Due to entry and exit in the perfectly competitive market,
we said that in the long run,
the price is equal to the minimum of the average total cost.
There's a profound implication from this result,
and it is that prices in the long run are not determined by demand,
rather they are determined by costs.
Let's look through an example of this.
Suppose that we start in a long-run equilibrium,
but the demand increases.
Maybe we're talking about the market for t-shirts and there's
economic growth and people want more of normal goods including t-shirts,
and because of that the demand shifts out.
We know what will happen in the market.
Demand shifts out.
We'll get a new equilibrium with a higher price.
Let's call it P1, and a higher equilibrium quantity,
let's call that Q1.
The individual firm doesn't really care why
the market demand changed or really why the price increased.
But they do see that the price is higher and they're going to change their behavior.
At this new price,
they will change how much they're producing because profit maximizing
firms always produce where marginal revenue equals marginal cost.
So, lo and behold,
this will be the new quantity that the firm is producing.
But at this quantity and because of the high price,
the firm is making a profit.
We can see price is greater than average total cost.
The firm is making a profit,
the firm is happy.
But we know that's not the end of the story.
In long run, perfectly competitive markets,
we'll have entry into this industry,
and as we have entry into this industry,
the supply curve will shift out.
This process of firms entering the market and the supply curve shifting out,
will continue as long as profits are positive.
So, more firms enter the market,
the supply shifts out,
and the price drops and the profits get smaller and smaller,
and this process continues until finally we
go back to exactly the same price we had before.
In other words, it doesn't matter that the demand changed that was a shock to the price,
but it's a shock to the price only in the short run.
In the long run,
price will come back to where it was before,
to the minimum of the average total cost curve.
Rebecca SteinSenior Lecturer
