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Different Cost Conditions and Long-Run Equilibrium

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In this article we will discuss about the different cost conditions and long-run equilibrium of a competitive firm.

It is assumed that all the firms within the industry are identical. Since this assumption implies that the cost curves of the firms are identical, it made our task fairly easy.

But in reality, firms may choose their own technology, entrepreneurs may differ in respect of organising ability and may have built plants of different sizes as a result of divergent price expectations.

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Some entrepreneurs may possess scarce factors such as fertile land that are not available to others. Because of any one or more of these differences, the cost functions of all firms may not be identical. Still, the firms and the industry may very well attain long-run equilibrium. Let us see how.

For the sake of simplicity, let us suppose that there are only three categories of firms:

(a) With ‘high’ cost level,

(b) With ‘medium’ cost level, and

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(c) With ‘low’ cost level.

The representative cost curves of the firms belonging to these categories have been shown, respectively, in parts (a), (b) and (c) of Fig. 10.10. Let us suppose now that, to start with, the price of the product is p1 which has been determined in Fig. 10.10(d) at the point of intersection T1 of the market demand curve, D1D1, for the product and the short-run supply (SRS) curve, S1S1, of the industry.

Given the SAC and SMC curves of different firms, the firm in Fig. 10.10(a) produces q1 of output at the point E1 (p = SMC), that in Fig. 10.10(b) produces q2 and that in Fig. 10.10(c) produces q3, in the short run, and all the firms of all categories are earning more than normal profit. That is why, in the long run, new firms belonging to all the three categories would join the industry.

Long-Run Equilibrium

As the number of firms increases, the SRS curve of the industry will be shifting rightwards from S1S1 till it becomes S2S2, when the market equilibrium point would move downwards from T1 to T2 along the demand curve, and the price of the good would fall from p1 to p2.

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At p = p2, the high cost representative firm in Fig. 10.10(a) would earn just the normal profit, for now, the AR = MR line has touched its LAC curve at the latter’s minimum point, Q1. At the price of p = p2, it is apparent that the firms in the medium cost and low cost categories would be able to earn more than normal profit, for their LAC curves have portions below the AR = MR line. However, what would actually happen is this.

The skilled and scarce factors like land, entrepreneurial services and capital employed by the ‘medium’ and ‘low’ cost firms would put pressure on the management of these firms to pay some surplus along with their remuneration, which would be in the nature of economic rent.

Consequently, the LAC curves of these firms would shift upwards, respectively, from LAC2 and LAC3 to LAC2* and LAC3*, to become tangent to the AR = MR line for p = p2, at their respective minimum points, Q2 and Q3.

It may be noted that these factors would be successful in forcing these hikes in their remuneration because of competition. Therefore, now the firms belonging to all the three categories would earn just the normal profit at the minimum points on their LAC curves, and the entry of new firms would stop, bringing the industry in long-run equilibrium.

We have seen in the above analysis that if the firms in a competitive industry do not possess identical cost curves, then also long-run equilibrium of the industry will be attained with all the firms earning just the normal profit.

But the vital difference between the identical and non- identical cost curve cases is that, in the former case, the inputs get their prices which do not contain any economic rent, whereas in the latter case some of the inputs that are skilled and, therefore, scarce, have economic rent included in their remuneration.

The amount of rent varies between inputs and between firms. The more skilled and scarce inputs would obtain larger amounts of economic rent.

In our example, since the ‘low’ cost firms employ more skilled inputs, some of the inputs working in the ‘low’ cost firms would earn a larger rent than those working in the ‘medium’ cost firms, and the inputs working in the ‘high’ cost firms are not in a position to earn any economic rent.

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