Question

2. Describe what happens to output, price, and economic profit in the short run and in the long run in a competitive market following: a) An increase in demand. b) A decrease in demand. c) The adoption of a new technology that lowers production costs.

Answer 1

1. An increase in demand

Increase in demand increases the market quantity, and the market price rises above ATC for each firm. In the short run, firms in the market earn an economic profit, and attract other firms to enter the market in the long run. It will shift the market supply curve rightward, it will decrease the price and market quantity continues to increase. The fall in the price reduces the firms’ economic profit and price again equals the minimum point on each firm’s ATC curve. At this point, firms earn zero economic profit and entry of new firms stops. In the long run, the price returns to the original level, market output is larger than the original amount, the number of firms is larger, and economic profit for each firm returns to zero.

2. A decrease in demand.

A decrease in demand decreases the market quantity, and the price falls below the minimum ATC for each firm. In the short run, firms in the market incur an economic loss, which leads some firms to exit the market in the long run. This exit shifts the market supply curve leftward, raising the price and continuing to decrease the market quantity. The increase in the price shrinks the economic loss for each remaining firm. In the long run, the market price returns to the original level, market output is less than the original amount, the number of firms is less, and economic profit for each firm returns to zero

3. Adoption of a new technology

Adoption of new technology that lower the cost will causes two actions to occur in the market:

i) firms will enter the industry with new technology.

ii) firms with old technology will leave market or adopt the new technology. These two will shift the industry supply rightward, decreasing market price and increasing market quantity.

In the long run, all firms in the industry will be new technology firm each firm will return to zero economic profit and market quantity will increase, and market price will fall to the new minimum ATC for each firm.