Daniel l. Rubinfeld

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274 Part 2 Producers, Consumers, and Competitive Markets 8 Profit Maximization and Competitive Supply 275 Dollars per unit of output 540 lMC Dollars' per unit of output Industry 5 To see ,·vhy all the conditions for long-run uilibrium must hold, assume that all firms have identical costs. Now consider ~~lat happens if too many firms enter the u1dustry in response to an opportunity for profit. The ind~lst~y supply cun-e in Figure_8.14(b) will.shift further t~ the 'oht, and price ,vIll tall below S30-say, to 52;:,. At that pnce, however, fIrms ~iIllose money. As a result, some firms will exit the industry. Finns will continue to exit until the market supply curve shifts back to 52' Only when there is no incenti\-e to exit or enter can a market be in long-run equilibrium. S30 (a) Output Initially the long-run equilibrium price of a product is $40 per unit, as shown in (b) as the intersection of demand curve D and supply curve 51' In (a) we see that firms earn positive profits because lona-run averaae cost reaches a . . f$ 0 0 rrurumum 0: 30 (at q~). This positive profit encourages entry of new finns and causes a shift to the right in the supply Cl.m'e to 52 as shovm m (a). The long-nm equilibrium occurs at a price of $30 as shovm in (b), ,vhere each firm earns zero profit and there is no incentive to enter or exit the long-run competitive equilibrium All firms in an industry are maximizing profit, no firm has an incentiye to enter or exit, and price is such that quantity supplied equals quantity demanded When a finn earns zero economic profit, it has no incentive to exit the industry. Likewise, other finns ha\-e no special incentive to enter. A long-run competitive equilibrium occurs when three conditions hold: 1. All firms in the industry are maximizing profit. 2. No firm has an incentive either to enter or exit the industry because all firms are earning zero economic profit. 3. The price of tl1e product is 511C11 that the qua11tit)T Sllpplied by the iI1dustry is equal to the quantity demanded by consumers. The dynamic process that leads to long-run equilibrium creates a puzzle. Firms enter the market because they hope to earn a profit, and like,·vise they exit because of economic losses. In long-run equilibrium, however, firms earn zero economic profit. vVhy does a firm enter a market knowing that it will evenhlally earn zero profit The answer is that zero economic profit represents a competitive return for the finn's inveshnent of financial capital. With zero economic profit, the finn has no incentive to go elsewhere because it carmot do better financially by doing so. If the firm happens to enter a market sufficiently early to enjoy an economic profit in the short run, so much the better. Similarly, if a firm exits an unprofitable market quickly, it can save its uwestors money. Thus the concept of long-nm equilibrium tells us the direction that firms' behavior is likelv to take. The idea of an evenhlal zeroprofit, long-rurl equilibrium should not dis~ourage a manager-it should be seen U1 a positive light, because it reflects the opporhmity to eam a competitive rehlrI1· Now suppose that all finns U1 the u1dustry do not haw identical cost curves. Perhaps one finn has a patent that lets it produce at a lower average cost than all other firms. In that case, it is consistent ,vith long-run equilibrium for that firm to earn a greater acco1llltillg profit and to enjoy a hiaher producer surplus than other finns. As long as other investors and firms cal;ot acquire the patent that lowers costs, they have no incentive to enter the industry. Com-ersely, as long as the process is particular to this product and this industry, the fortunate firm has no incentive to exit the u1dustry. The distinction between accounting profit and economic profit is important here. If the patent is profitable, other firms U1 the u1dustry will pay to use it (or attempt to buy the entire firm to acquire it). TIle increased value of the patent thus represents an opporhmity cost to the finn that holds it. It could sell the rights to the patent rather than use it. If all finns are equally efficient otherwise, the ecolloJllic profit of the firm falls to zero. However, if the firm with the patent is more efficient than other finns, then it will be earning a positive profit. But if the patent holder is otherwise less efficient, it should sell off the patent and exit the u1dushy. There are other instances in which firms earning positive accounting profit may be earning zero economic profit. Suppose, for example, that a clothing store happens to be located near a large shopping center. The additional flm·" of customers may substantially increase the store's accounting profit because the cost of the land is based on its historical cost. However, as far as economic profit is concerned, the cost of the land should reflect its opporhmity cost, which in this case is the current market value of the land. When the opportunity cost of land is included, the profitability of the dothu1g store is no higher than that of its competitors. Thus the condition that economic profit be zero is essential for the market to be in long-run equilibrium. By definition, positive economic profit represents an opportunity for investors and an incentive to enter an industry. Positive accounting profit, however, may signal that finns already in the industry possess valuable assets, skills, or ideas, which will not necessarily encourage entry. Economic Rent We have seen that some firms earn higher accounting profit than others because they have access to factors of production that are in lunited supply; these might inclUde land and natural resources, entrepreneurial skill, or other creative talent. In these sihlations what makes econOlnic profit zero in the long nm is the willu1gness of other firms to use the factors of production that are m limited supply. TIle positive accountu1g profits are therefore translated into econoJllic rellt that is earned by the scarce factors. Economic rent is what firms are willu1g to pay for an input less the muumum amOl.mt necessary to buy it. In competitive markets, in both the short and the long rW1, economic rent is often positive even though profit is zero. economic rent Amount that firms are willing to pay for an input less the minimum amount necessary to obtain it.
