Question

2. Suppose bicycles are produced by a competitive constant-cost industry, which is initially in a long-run equilibrium. For the following situation, design a supply-demand diagram that shows how market price and quantity will be affected in both the short run and the long run. In your diagrams, show the short-run supply, long-run supply, and demand curves, along with any shifts in these curves. Label the initial long-run equilibrium E₀, the new short-run equilibrium E₁, and the new long-run equilibrium E₂.

Bicycling increase in popularity as more people become aware of health benefits of bicycling. How are the profits of bicycle manufacturers affected in the short run? How are their profits affected in the long run? Explain and illustrate with a diagram as mentioned above (the first paragraph).       

Answer 1

Ans. Suppose initially the industry is in long run equilibrium with quantity Q0 and price P0 and as the market is perfectly competitive, the individual firm is earning normal profits and is producing qo units of cycles. The market supply curve in short run is upward sloping.

As the popularity of bicycles increase, the demand increase shifting the demand curve to the right from D0 to D1 and at given level of supply, prices rise this increases the quantity of bicycles supplied to increase, thus, new price is P1 and quantity is Q1. Also, now the individual firm who is a price taker, increases production to q1 and start earning profits. As the firm start earning profits, it becomes profitable for other firms to enter the market, this increases the market supply of bicycles shifting the supply curve to the right from S0 to S1, bringing the price back to the original level P0 and increasing the quantity to Q2. As the price decreases the firm again starts earning normal profit and earn only normal profit, this stops the entering of firms to the market and the economy is in long tun equilibrium.

We can see that price being constant, the quantity has increased from Q0 to Q2, thus, the supply curve of the market in long run is horizontal and represented by LRS.

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