Question

Suppose you have a perfectly competitive industry and firms have positive profits. Explain the forces of change that will move the situation toward equilibrium (just as in the assignment on this chapter)

include what happens in the market diagram and then say how that changes the picture of the firm's diagram (what is the relationship between the firm's Demand and ATC after the adjustment?) be clear about how that picture looks

Answer 1

In following graph, left panel shows the long-run market equilibrium where demand and supply curves (D0 and S0) intersect at point A with market price P0 and market quantity Q0. In right panel of the graph, firms take P0 as their relevant price and produces at point B where P0 intersects MC0 with firm output being q0. In long run equilibrium, firm profit is zero, shown by intersection of P0, ATC0 and MC0 at point A.

However, a short-term increase in demand will cause D0 to shift rightward to D1, intersecting S0 at point C with higher market price P1 and higher market output Q1. In right panel, for Firms, P1 is their new price. New short run equilibrium is at point E, where P1 intersects MC0 with higher firm output q1. Firms earn short run economic profit equal to area P1EFG.

However, in the long run, short run profit attracts new entry, so new firms enter and market supply increases, shifting S0 rightward to S1. New long run equilibrium is at point H where D1 and S1 intersect at original price P0 but higher market quantity Q2. So firms return to initial long run equilibrium point B.