LONG-RUN COMPETITIVE EQUILIBRIUM
There are two ways capital can change in the long-run:
1) Change in the size of individual firms through additional or improved equipment and buildings
or through reduction or depreciation of equipment and buildings
2) Entry into or exit from industry by firm of the same size as existing firms
Economies of Scale (Increasing Returns to Scale): occur when a % increase in all factor inputs
causes a greater % increase in output
Diseconomies of Scale (Decreasing Returns to Scale): occur when a % increase in all factors
causes a smaller % increase in output
Constant Returns to Scale: occurs when a % increase in all factors causes the same %
increase in output
AC decreases with Economies of Scale
AC increases with Diseconomies of Scale
AC does not change with Constant Returns to Scale
Long Run Average Cost
Shows the lowest average cost for each output in the long-run. This defines the size of capital
for the lowest average cost for each output.
Profit Maximization in the long-run implies that firms change capital and labour until they find the
capital with the Short-Run Average Cost function that gives minimum Long-Run Average Cost
for the desired output.
Provided that there is no technological change, the diagram shows that in competitive
conditions, price will fall from Po to P* as new firms enter the industry due to economic profits at
Po for all capitals and above P* for the minimum efficient scale capital. In the long-run, no firm
could obtain the average return on capital unless the firm was the size (capital) that permitted
Minimum Efficient Scale.
The assumption of perfect competition means that we do not need to draw the LRAC function
since we know that its minimum is minimum SRAC of the firm.