Unit 8 Supply and demand: Markets with many buyers and sellers

8.7 Short-run and long-run equilibria

short run
The term does not refer to a specific length of time, but instead to what happens while some things (such as prices, wages, capital stock, technology, or institutions) are assumed to be held constant (they are assumed to be fixed, or exogenous). For example, the firm’s stock of capital goods may be fixed in the short run, but in the longer run the firm could vary it (by selling some, or buying more).
long run
The term does not refer to a specific length of time, but instead to what is held constant and what can vary within a model. The short run refers to what happens while some variables (such as prices, wages, or capital stock) are held constant (taken to be exogenous). The long run refers to what happens when these variables are allowed to vary and be determined by the model (they become endogenous). A long-run cost curve, for example, refers to costs when the firm can fully adjust all of the inputs including its capital goods.
opportunity cost of capital
The opportunity cost of capital is the amount of income an investor could have received, per unit of investment spending, by investing elsewhere.

To analyse equilibrium in the bread market, we assumed there were 50 bakeries in the city, each with given capacities to produce bread. That is, the number of bakeries and their capacities were exogenous. We then worked out how much an individual bakery would supply at the market price given its current production capacity: in other words, what it would do in the short run. Then we obtained the short-run market supply curve by adding together the amounts of bread each of the existing bakeries would supply at each price.

What would we expect to happen in the long run? That is to say, if bakery owners could change their capacity, or enter or leave the market, what would they do and how would the market equilibrium change? Owners who are making a loss in the short-run equilibrium may decide to leave the market in the long run. Or, if bakeries are earning rents in the short run, they may decide to invest in more capacity, and other bakeries may enter the market.

In economic models, short run and long run don’t refer to specific periods of time. In a short-run equilibrium, one or more variables—typically something that takes more time to adjust—is exogenous (held constant). Modelling what will happen when such a variable becomes endogenous (can be adjusted) gives us the long-run equilibrium.

Imagine yourself as a bakery owner again. Figure 8.16 shows your marginal costs (your short-run supply curve given your current capacity). The market is in equilibrium at a price of €2. You are producing 120 baguettes a day at a marginal cost of €1.50, so you are making a surplus of €0.50 per loaf. The figure also shows your average cost curve, allowing for your fixed costs, which include the opportunity cost of capital: the cost of financing your current investment in premises and equipment. Your average cost for 120 loaves is €1.75, so you are earning a positive economic profit of €0.25 per loaf. Should you invest in more equipment to increase your capacity? We will assume that you could install enough equipment to make 80 additional loaves in your current premises.

In this diagram, the horizontal axis shows the quantity of loaves, denoted Q, and ranges from 0 to 250. The vertical axis shows the price denoted P, marginal cost and average cost in euros, and ranges from 0 to 3.5. The marginal cost of loaves is €1.5 until the 120th loaf, and €2.5 from the 121st loaf. Alternatively, the marginal cost of loaves can be €1.5 until the 200th loaf, and €2.5 after the 201st loaf. The price of loaves is €2 each. Two downward-sloping, convex lines represent average cost.

Figure 8.16 Investing in more capacity (at the firm level).

The dotted lines in the figure show what your marginal and average costs will be if you install more equipment, thereby raising normal capacity to 200 loaves per day. The average cost curve will shift upwards because you now need to finance a larger investment in equipment. But if the price remains at €2, you will then produce 200 loaves at a lower average cost of €1.71 per loaf: your profit will increase. And reducing the average cost will help you to remain profitable if the price falls.

