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(S&DLR.1) An Example
Consider a peculiar service: a professional line-stander. If you wanted to hear a controversial Supreme Court case (like the March 2012 case regarding Obamacare, shown below), but you make too much money to waste standing in line, why not simply pay someone else (whom I will call a stander) to stand in line for you? Someone whose opportunity cost of time is much less because the wage they could earn working elsewhere is much lower than yours. According to a newspaper article these standards cost around $13 per hour. When standers are offered more than $13 for their services lots of people clamor for the job, allowing you to negotiate a lower price. If paid substantially less than $13 no one wants to be a stander, and you must offer a higher price.
Let us suppose that there are many more people willing to be standers for around $13 than their are people who want to hire standers. This means that the compensation for standers will be around $13 per hour regardless of whether there are hundreds of people hiring standers or only two. Their compensation stays the same regardless of the demand for standers because there is free entry and exit of standers. As the demand for standers rises their compensation may initially rise, but that higher compensation attracts new standers, giving buyers the negotiating power to reduce wages back to $13. If the demand for standers falls their compensation might fall also, but immediately standers begin to leave and buyers recognize they must increase the compensation back to $13.
Figure 1—Professional Standers During ObamaCare Trial at Supreme Court(P) standing in line.jpg)
This example is a good metaphor for the long-run supply and demand. If you can understand this example, you can understand the following examples as well.
(S&DLR.2) Long-Run Supply and Demand
The long-run supply and demand for a good depicts how equilibrium prices and quantities behave over very long time periods. How long? It depends on how long it takes for new firms to enter an industry and old firms exit. The long-run for pecans is decades, as it may take fifteen years before a new trees provides a harvest. The long-run for chickens is much faster because the reproductive cycle for poultry is relatively fast.
A supply and demand diagram usually refers to the short-run, which is a period over which new firms do not have enough time to enter and old firms don't have enough time to exit. The number of firms is fixed in the short-run but can increase or decrease in the long-run. The result is a very flat long-run supply curve.
Because new firms make it easier for a firm to increase production in response to a price increase, the supply curve in the long-run is much more elastic, meaning it resembles something close to a horizontal line. If that is confusing, refer back to the standers. Suppose in the short-run the number of standers cannot be changed. An increase in demand would then have no effect on the number of standers, but it would drive their compensation higher as more buyers seek to hire the same number of standers (the supply curve would be a vertical line). In the short-run changes in demand can have a large impact on price. Now look to the long-run, when standers may increase or fall in number, thereby resembling the story in the first section of this article. In this long-run story price stays the same regardless of how many standers are employed, and the supply curve would be a horizontal line.
Figure 2—Long-Run Supply and Demandgraph,1(B).png)
In real industries there is no reason to believe the supply curve would ever be a perfectly horizontal line. However there is every reason to believe that the entry and exit of new firms allows quantity supplied to be very, very sensitive to price changes over long time periods, resulting in a supply curve with a very gentle slope, almost becoming a horizontal line, as in Figure 2.
(S&DLR.3) Demand increases in the long-run
When demand increases from D to DH price does rise considerably in the short-run, but remember, Figure 2 is not the short-run. This price rise entices new firms to enter the market, increasing the quantity of goods sold by significant amount, which forces price back down—not to its original price, but something slightly higher. So however much the demand increase pushes up prices initially, in the long-run that price increase will be smaller. For instance, if an increase in beef demand increases prices by $10 / cwt in the first year, that increase will fall over time. Over five years the demand increase may raise prices by only $2.
Why doesn't price fall back to its original price? Because as market output expands firms use more inputs, bidding the input prices up in the process. With higher input prices, firms need to receive a higher price to remain in the market.
What about quantity? The demand increase does initially increase quantity, but in the long-run that quantity increase is much larger. So if the initial quantity increase is 10 million cwt of beef, in the long-run the increase may be 20 million cwt.
Figure 3—Demand increase in long-rungraph,2(B).png)
(S&DLR.4) Demand decreases in the long-run
When demand falls from D to DL the initial, short-run impact is for price to fall considerably. Over time this lower price will deter some firms from competing, and they go out of business. The exiting of these firms causes market output to fall dramatically, and this fall in supply forces price upwards—not to its original price, but something slightly lower. However much the initial demand decrease pushed prices down, prices will recover some of their value as firms go out of business. Like, if a demand decrease pushed beef prices down $15 / cwt, after a few years the price decrease may be only $3 / cwt.
Why doesn't price increase back to its original price? Because as market output contracts firms use less inputs, and this decrease in input demand causes input prices to fall. With lower input prices, the firms that remain are willing to do so at lower prices, and so prices remain below their original level.
While the effect of a demand decrease on prices is tempered in the long-run, its effect on quantity is amplified. A demand decrease may cause beef supplied to fall 10 million cwt initially, but over time as firms exit the industry, the decrease may be as large as 30 million.
Figure 4—Demand decrease in long-rungraph,3(B).png)
(S&DLR.5) How to use the concept of long-run market equilibrium
Many students find themselves in jobs where they must predict how the future prices of commodities might change in the next year, five years, or even twenty years. If one is considering building a multi-million dollar sorghum processing facility one must certainly evaluate whether it will be profitable over the next twenty years, which means sorghum prices over the next twenty years must be predicted. It would be a mistake to take the sorghum price in any one year and simply assume that is a good predictor of future prices. Instead, one must also consider how that current price will motivate firms to enter the market or force some firms to leave.
Consider the behavior of sorghum prices in the last sixty years, below. In 2009 prices were very high, around $10.00. Suppose that it is 2009, and in your budgets used for evaluating the profitability of a sorghum processing plant, the plant would be profitable whenever sorghum prices were under $8.00 (higher sorghum prices mean the plant pays more for its inputs). Using contemporary prices of $10.00 the plant would seem very unprofitable, but what is the likelihood prices will remain that high? Won't farmers increase their sorghum production in response to the high prices? Won't the high prices induce some new farms to be established? If the answer is yes, then the increase in sorghum production would drive prices back down, and if sorghum prices revert to its typical (long-run) behavior, the plant is likely to be profitable.
Figure 5—Sorghum Prices from 1949 to 2009sorghum.jpg)
References
Perry, Mark J. March 26, 2012. "Markets in Everything: Professional Line-Standing." Carpe Diem [blog].
