Short-Term and Long-Term Equilibrium

Short-term and long-term equilibrium
In perfect competition, the equilibrium of the firm and the market is achieved differently in the short-run and long-run periods. Understanding this dynamic explains why profits “normalize” and how the market responds to shocks.

Short-Term Firm Equilibrium

Optimality condition:
P = MC (since MR = P)

Decision about output:
Find Q*, where P = MC

Check shutdown rule:
P ≥ AVC?
If yes — produce Q*
If no — do not produce (Q = 0)

Firm profit:
Profit = (P − ATC) × Q*

If P > ATC: positive profit
If P < ATC: negative profit
If P = ATC: zero economic profit

Firm Supply Curve

The supply curve of a competitive firm is the part of the MC curve above AVC.

Logic:
At each price, the firm chooses Q where P = MC
But only if P ≥ AVC
Therefore, supply is MC from the shutdown point upwards.

Market supply: horizontal sum of individual supply curves of all firms.

Short-Term Market Equilibrium

The intersection of market demand and market supply determines:

• Market price P*
• Market quantity Q*

In short-term equilibrium:

• Firms may earn supernormal profits (P > ATC)
• Firms may incur losses (P < ATC)
• Number of firms is fixed

Transition to Long-Term Equilibrium

If P > ATC (profit):

• New firms enter (attracted by profit)
• Market supply shifts to the right
• Market price falls
• Profit decreases
• Entry continues until P = ATC

If P < ATC (loss):

• Firms exit
• Market supply shifts to the left
• Market price rises
• Losses decrease
• Exit continues until P = ATC

Long-Term Equilibrium

Long-term equilibrium conditions:

• P = MC (profit maximization)
• P = ATC (zero economic profit)
• P = minimum LRAC (optimal scale)

All three conditions together: P = MC = minimum ATC

Implications:

• Economic profit = 0
• No incentives for entry or exit
• Firms operate at the minimum of average costs
• Productive efficiency is achieved

Efficiency in Perfect Competition

Productive efficiency:

• Each firm produces at the minimum ATC
• Resources are not wasted

Allocative efficiency:

• P = MC
• The price paid by consumers equals marginal cost of production
• Resources are allocated where they are valued most
• No deadweight loss

Response to Shocks

Increase in demand:

• Short-term: price rises, existing firms receive profit
• Long-term: new firms enter, supply increases, price returns to minimum LRAC
• Result: more firms, more output, same price (under constant costs)

Increase in costs:

• Short-term: some firms incur losses
• Long-term: firms exit, supply decreases, price rises to new minimum ATC
• Result: fewer firms, higher price

For the Investor

Long-term profit rate:

• In competitive industries — tends toward the cost of capital
• Supernormal profits are temporary without barriers

Commodity businesses:

• Close to perfect competition
• Compete on costs
• Low margin, high sensitivity to cycles

Disruption and competition:

• The Internet brings many markets closer to competition
• Price transparency, lower barriers
• Pressure on margin for “traditional” players