You decide that potential profits are high enough to make the investment worthwhile, and increase your normal capacity to 200 loaves per day.

costs of entry
Startup costs that are incurred when a seller enters a market or an industry. These would usually include the cost of acquiring and equipping new premises, research and development, the necessary patents, and initial costs of finding staff.
profit, economic profit
A firm’s profit is its revenue minus its total costs. We often refer to profit as ‘economic profit’ to emphasise that costs include the opportunity cost of capital (which is not included in ‘accounting profit’).
normal profits
Normal profits are the returns on investment that the firm must pay to the shareholders to induce them to hold shares. The normal profit rate is equal to the opportunity cost of capital and is included in the firm’s costs. Any additional profit (revenue greater than costs) is called economic profit. A firm making normal profits is making zero economic profit.

If you are the only bakery owner who decides to expand, your increased production is unlikely to affect the market price. But if other bakeries are also earning rents, they may decide to invest in more capacity, too. And new firms may enter the market in pursuit of the profits to be made in baguette production. They will incur some costs of entry (for example, to acquire new premises) but provided these are not too high, entry may be profitable. These changes will lead to an increase in market supply, and the equilibrium price will change.

Figure 8.17 shows the original short-run equilibrium at point A, with equilibrium price €2. If rents are being earned in the short run and firms respond, the capacity of the market will change. At each price, the bakeries will supply more bread, so the supply function moves outwards. A new equilibrium is reached at point B, where the price is lower and more bread is sold.

In this diagram, the horizontal axis shows the quantity of loaves, denoted Q, and ranges from 0 to 10,000. The vertical axis shows the price in euros, denoted P, and ranges from 0 to 5. Coordinates are (quantity, price). An upward-sloping, convex curve starting from point (0, 1) is labelled original supply (marginal cost). A downward-sloping, convex curve starting from point (0, 4.75) and passing through point (10,000, 0.5) is labelled demand. The demand and original supply curves intersect at point A (5,000, 2). Another upward-sloping, convex curve is labelled new supply (marginal cost), lies below the original supply curve at all points, and intersects the demand curve at point B (6,100, 1.5).

Figure 8.17 An increase in the supply of bread: investment in new capacity (at the market level).

How has the move to point B affected your bakery? The market price has fallen, but you can still use your new capacity and make a surplus on each loaf: you now produce 200 loaves per day at a marginal cost of €1.50, and sell them at €1.74 each. Your average cost has fallen to €1.71, so your profit on each loaf is €0.03. Compared with the original equilibrium, your total economic profit is lower. But overall, you are satisfied with your decision. You were able to benefit from higher profit margins while the market adjusted; you are now making just above normal profits on a bigger investment, and you are employing more staff and producing more efficiently. In fact, if you hadn’t expanded while other firms did, your average cost would have been above the new market price, and your economic profit would have been negative.

Will the market remain at the new equilibrium, B? Should we expect further changes to happen? The answer depends on whether many firms are still earning rents. If your bakery is typical, and most bakeries are now operating with average costs close to the market price and economic profit close to zero, then B is a long-run equilibrium. On the other hand, if there are many other existing firms or potential entrants who can produce at lower average cost than you, supply may increase again and the price will fall further. You will then have to consider whether you can reduce costs sufficiently to compete. If not, it may be better to close your business.

If and when the market reaches a long-run equilibrium, rent-seeking and competition will have eliminated both the less-efficient firms and the rents. Firms that remain will be producing at low average cost, and since the market price will have fallen close to their average cost, they will be making normal profits. The market will remain here unless there is an exogenous supply or demand shock.

Short-run and long-run elasticities

When demand for a good increases, the increase in the quantity sold depends on the elasticity of the market supply curve (that is, the marginal cost curve). So if the demand for bread increases, a steep (inelastic) supply curve means that the price of bread rises a lot in the short run, while capacity in the market is fixed with a relatively small rise in quantity. But in the longer run, this will lead to more investment in bread production: supply increases, so the price falls, and quantity increases more. We say that, because of the possibility of changes in capacity, the supply of bread is more elastic in the long run.

The distinction between the short run and the long run applies in many economic models. Whenever there are some economic variables that can only adjust slowly, it is useful to distinguish between what happens before and after they adjust.

