P-Competitive Equilibrium as an Ideal

Figure 3

We notice something else about the long-run equilibrium of a P-Competitive industry: each firm chooses the plant and equipment and productive capacity that gives the lowest average cost overall. This is shown by the above figure.

To see what this means, we might ask the following hypothetical question:

If an industry is to produce a certain amount of output, how should the output it be divided up among the different firms? More specifically, how many firms should share that production assignment? If there are very many firms, then each will be producing at a very small scale. They will not be taking advantage of the economies of scale, and cost per unit will be high. On the other hand, if there are very few firms, each will be producing on a very large scale, and suffering from diseconomies of scale, so, again, unit costs would be high. It would be best to balance the disadvantages of too large scale against the disadvantages of too small scale, and have just enough firms in the industry so that each is at the bottom of its average cost curve. The total cost of producing that output is then at a minimum.

What we see is that the equilibrium in a P-competitive industry does just that. That is one reason why economists often think of P-competition as an ideal. (We will see another reason in the next chapter).

Remember the assumption behind this whole argument! The assumption is that the long run average cost curve is u-shaped as shown. There may be some industries for which that is not true, and the argument would not be applicable to those industries.