Question

QUESTION 11 Use the figure below to answer the question that follows 1 Price Price (a) MC 6) SOS1 ATC 02 03 Quantity QW QYOX QZ Quantity Assume that the market starts in equilibrium at point W in panel(b). An increase in demand from Doto D1 will result in: a. Rising prices and failing profits in the market and new long-run equilibrium at point b. An eventual increase in the number of firms in the market and a new long-run equilibrium at point Z OC. A new market equilibrium at point X d. Falling prices and failing profits for existing firms in the market

Answer 1

In the question we can see that there is a perfect competition market where fig-a is the equilibrium of a single firm in the market and fig-b is the equilibrium of the whole market.

now if the demand of market increase from D0 to D1 then the result will be an eventual increase in the number of the firms and lond run equilibrium at point z.

How this will happen lets see.

In the perfect competition market all the firms are identical and they produce homogeneous goods.as all firms are identical then all the firms has the same cost structure and there is a price which is set by the market demand and supply.all the firms produce at a minimum cost which is achived at the lower point of ATC where ATC=MC.and price P=ATC=MC so all the firms earn only natural profit.now if the market demand will increase for some external forces then the market demand curve will shift from D0 to D1.but the supply from the firms are not increasing so they remain on the same supply curve.so at the price level P2 the market demand is P2Z and market supply is P2W.so there is an excess demand of WZ amount.the new demand curve D1 cut the initial supply curve S0 at point Y.this is the temporary equilibrium of the market and at this equilibrium the price is P3 which is higher thsn the initial price P2.so all the firms earns abnormal profit.but this is a perfect competition so everyone knows the market so this abnormal profit will attract some more firms to come in the market.now as new firms are coming then the supply of the whole market will increase.now the supply curve of market will shift from S0 to S1.as supply increases it tends to falls the market price level also.so at the new long run equilibrium will achive at Z where the new demand curve D1 and new supply curve S1 intersect. So new price level will fall from P3 to P2 where all the firms are at equilibrium as before.and now all the firm will earn normal profit so no other firm will enter the market and this equilibrium will maintain in long run