Question

Assume that the oil industry is in a long-run competitive equilibrium at a price of $100 per barrel, and that the oil industry is constant-cost. Use a carefully labeled set of two graphs to explain what would happen in the long run to the number of firms and to the production of each firm as a result of the drop in price from $100 to $76, assuming it reflected a decrease in demand. Be sure to define constant-cost and describe what it means for the long-run supply curve.

Answer 1

In the case of a perfectly competitive firm, equilibrium price level occurs at the minimum point of the average total cost curve. In the diagram below, the intial equilibrium in the market and firm occurs at point E1 where P1 is the equilibrium price level and corresponding to this equilibrium market quantity is equal to Q1 and and since firms are price takers, q1 is the equilibrium amount of firms quantity. A decrease in demand will shift the market demand curve leftwards to D'D' and new short run equilibrium moves from point E1 to point E2. This can be depicted in the diagram as:

At new short run equilibrium, both the prices and equilibrium quantity has decreased at P2 and Q2. At a lower price level P2, the firm will produce only Q2 amount of the output and the firm will be making losses represented by the red shaded area. Since firms will start making losses, this will lead to exit of some firms from the industry and the exit will reduce number of firms and supply curve will shift leftwards to S'S' until prices rise again to P1 and new long run equilibrium is established at point E3 where market equilibrium quantity has decreased to Q3 and price level is constant at P1. The firm will also take P1 as given and start producing q1 units of output.

This leads to a horizontal shaped long run supply curve of the firm at the price level equal to P1 which is the minimum point of the average cost curve. Since it is a constant cost industry, this leads to a horizontal shaped long run supply curve of the industry.