Long-Run Supply in Microeconomics: Cost Curves, Elasticity, and Market Dynamics

Long-Run Supply in Microeconomics

Introduction

This study guide covers the key concepts from Lecture 6 of Principles of Microeconomics, focusing on long-run supply, cost curves, elasticity of supply, and the behavior of firms in perfectly competitive markets. The material is structured to provide clear definitions, explanations, and examples relevant to college-level microeconomics.

Short-Run and Long-Run Cost Curves

Short-Run Cost Curves

In the short run, some factors of production are fixed, leading to the following cost curves:

• Marginal Cost (MC): The additional cost of producing one more unit of output. Denoted as $MC(q)$.

• Average Variable Cost (AVC): The variable cost per unit of output. Denoted as $AVC(q)$.

• Average Total Cost (ATC): The total cost per unit of output, including both fixed and variable costs. $ATC(q) = \frac{TC(q)}{q}$.

Example: For a Persian Arabian oil well, the minimum AVC is $5. If the market price falls below this, the firm will supply zero output in the short run.

Short-Run Supply Decision

• If $P \geq AVC_{min}$, the firm supplies output where $P = MC(q)$.

• If $P < AVC_{min}$, the firm supplies zero output.

Graphical Representation: The short-run supply curve is the portion of the MC curve above the minimum AVC.

Aggregating Short-Run Supply

Market supply is the horizontal sum of individual firms' supply curves. For example, the total supply from multiple oil wells is the sum of their individual supply curves at each price level.

Long-Run Cost Curves and Supply

Long-Run Cost Curves

In the long run, all factors of production are variable. Firms can adjust their scale of operation, leading to different cost structures:

• Long-Run Average Total Cost (LRATC): The lowest possible average total cost for each output level when all inputs are variable.

• The LRATC curve is the lower envelope of all possible short-run ATC curves.

Economies and Diseconomies of Scale

• Economies of Scale: Increasing all inputs leads to a more than proportional increase in output, causing LRATC to fall.

• Constant Returns to Scale: Increasing all inputs leads to a proportional increase in output; LRATC remains constant.

• Diseconomies of Scale: Increasing all inputs leads to a less than proportional increase in output, causing LRATC to rise.

Example: An oil company may initially experience economies of scale by adding more drills, but eventually, management complexity or resource limitations can lead to diseconomies of scale.

Elasticity of Supply

Definition and Calculation

Price Elasticity of Supply measures the responsiveness of quantity supplied to a change in price:

• Formula: $\text{Elasticity of Supply} = \frac{\% \text{ change in quantity supplied}}{\% \text{ change in price}}$

• In competitive markets, elasticity of supply is always positive.

Determinants of Elasticity

• Flexibility of Factors of Production: The more easily factors can be adjusted, the more elastic the supply.

• Time Horizon: Elasticity is generally greater in the long run, as firms can adjust all inputs.

Example: In the oil industry, labor may be the only variable factor in the short run, but in the long run, all inputs (land, capital, labor) can be adjusted, increasing elasticity.

Profit Maximization and Exit Decisions

Profit Calculation

• Profit: $\text{Profit} = \text{Total Revenue} - \text{Total Cost}$

• Total Cost: Includes both fixed and variable costs in the short run; all costs are variable in the long run.

Exit Decision in the Long Run

• If the market price is less than the minimum LRATC, the firm should exit the market.

• If the market price is at least as high as the minimum LRATC, the firm can remain in the market and produce where $P = MC$.

Economic vs. Accounting Profits

Definitions

• Accounting Profit: $\text{Total Revenue} - \text{Out-of-pocket Costs}$

• Economic Profit: $\text{Total Revenue} - (\text{Out-of-pocket Costs} + \text{Opportunity Cost})$

Supernormal (Economic) Profits: Occur when economic profit is positive, attracting new firms to the industry.

Normal Profits: Economic profit is zero; firms earn just enough to cover all costs, including opportunity costs.

Perfect Competition and Long-Run Market Supply

Characteristics of Perfect Competition

• Many buyers and sellers, none large enough to influence market price.

• Identical (homogeneous) products.

• Free entry and exit from the market.

Long-Run Market Supply Curve

• With free entry and exit, firms enter when price exceeds minimum LRATC and exit when price falls below it.

• In the long run, the market supply curve is perfectly elastic at the minimum LRATC.

• Any quantity can be supplied at this price in the long run, as firms enter or exit to restore zero economic profit.

Implications for Profits

• In the long run, economic profit is zero, but accounting profit may be positive due to the inclusion of opportunity costs in total cost.

• Market forces drive the price to the minimum LRATC, ensuring efficient allocation of resources.

Summary Table: Types of Profit

Type of Profit	Formula	Includes Opportunity Cost?	Implication
Accounting Profit	$\text{Total Revenue} - \text{Out-of-pocket Costs}$	No	May be positive even if economic profit is zero
Economic Profit	$\text{Total Revenue} - (\text{Out-of-pocket Costs} + \text{Opportunity Cost})$	Yes	Zero in long-run equilibrium under perfect competition

Key Takeaways

• Short-run supply is determined by the MC curve above minimum AVC; long-run supply is determined by the MC curve above minimum LRATC.

• Elasticity of supply depends on factor flexibility and the time horizon.

• In perfect competition, long-run market supply is perfectly elastic at minimum LRATC, and economic profit is zero.

• Accounting profit can be positive even when economic profit is zero, due to the inclusion of opportunity costs in total cost.

Additional info: Some details, such as the precise graphical forms and the aggregation of supply curves, were inferred from standard microeconomic theory and the context of the provided slides.