Examining the Firm's Long-Run and Short-Run Adjustments to a Price Increase

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Examining the Firm's Long-Run and Short-Run Adjustments to a Price Increase A price increase for a competitive firm’s product produces different responses in the short run and in the long run. In the short run, a firm increases output by moving along its short-run cost curves to the output level where price equals short-run marginal cost (SMC), P = SMC. In the long run, the competitive firm has the flexibility to change all its inputs and increases output further to the point where price equals long-run marginal cost, P = LMC. With the increased price the firm is able to make an economic profit in both the short run and long run, but the profit is higher in the long run. Using the trucking firm example, the firm faces short-run and long-run cost curves. The long-run curves are always lower than the short-run curves because in the long run, the firm has more flexibility to change the combination of capital and labor. In the short run, the firm can vary only labor if it wants to change output. In the example on the left, if market price for the firm’s product is P0, the firm is breaking even: it is making zero economic profit. Assume now that the market price rises to P1. The firm’s short run response to the price increase is to increase output to y1s. The output level the firm chooses is where MR = P = SMC. (Recall for a competitive firm MR = P.) The firm is now making an economic profit, as shown by the shaded area on the left. Profit is the area above the ATC curve. Note: Often q is used instead of y to represent quantity. In the long run the firm has the option of increasing output to y1L where MR= P = LMC. It would prefer the long-run output level at the new price because long-run profits are greater than in the short run. In the long run, the firm would buy additional trucks as well as hire more drivers because it has the flexibility to alter all inputs to achieve the profit-maximizing output level. To summarize the firm’s long-run and short- run response to a price increase: 1. the firm increases output in both the long run and the short run, but the long run increase is greater; 2. the firm realizes an economic profit in both the long run and the short run, but the long run profit is greater. .

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