Question

Suppose that the market for DVD rentals is perfectly competitive and operates at the industry's long-run equilibrium. At this point, Amazon and Hulu expand their online streaming services. Describe the long-run adjustment observed in the DVD rental industry, step by step. Explain the economic intuition for each change you describe and illustrate it with a graph.

Answer 1

When Amazon & Hulu expands their offerings, demand for DVD rental decreases, so its market demand curve shifts leftward, decreasing market price and market quantity of DVD rental. Firms being price takers, in new short run equilibrium, firms incur economic loss.

In long run, economic loss causes some firms to exit, therefore market supply of DVD rental decreases, shifting market supply curve leftward. New long run equilibrium is acieved when new market demand and new market supply curves intersect at original price but higher market quantity.

In following graph, left panel shows the market equilibrium where demand and supply curves (D0 and S0) intersect at point A, with initial market price P0 and market quantity Q0.

In right panel, firms treat P0 as their own price and produces at point B, where P0 intersects MC0 with firm quantity q0. In long run equilibrium, price is equal to ATC, therefore P0, ATC0 and MC0 intersect at equilibrium point B.

When market demand decreases, D0 shifts leftward to D1, intersecting S0 at point C with lower market price P1 and lower market quantity Q1.

Firms treat P1 as their new price. New short run equilibrium is at point E, where P1 intersects MC0 with lower firm quantity q1. Firms incur economic loss equal to area P1EFG.

In long run, market supply decreases, shifting S0 leftward to S1. New long run equilibrium is at point H where D1 and S1 intersect at original price P0 but lower market quantity Q2. Therefore, firms return to initial long run equilibrium point B.