276 Part 2 Producers, Consumers, and Competitive Markets Chapter 8 Profit Maximization and Competitive Supply 277 For example, suppose that two firms in an industry own their land outrietht. thus the minimum cost of obtaining the land is zero. One finn, hmyeve~ i; located on a river and can ship its products for $10,000 a year less than the other firm, which is inland. In this case, the $10,000 higher profit of the first finn is due to the $10,000 per year economic rent associated with its river location. The rent is created because the land along the river is valuable and other firms would be 'willing to pay for it. Eventually, the competition for this specialized factor of production will increase the value of that factor to $10,000. Land rent-the difference bet\".'een $10,000 and the zero cost of obtaining the land-is also $10,000. Note that "while the economic rent has increased, the economic profit of the firm on the river has become zero. The presence of economic rent explains ,"vhy there are some markets in which firms cannot enter in response to profit opporhmities. In those markets, the supply of one or more inputs is fixed, one or more firms earn economic rents, and all firms enjoy zero economic profit. Zero economic profit tells a firm that it should remain iIl a market only if it is at least as efficient m production as other firms. It also tells possible entrants to the market that entry will be profitable only if they can produce more efficiently than firms already in the market. Ticket price 57 (a) 1.0 LylC LAC Season ticket sales (millions) Ticket price 510 57 Economic Rent (b) 13 Season ticket sales (millions) Producer Surplus in the Long Run Suppose that a firm is earning a positive accountiIlg profit but that there is no mcentive for other firms to enter or exit the mdustry. This profit must reflect economic rent How then does rent relate to producer surplus To begin with, note that while economic rent applies to factor inputs, producer surplus applies to outputs. Note also that producer surplus measures the difference between the market price a producer receives and the margmal cost of production. Thus, in the long nm, m a competitive market, tlze producer surplus tlzat a firm eams Oil tile output that it sells collsists of tlze ecolloll1ic rellt tlzat it enjoys fro 111 all its scarce illPuts. Let's say, for example, that a baseball team has a franchise allowing it to operate in a particular city. Suppose also that the only alternative location for the team is a city m which the team will generate substantially lower re\·enues. The team will therefore earn an economic rent associated with its current location. This rent will reflect the difference between what the firm would be willing to pay for its current location and the amount needed to locate in the alternativ~ city. The firm will also be earniI'lg a producer surplus associated with the sale at baseball tickets and other franchise items at its current location. This surplus will reflect all economic rents, includmg those rents associated with the finn's other factor iIlputs (the stadium and the players). Figure 8.15 shows that firms earning economic rent earn the same economic profit as firms that do not earn rent. Part (a) shows the economic profit of a baseball team located m a moderate-sized city. The average price of a ticket is $7, and costs are such that the team earns zero economic profit. Part (b) shows the profit of a team ''''ith the same costs, even though it is located iIl a larger city. Because more people want to see baseball games, the latter team can sell tickets for $10 apiece and thereby earn an accounting profit of $3 on each ticket. Hm\'ever, the rent associated with the more desirable location represents a cost to the firm-an opportwlity cost-because it could sell its franchise to another team. As a result, the economic profit iIl the larger city is also zero. S In a noncompetiti\"e market, producer surplus will reflect economic profit as well as economiC rent In long-run equilibrium, all firms earn zero economic profit. In (a), a baseball team in a moderate-sized city sells enough tickets so that price ($7) is equal to marginal and average cost. In (bt the demand is greatel~ so a $10 price can be charged. The team increases sales to the point at which the average cost of production plus the average economic rent is equal to the ticket price. When the opportunity cost associated with owning the franchise is taken into account, the team ean1S zero economic 8.8 In our analysis of short-run supply, we first deri\"ed the firm's supply CUl"\"e and then showed how the summation of individual firms' supply cun"es generated a market supply curve. We cannot, however, analyze long-run supply in the same way: In the long run, firms enter and exit markets as the market price changes. This makes it impossible to sum up supply cun"es-we do not know which firms' supplies to add up to get market totals. The shape of the long-run supply Clln'e depends on the extent to which ~creases and decreases in industry output affect the prices that firms must pay tor inputs into the production process, To determine long-run supply, I've assume all firms ha\'e access to the a\'ailable production technology. Output is Increased by using more inputs, not by im-ention. vVe also assume that the con ~itions underlying the market for inputs to production do not change when the Industry expands or contracts. For example, an increased demand for labor does not increase a union's ability to negotiate a better wage contract for its workers. In our analysis of long-run supply, it 'will be useful to distinguish among three types of industries: constant-cost, ill creasing-cost, and decreasing-cost. Constant-Cost Industry Figure 8.16 shows the derivation of the long-run supply cun-e for a constantcost industry. A fum's output choice is giwn in (a), while U;dush-y output is shown In (b). Assume that the industry is initially in equilibrium at the intersection of constant-cost industry Industry whose long-run supply curve is horizontal.
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Daniel l. Rubinfeld

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