9.4 Long-Run Decisions

Question 1

How is the short/long run of a single firm similar to that of an entire industry?

Answer 1

When we look at the entire industry, the distinction is very similar. In the short run, there is a given number of firms and each has a given plant size. In the long run, both the number of firms and the size of each firm’s plant are variable.

Question 2

What is zero-profit equilibrium?

Answer 2

With an unchanged market demand curve, this rightward shift in the industry supply curve will reduce the equilibrium price. In order to maximize profits, both new and old firms will have to adjust their output to this new price. New firms will continue to enter, and the equilibrium price will continue to fall, until all firms in the industry are just covering their total costs. The industry has now reached what is called a zero-profit equilibrium. The entry of new firms then ceases.

Question 3

What are profits in a competitive industry a signal for?

Answer 3

Profits in a competitive industry are a signal for the entry of new firms; the industry will expand, pushing price down until economic profits fall to zero.

Question 4

What do negative profits lead to in a firm

Answer 4

Negative profits lead to the eventual exit of some firms as their capital becomes obsolete or becomes too costly to ­operate; this exit increases the equilibrium price and increases profits for those firms remaining in the market.

Question 5

What are losses a signal for in a competitive industry?

Answer 5

Losses in a competitive industry are a signal for the exit of firms; the industry will contract, driving the market price up until the remaining firms are just covering their total costs.

Question 6

What affects the speed of exit for a loss-making firm?

Answer 6

The longer it takes for firms’ capital to become obsolete or too costly to operate, the longer firms will remain in the industry while they are earning economic losses.

Question 7

When does the long-run equilibrium of a competitive industry occur?

Answer 7

The long-run equilibrium of a competitive industry occurs when firms are earning zero profits.

Question 8

What is the break-even price?

Answer 8

The price at which a firm is just able to cover all of its costs, including the opportunity cost of capital.

Question 9

What are the four conditions for long-run equilibrium?

Answer 9

Existing firms must be maximizing their profits, given their existing capital. Thus, short-run marginal costs of production must be equal to the market price.

Existing firms must not be suffering losses. If they are suffering losses, they will not replace their capital and the size of the industry will decline over time.

Existing firms must not be earning profits. If they are earning profits, then new firms will enter the industry and the size of the industry will increase over time.

Existing firms must not be able to increase their profits by changing the size of their production facilities. Thus, each existing firm must be at the minimum point of its long-run average cost (LRAC) curve.

Question 10

What condition my be fulfilled in order for a competitive firm to be maximizing its long-run profits?

Answer 10

For a competitive firm to be maximizing its long-run profits, it must be producing at the minimum point on its LRAC curve.

Question 11

Where on the LRAC curve is a firm that is in long-run equilibrium?

Answer 11

In long-run competitive equilibrium, each firm is operating at the minimum point on its LRAC curve.

Question 12

What is a firm’s average cost of production in a long-run competitive equilibrium?

Answer 12

In the long-run competitive equilibrium, each firm’s average cost of production is the lowest attainable, given the limits of known technology and factor prices.

Question 13

What will technological improvements do to a short-run supply curve?

Answer 13

Now suppose that some technological development lowers the cost curves of newly built plants but no further advances are anticipated. Because price is just equal to the average total cost for the existing plants, new plants will be able to earn profits, and some of them will now be built. The resulting expansion in capacity shifts the short-run supply curve to the right and drives price down.

Question 14

How long will the expansion in industry output and fall in price continue for in the face of technological development?

Answer 14

The expansion in industry output and the fall in price will continue until price is equal to the short-run average total cost of the new plants. At this price, old plants will not be covering their long-run costs.

Question 15

What happens to outmoded plants in the face of technological development, and how does this affect the long-run equilibrium?

Answer 15

As the outmoded plants wear out or become too costly to operate, they will gradually be closed. Eventually, a new long-run equilibrium will be established in which all plants will use the new technology; market price will be lower and output higher than under the old technology.

Question 16

How long will out of date firms stay in the industry?

Answer 16

Entry of progressively lower-cost firms forces price down, but older plants with higher costs remain in the industry as long as price covers their average variable costs.

Question 17

Industries subject to continuous technological change have three common characteristics.

Answer 17

In industries with continuous technological improvement, low-cost plants will exist side by side with older high-cost plants. The older plants will continue operating as long as their revenues cover their variable costs.

A second characteristic of a competitive industry subject to continuous technological improvement is that price is eventually governed by the minimum ATC of the lowest-cost (i.e., the newest) plants.

A third characteristic is that old plants are discarded (or “mothballed”) when the price falls below their AVCs.

Question 18

When is capital typically discarded in an industry with continuous technological progress?

Answer 18

In industries with continuous technological progress, capital is usually discarded because it is economically obsolete, not because it is physically worn out

Question 19

How long with a profit-maximizing firm stay in a steadily declining demand industry?

Answer 19

The profit-maximizing response to a steadily declining demand is to continue to operate with existing equipment as long as revenues can cover the variable costs of production.

Question 20

What does antiquated equipment in a declining industry mean?

Answer 20

The antiquated equipment in a declining industry is typically the effect rather than the cause of the industry’s decline.

Question 21

Governments will typically try and support failing industries to protect jobs. Is this always a good thing?

Answer 21

Experience suggests, however, that propping up genuinely declining industries only delays their demise—at a significant cost to the taxpayers. When the government finally withdraws its support, the decline is usually more abrupt and, hence, the required adjustment is more difficult than it would have been had the industry been allowed to decline gradually under the natural market forces.

Question 22

What is a more effective response in the face of an inevitably collapsing industry?

Answer 22

Once governments recognize that the decay of certain industries and the collapse of certain firms are an inevitable part of a changing and evolving economy, a more effective response is to provide retraining and temporary income-support schemes that cushion the impacts of change.