Question

Assume that the perfectly competitive market for ethanol is in long-run equilibrium. Now suppose that the price of gasoline, a substitute for ethanol, increases. Explain what will happen in the market for ethanol. 1) Describe how this change will affect short-run economic profits. 2) What will happen to the number of firms producing ethanol in the long run? 3) How will price and output in this industry adjust in the long run?

Answer 1

1) initially the equilibrium is at e with P and Q. Now increase in price of a substitute will increase the demand for ethanol that will shift the D curve rightward. Existing firms earn positive economic profit due to higher price.

2) in the long run new firms will enter the market to exploit profit opportunities that will increase the market supply shifting the S curve rightward.

3) this increase in supply results in decrease in price back to the initial level eliminating all the positive economic profit. Thus in the long run output increases and price remains the same.