Two Adjustments

• Firm Adjustment: Each firm in the monopolistically competitive industry adjusts short-run production and long-run plant size to achieve profit maximization. This adjustment entails producing the quantity that equates marginal revenue',500,400)">marginal revenue to short run marginal cost for a given plant size as well as selecting the plant size that equates marginal revenue to long-run marginal cost.


• Industry Adjustment: Firms enter and exit a perfectly competitive industry in response to economic profit and loss. If firms in the industry earn above-normal profit or receive economic profit, then other firms are induced to enter. If firms in the industry receive below-normal profit or incur economic loss, then existing firms are induced to exit. The entry and exit of firms causes the market price to change, which eliminates economic profit and loss, and leads to exactly normal profit.

The Shady Valley Restaurant Industry

Firm Adjustment

Firm Adjustment

The LRAC is Manny's long-run average cost curve, which is an envelope of an infinite number of short-run average total cost curves. The LRMC is the long-run marginal cost curve. This indicates the change in total cost resulting from a change in production when ALL inputs, including capital and plant size, are variable.

• Short-Run Equilibrium: The current situation shows Manny maximizing short-run profit given a relatively small plant size. His production level is 150 meals per day. This production level, however, does not maximize long-run profit. Manny's task is to identify the long-run profit-maximizing production level.


• Long-Run Profit Maximization: To maximize long-run profit, Manny needs to find the production level that equates marginal revenue and long-run marginal cost, which is the intersection of the MR and LRMC curves. This can be highlighted by clicking the [Profit Max] button. The resulting quantity is approximately 405 meals per day.


• Plant Size: Once Manny determines the profit-maximizing quantity, he needs to identify the plant size (that is, size of his restaurant, number of tables, etc.) that he can use for the short-run production of food. For each quantity of output there is one and only one plant size and corresponding set of short-run cost curves. The short-run average total and marginal cost curves for the profit-maximizing quantity selected by Manny can be revealed by clicking the [Plant Size] button.


• Economic Profit: At this production level, achieved with the larger plant size, Manny maximizes long-run profit. The extent of this profit can be highlighted in yellow with a click of the [Economic Profit] button.

It is no coincidence that the tangency between the SRAC and the LRAC corresponds with an intersection between the SRMC and LRMC. In much the same way that the long-run average cost curve is derived from a series of points from an array of short-run average total cost curves, the long-run marginal cost curve is derived from a series of corresponding points from an array of short-run marginal cost curves.

The end result is that Manny maximizes profit in the long run and he maximizes profit in the short run. The quantity of output Manny produces is the short-run profit maximizing quantity given the plant size selected.

Industry Adjustment

While Manny can adjust no further (for the time being), other firms can take action.

Industry Adjustment

In particular, the plant size, profit-maximizing adjustment illustrated in this exhibit is bound to induced resource mobility. Manny's adjustment not only maximizes his profit, it generates a positive economic profit, an above-normal profit, a profit that exceeds that earned in other industries (such as macrame sales or bookstores). Other firms, those not currently in the monopolistically competitive restaurant industry, are bound to take notice.

For example, a rash of bookstores might be attracted by the above-normal profit received by Manny and other restauranteers in the industry. They are inclined to switch from book sales to food sales. And what might stop the book stores from starting restaurants? Almost nothing. There is relative freedom to enter this monopolistically competitive industry.

• Entry of New Firms: The result of an increase in the number of producers in the restaurant industry is an increase in the supply (a rightward shift of the supply curve), which results in relatively less demand for each existing firm. To see what this means for Manny's production, click the [More Firms] button.

  Note that average revenue (AR) and marginal revenue (MR) curves shift down until the average revenue curve just touches the long-run average cost curve (LRAC). At this average revenue (and price) all economic profit is eliminated. Price is equal to long-run average cost and the only profit generated is a normal profit.



• Plant Size Readjustment: This lower price forces Manny (and the other firms) to re-evaluate their profit-maximizing production and plant size. What had been Manny's long-run profit-maximizing production level using the larger restaurant, is no longer correct. Manny is no longer maximizing profit. Marginal revenue is not equal to marginal cost. Manny must adjust.

  To see how Manny adjusts his plant size, click the [New Plant Size] button. Manny selects a new plant size that equates marginal revenue and marginal cost once again. However, this adjustment moves Manny to a smaller level of production and point of tangency on the LRAC curve.

Long-Run Equilibrium Conditions

MR = MC = LRMC

P = AR = ATC = LRAC