Long Run Equilibrium
Long run equilibrium is a state in which economic forces are fully reconciled, so that there is no tendency for change. In microeconomics, it refers to a situation in which firms have fully adjusted their inputs, entry and exit have occurred, and each firm earns only normal profit. In macroeconomics, it refers to a situation in which the economy operates at its potential output, with unemployment at its natural rate and no unanticipated inflation. The long run differs from the short run in that all factors of production can vary and all adjustments are complete.
Microeconomic long run equilibrium
In a perfectly competitive market, long run equilibrium occurs when price equals minimum average total cost, so that firms earn only normal profit and there is no incentive for entry or exit. If firms are earning above-normal profit, new firms enter, increasing supply and lowering price until profit is normal. If firms are incurring losses, firms exit, reducing supply and raising price until losses are eliminated. The number of firms adjusts endogenously to the level consistent with zero economic profit.
For a firm, long run equilibrium also requires that the firm be operating at the efficient scale, the output level at which long-run average cost is minimised, and that it have chosen the optimal combination of inputs. The long-run equilibrium condition is therefore more restrictive than the short-run condition, which allows for fixed inputs and for profits or losses.
Macroeconomic long run equilibrium
In macroeconomics, long run equilibrium is characterised by full employment, with output at its potential level and unemployment at its natural rate. The natural rate of unemployment reflects frictions such as job search, matching, and structural change; it is not zero. In the long run, monetary policy affects the price level and inflation but not output or employment, a proposition known as the neutrality of money.
The transition from short-run to long-run equilibrium involves adjustment of prices and wages and of expectations. If output is above potential, inflation accelerates, and expectations adjust upward, shifting the short-run aggregate supply curve until output returns to potential. If output is below potential, inflation decelerates, and the adjustment works in reverse. The long-run aggregate supply curve is therefore vertical at potential output, reflecting the independence of output from the price level in the long run.
Adjustment mechanisms
Adjustment to long-run equilibrium operates through several mechanisms. In product markets, entry and exit, price competition, and innovation restore normal profits. In labour markets, wage adjustment, migration, and changes in participation reconcile labour supply and demand. In financial markets, interest rates equilibrate saving and investment. In the macroeconomy, expectations and price adjustment move output toward potential.
The speed of adjustment varies. Some markets adjust quickly, while others, such as labour markets, may adjust slowly because of contracts, regulation, and information lags. Persistent deviations from long-run equilibrium, such as prolonged unemployment, are a central concern of macroeconomic policy, and they motivate policies to reduce structural rigidities and to support demand during downturns.
Policy implications
The concept of long run equilibrium shapes policy. If the economy self-corrects to full employment, the role of stabilisation policy is to reduce the amplitude and duration of deviations, and monetary and fiscal policy are viewed as short-run tools. If adjustment is slow or the natural rate is itself affected by the level of demand, a phenomenon known as hysteresis, then policy can have lasting effects on potential output, and the case for active demand management is stronger.
The long run is also the horizon for growth policy. Policies that affect investment, education, innovation, and the efficiency of resource allocation determine the level and growth of potential output, and thus the position of the long-run aggregate supply curve. Understanding long-run equilibrium is therefore essential for both stabilisation and growth policy.
Long run equilibrium and hysteresis
The concept of long-run equilibrium assumes that the economy eventually returns to potential output. However, persistent deviations can have lasting effects, a phenomenon known as hysteresis. Prolonged unemployment can erode skills and attachment to the labour force, reducing the natural rate of employment. Prolonged weakness in investment can reduce the capital stock and potential output. In such cases, the long-run equilibrium itself shifts as a result of temporary shocks.
Hysteresis has important policy implications. If the natural rate is affected by demand, then stabilisation policy can have permanent effects, and the case for intervening during downturns is stronger. The concept has been used to explain why deep recessions are followed by slow recoveries and why active labour market policies can help to prevent the erosion of skills and employability.
Disequilibrium and adjustment costs
Adjustment to long-run equilibrium is not instantaneous. Prices and wages may be sticky because of contracts, menu costs, and coordination problems. Capital may be immobile in the short run. Information may be imperfect. These frictions mean that the economy can remain in disequilibrium for extended periods, and that the path to equilibrium matters as much as the destination.
Understanding the adjustment process requires models of price setting and of expectations. New Keynesian models, which incorporate sticky prices and forward-looking behaviour, provide a framework for analysing the short-run deviations and the gradual return to potential. These models inform the analysis of monetary and fiscal policy and of the trade-offs involved in stabilisation.
Policy frameworks and the long run
Policy frameworks are designed with the long run in mind. Inflation-targeting regimes aim to anchor long-run inflation expectations, while fiscal rules seek to ensure debt sustainability. Structural policies, including investment in education and infrastructure and reforms to product and labour markets, aim to raise potential output and thereby shift the long-run equilibrium.
The interaction between short-run stabilisation and long-run growth is a recurring theme. Policies that support demand in the short run can, through hysteresis, also improve long-run outcomes, while policies that raise potential output can reduce inflationary pressure and create room for sustained growth. Recognising the links between the short run and the long run is essential for coherent economic policy.