Other things, external to the industry, like inflation, may cause its cost to rise, but output changes in the industry itself will not affect its costs.
Consider shoe industry as a constant-cost industry, under perfect competition with free entry and exit of firms.
Industry in L.R. equilibrium at a price P o and q = q o . All producers just covering all costs. Just earning a “normal” return. Now, let P o P 1 because overall shoe D shifts to D 1 . Now what?
For any producer, AC now less than price. There are temporary economic profits – capital owners getting a short-term rent. (Quasi rent) Returns to capital are temporarily in excess of normal return to capital. Remember, AC includes normal return to capital .
What now happens?
With capital in this industry receiving excess returns , new firms will enter, attracted by returns greater than normal.
Then what happens?
Under perfect competition with free entry and exit of firms supply shifts to right. (S 1 ) Price falls back to P 0 .
Now in equilibrium all firms make no more than normal return. Also, P=MC=AC (minimum AC) for all producers. This is efficient. P=minimum AC. Nirvana for economists.
Now, over the centuries, people have found ways to thwart this process and receive contrived rents , or long term returns in excess of “normal returns.”
The best way, or the oldest way, is to restrict competition.
So, let us more closely examine monopoly or oligopoly rents from rent-seeking behavior: a clear symptom of allocative inefficiency .
How to get such monopoly rents? Secure a monopoly or oligopoly privileges, most often granted by government thru licensing franchises. Monopoly rent- can prevail even in L.R.
Consider the shoe industry. We saw earlier that the competitive solution is P = MC = AC, where AC at a minimum for all producers.
If the constant cost shoe industry were turned over to a monopolist, instead of a perfectly competitive outcome then what would we have? Take a look:
Now LRAC is also LRMC ? Why?
Because with horizontal AC, MC = AC.
And with a monopolist have downward sloping D facing one producer, the monopolist.
Now the monopolist has a MR curve. Where will it be? It will have twice the slope of the AR curve (D curve).
Now profit maximizing monopolist does what? Equates MR and MC.
This will be at output level Q m . Now D curve says that Q m can be sold for P m .
Now, the competitive solution would be Pc, Qc recall. Why?
The monopoly solution involves output restrictions : Q m <Q c
And Price P m >P c
Monopolization generates rents – these are contrived, or unnatural rents. Not like natural resource rents, or quasi-rents.
The monopolist now earns a return in excess of the normal return: P m >AC
Per unit rent is distance OZ from A R curve to AC curve. Overall rents are the total area (PmZ PcO).
Now, what would we have here is a very simple kind of rent. One example of a contrived rent. Rents are attractive right? People like to receive them. They seek them. But presence of contrived rents indicates and introduces inefficiency in the system.
Why?
Consider again the triangle CZO in the monopoly diagram. This is deadweight loss, or economic waste, or inefficiency.