi- tive model, it means that no individual has an incentive to change behavior given the economic environment that has emerged “spontaneously”. 2. The short run for an industry is the time over which the number of firms in the industry is fixed because firms have not had an opportunity to enter or exit the industry. The short run industry (or market) supply curve is there- fore the sum of the firm supply curves for the (short run) fixed number of firms in the industry, and the short run equilibrium is driven by the price at which the short run industry supply curve intersect the market demand curve (which is simply the sum of all individual demand curves). 3. The long run for an industry is the time it takes for sufficient numbers of firms to enter or exit the industry as conditions change. The long run in- dustry (or market) supply curve therefore arises from the condition that the marginal firm in the industry must make zero profits so that no firm in the industry has an incentive to exit and no firm outside the industry has an in- centive to enter. When all firms face identical costs, this implies a horizontal 299 14A. Solutions to Within-Chapter-Exercises for Part A long run industry supply curve at the price which falls at the lowest point of each firm’s long run AC curve. The long run equilibrium then emerges at the intersection of market demand and long run industry supply. 4. To analyze what happens as conditions change in a competitive market, the most important curves to keep track of on the firm side are the (1) long run AC curve and (2) the short run firm supply curve that crosses the long run AC curve at its lowest point (but extends below it because shut down prices are lower than exit prices.) Any change that impacts short run firm sup- ply curves will impact the short run industry supply curve, and any change that impacts the long run AC curve will impact the long run industry supply curve....
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- Fall '08
- Supply And Demand