In the next section, we will discuss another example: the demand for oil is more elastic in the long run, because consumers can switch to different fuels for cars or heating. What we mean by the short run, in this case, is the period during which firms are limited by their existing production capacity, and consumers by the cars and heating appliances they currently own.

Exercise 8.7 The market for quinoa

The production of quinoa.

Figure 8.13a (reproduction) The production of quinoa.

Quinoa producer prices.

Figure 8.13b (reproduction) Quinoa producer prices.

Global import demand for quinoa.

Figure 8.13c (reproduction) Global import demand for quinoa.

Consider again the market for quinoa. The changes shown in Figures 8.13a–c can be analysed as shifts in demand and supply.

  1. In the early 2000s, there was an unexpected increase in demand for quinoa (a shift in the demand curve). What would you expect to happen to the price and quantity initially?
  2. When demand continued to rise over the next few years, how do you think farmers responded?
  3. Why do you think the price stayed constant until 2007?
  4. Suggest an explanation for the rapid price rise in 2008 and 2009.
  5. Explain why you would or would not expect the price to fall eventually to its original level.

Question 8.9 Choose the correct answer(s)

There are currently 50 identical bakeries in the market. The figure below shows how each bakery’s marginal costs vary with the number of loaves produced per day, both at its current capacity (solid line) and if it chooses to expand capacity (dotted line). The bakery’s original average cost curve intersects the marginal cost curves at (25, 2.10) and (40, 1.50), respectively. If the bakery expands capacity, the new average cost curve intersects the marginal cost curves at (25, 2.40) and (40, 1.73), respectively. The current market price is €2.50. Based on this information, read the following statements and choose the correct option(s).

In this diagram, the horizontal axis shows the quantity of loaves, and the horizontal axis shows the following measures: marginal cost at lower capacity, marginal cost at higher capacity, average costs, market price, average costs for quantities above 40, average costs at higher capacity. The market price for loaves of bread is €2.5 each. The marginal cost of loaves of bread at lower capacity is €1 until the 25th loaf, and €3 from the 26th loaf. The marginal cost of loaves of bread at higher capacity is €1 until the 40th loaf, and €3 from the 41st loaf. The average costs at higher capacity are higher than the average costs for quantities above 40.
  • In short-run equilibrium, each bakery makes an economic profit of €10.00.
  • In the long-run equilibrium, if all bakeries expanded production, total market output would be 2,000 loaves.
  • If the price falls below €1.50 (due a decrease in demand), then in the long run there would be fewer than 50 bakeries in the market.
  • If all bakeries expanded their capacity, each bakery would make an economic profit of at least €30.80.
  • In the short-run equilibrium, each bakery sells 25 loaves and makes a profit per loaf of 2.50 – 2.10 = 0.40, so each bakery’s economic profit is €10.00.
  • The positive profits will encourage more bakeries to enter, so while each existing bakery expands capacity to 40 loaves each, the total market output will be greater than 2,000 loaves once we count the output of the new bakeries.
  • In the short run, the price of a loaf wouldn’t cover the average cost of production, even if firms expanded capacity, so some bakeries would leave the market.
  • Each bakery would only make an economic profit of €30.80 (= 40(2.5 − 1.73)) if the price stayed at €2.50. However, if all bakeries expanded their capacity, the market supply curve would move outwards, lowering the price, so each bakery’s economic profit would be less than €30.80.

Extension 8.7 Short-run and long-run equilibria: An example

In this extension we illustrate how the market price is determined in the short run and in the long run in a town with many bakeries, each of which has the same cost function. We analyse the example of a particular cost function for which the marginal cost curve is upward-sloping, like the ones discussed in Extension 8.4. We use calculus to derive the market supply function from the cost function, both in the short run when the number of bakeries is fixed, and in the long run when they can enter or leave the market, and hence determine the short- and long-run equilibrium prices and quantities.

Coming soon.