Question

A competitive market is in long-run equilibrium. If demand increases, what would happen to the price level, output level, profits earned, and the number of firms in the market in the short and long run when some resources used in production are only available in limited quantities? Please show your answers with diagrams.

Answer 1

A competitive market is a market where a large number of producers sell their products to a large group of people. There are free entry and exit of the firms in this market.

It is given that the market is in equilibrium in the long-run, and there are limited resources available for production.

If demand increases, it will shift the aggregate demand curve to the right, as shown in the graph below:

When the aggregate demand curve shifts rightward, it increases the price level as well as the output level in the short-run. An increase in the price level will increase the profit earned by the existing firms that attract more firms to enter the market due to which output level increases.

In the long-run, there are limited resources available in the market due to which producers cannot increase the supply due to which output level will remain the same in the market. As a result, no firm can enter the market. When aggregate demand exceeds the aggregate supply, the price level will increase. As a result, the profit of existing firms will also increase as people are now ready to pay higher for the same level of output.