blanchard_ch10

The economic loss is a signal for some firms to exit

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Unformatted text preview: ket supply decreases and the market supply curve gradually shifts leftward. As market supply decreases, the price rises. At each higher price, a firm’s profit-maximizing output is greater, so the firms remaining in the market increase their output as the price rises. Each firm moves up along its marginal cost or supply curve in Fig. 10.10(b). That is, as some firms exit the market, market output decreases but the output of the firms that remain in the market increases. Eventually, enough firms have exited the market for the market supply curve to have shifted to S1 in Fig. 10.10(a). The market price has returned to its original level, P0. At this price, the firms remaining in the market produce q0, the same quantity that they produced before the decrease in demand. Because firms are now making zero economic profit, no firm has an incentive to enter or exit the market. The market supply curve remains at S1, and market output is Q2. The market is again in long-run equilibrium. The difference between the initial long-run equilibrium and the final long-run equilibrium is the number of firms in the market. A permanent decrease in demand has decreased the number of firms. Each firm remaining in the market produces the same output in the new long-run equilibrium as it did initially and makes zero economic profit. In the process of moving from the initial equilibrium to the new one, firms incur economic losses. We’ve just worked out how a competitive market responds to a permanent decrease in demand. A permanent increase in demand triggers a similar response, except in the opposite direction. The increase in demand brings a higher price, economic profit, and entry. Entry increases market supply and eventually lowers the price to its original level and economic profit to zero. The demand for Internet service increased permanently during the 1990s and huge profit opportunities arose in this market. The result was a massive rate 000200010270728684_CH10_p195-220.qxd 6/23/11 4:13 PM Page 209 C hanging Tastes and Advancing Technology FIGURE 10.10 209 A Decrease in Demand Price and cost Price S1 S0 MC ATC P0 P0 MR 0 P1 P1 MR 1 D0 D1 0 Q2 Q1 Q0 Quantity (a) Industry 0 q1 q0 Quantity (b) Firm A market starts out in long-run competitive equilibrium. Part (a) shows the market demand curve D0, the market supply curve S0, the market price P0, and the equilibrium quantity Q0. Each firm sells its output at the price P0, so its marginal revenue curve is MR0 in part (b). Each firm produces q0 and makes zero economic profit. Market demand decreases permanently from D0 to D1 in part (a) and the market price falls to P1. Each firm decreases its output to q1 in part (b), and the market output decreases to Q1 in part (a). Firms now incur economic losses. Some firms exit the market, and as they do so, the market supply curve gradually shifts leftward, from S0 toward S1. This shift gradually raises the market price from P1 back to P0. While the price is below P0, firms incur economic losses and some firms exit the market. Once the price has returned to P0, each firm makes zero economic profit and has no incentive to exit. Each firm produces q0, and the market output is Q2. animation of entry of Internet service providers. The process of competition and change in the Internet service market is similar to what we have just studied but with an increase in demand rather than a decrease in demand. We’ve now studied the effects of a permanent change in demand for a good. In doing so, we began and ended in a long-run equilibrium and examined the process that takes a market from one equilibrium to another. It is this process, not the equilibrium points, that describes the real world. One feature of the predictions that we have just generated seems odd: In the long run, regardless of whether demand increases or decreases, the market price returns to its original level. Is this outcome inevitable? In fact, it is not. It is possible for the equilibrium market price in the long run to remain the same, rise, or fall. External Economies and Diseconomies The change in the long-run equilibrium price depends on external economies and external diseconomies. External economies are factors beyond the control of an individual firm that lower the firm’s costs as the market output increases. External diseconomies are factors outside the control of a firm that raise the firm’s costs as the market output increases. With no external economies or external diseconomies, a firm’s costs remain constant as the market output changes. Figure 10.11 illustrates these three cases and introduces a new supply concept: the long-run market supply curve. A long-run market supply curve shows how the quantity supplied in a market varies as the market price varies after all the possible adjustments have been made, including changes in each firm’s plant and the number of firms in the market. 000200010270728684_CH10_p195-220.qxd 4:13 PM Page 210 CHAPTER 10 Perfect Competition Figure 10.11(a) shows...
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