6.5: Long Run Equilibrium

Does market structure have any connection with a firm’s prospects for profit? Yes! Remember, market structure measures the level of competition within an industry. As an industry becomes more competitive and moves along the market structure spectrum toward perfect competition (see figure 12) it becomes increasingly difficult to keep economic profit.

Figure 12

The reason why perfectly competitive firms cannot hold on to economic profits is because of market entry. Whenever a perfect competitor manages to earn an economic profit, it will be noticed by all. Those who find themselves in unprofitable industries or who are out of work will join the market (this is easy since there are no barriers to keep out new competition). When enough firms enter a market the market supply will shift to the right.

A good example of market entry causing a rightward shift in the market supply curve is the computer memory chip industry in the 1980s. Intel, a U.S. electronics company, first developed the DRAM in the early 1970s. In the 1980s, Japanese semiconductor manufacturers rushed into the market only to be followed by Korean companies mass-producing small, low-priced DRAMs made specifically for PCs. As a result of this increase in competition, the market supply curve shifted to the right and prices fell. See figure 13.

Figure 13

News Alert

U.S. Wine Producers Face Increasing Competition

Vying for Business at Home and Abroad

U.S. wine producers are necessarily becoming more competitive both at home and abroad. Robust exports during the first half 1999/2000 (August-to-July) came at the expense of lower prices. For the first six months volume was up 23 percent, while price (average per-unit value) was down six percent. The partial offset resulted in total export value rising by 16 percent. For the three years prior to 1998/99, annual export growth averaged 22 percent in volume and 29 percent in value.

Grape growers are feeling the fallout from wine price and product competition. Prices for grapes used in making wine have softened and cut farm earnings in California's central producing areas. California produces 95 percent of U.S. wine, and central areas between San Lois Obispo and San Francisco crush two-thirds of the state's grapes for wine.

Foreign competition is expected to increase this year, as major European producers Italy, France and Germany increased their wine production by a combined total of 10 percent. Although world trade in wine may have benefited from last New Year's once-in-a-lifetime bash, it is unclear whether the 'true' millennium change in 2001 will bring a repeat rush for sparkling wine. A further obstacle is the relative weakness of foreign currencies compared with the U.S. dollar, making foreign wine more price-competitive in the U.S. and markets overseas.

Increasing competition in the U.S. market from Southern Hemisphere producers comes principally from Australia and Chile. Southern Hemisphere wine has tripled its share of U.S. imports in the 1990s, averaging about 24 percent in the last three years. Western European competitors, principally France and Italy, have given up U.S. import share, sliding from nearly 90 percent at the start of the decade to around 70 percent this year.

Source: Wine Business Monthly, http://www.winebusiness.com/wbm/?go=...cle&dataId=337

Which of the following graphs best represents the situation in the wine industry described in the article above (assume that the California wine industry is perfectly competitive)?

1. A
2. B
3. C
4. D

Explanation: The U.S. wine industry experienced an increase in supply (mainly due to foreign competition) and a fall in price. These events would be represented by a rightward shift in the market supply curve. This shift would cause the equilibrium price to fall and equilibrium quantity to increase. Individual firms would see a fall in prices. These events are best represented by graph A.

Efficient Outcomes

The relentless competition and downward pressure on prices in the perfect competition market structure leads to an efficient long-run outcome. Firms that are at a cost disadvantage (i.e., higher \(\mathrm{ATC}\)) are vulnerable in the marketplace. See figure 14.

Figure 14

Firm 1 is at a cost disadvantage when compared to firm 2. This disadvantage can be seen by comparing \(\mathrm{ATC}\) curves. When business costs increase the \(\mathrm{ATC}\) will shift upward.

Firm 1’s disadvantage becomes apparent when it faces a market price of \(\mathrm{P}_1\). At the price of \(\mathrm{P}_1\), firm 1 experiences a loss. This is because the market price is below its average costs. Firm 2 on the other hand has lower costs than Firm 1 and as a result can turn a profit at the prevailing market price.

Firm 1 no has only two options:

• Get more efficient and lower its \(\mathrm{ATC}\)
• Shutdown

Either one of these options will lead to more efficient use of resources. If firm 1, after taking losses at the current market price, manages to make changes that lead to lower costs then this means it is making more efficient use of its scarce resources. If, on the other hand, firm 1 concludes that it cannot match firm 2’s cost structure and decides to leave the industry and shuts down, then it frees up resources and gives others a chance to make better use of them.

Either way, society benefits from the competitive pressure to be more efficient.