Long Run versus Short Run
Competitive market equilibrium is the traditional concept of economic equilibrium, appropriate for the analysis of commodity markets with flexible prices and many traders. It relies crucially on the assumption of a competitive environment where each trader decides upon a quantity that is so small compared to the total quantity traded in the market that their individual transactions have no influence on the prices. This paper will discuss the short run competitive equilibrium versus the long run competitive equilibrium and the differences between the short run and long run shut down decision of a firm.
2.Short run versus long run competitive equilibrium in an economy with production
Market equilibrium exists when the total amount the firms wish to supply is equal to the total amount the consumers wish to demand. In a diagram, the equilibrium price is the price at which the demand and supply curves cross. The long and the short run do not refer to a specific period of time such as three months or five years. The difference between the two is the flexibility decision makers have. "Economics" of Parkin and Bade's gives an excellent distinction between them: "The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. The long run is a period of time in which the quantities of all inputs can be varied. 2.2Short run supply curve
A perfectly competitive firm's supply curve is that portion of its marginal cost curve that lies above the minimum of the average variable cost curve. A perfectly competitive firm maximizes its profits by choosing to supply the level of output where its marginal revenue equals its marginal cost. When marginal revenue exceeds marginal cost, the firm can earn greater profits by increasing its output. When marginal revenue is below marginal cost, the firm is losing money, and consequently, it must reduce its output. Profits are therefore maximized when the firm chooses the level of output where its marginal revenue equals its marginal cost. 2.3Long run supply curve
The long-run supply curve is determined by the long-run competitive equilibrium. The optimal level of output is the point where price equals the minimum of average costs of production and where price equals marginal cost. At the point known as the long-run competitive equilibrium, each firm’s profits are exactly enough to cover the average costs of production and economic profits are zero. Below is a graphic representation of this relationship.
As is shown in above graph, the long-run competitive equilibrium (Pe) is where price equals the minimum average costs (AC) and where price equals marginal cost (MC).
3.Short run shut down decision versus long run shut down decision When the firm's average total cost curve lies above its marginal revenue curve at the profit maximizing level of output, the firm is experiencing losses and will have to consider whether to shut down its operations. The firm must pay its fixed costs, considered sunk costs, regardless of whether it produces any output. If the firm's average variable costs are less than its marginal revenue at the profit maximizing level of output, the firm will not shut down in the short-run. The firm is better off continuing its operations because it can cover its variable costs and use any remaining revenues to pay off some of its fixed costs. In the long-run, a firm that is incurring losses will have to either shut down or reduce its fixed costs by changing its fixed factors of production in a manner that makes the firm's operations profitable.
The firms short run shut down decision
4.Real life application
American Italian Pasta Company is a Delaware corporation and commenced its operations in 1988.. Richard C. Thompson, the founder from the start, decided to focus on producing...