Question

Consider a perfectly competitive industry with a large number of identical firms. Each firm’s long-run average total cost curve reaches a minimum at $4, where output is 100 units. The current market price of the good is $4. a. Is this industry in long-run equilibrium? Why or why not?

b. Suppose that the industry is a constant-cost industry. The government announces that this product is harmful to consumer health, so aggregate consumer demand falls (but not to zero!). How does this affect the long run equilibrium outcome, in terms of the market price of the good, the quantity of the good that is bought and sold in the market, and the number of firms in the industry? Explain, using graphs of the industry and a representative firm.

Answer 1

Below is the graph for a perfectly competitive industry where each firm’s long-run average total cost curve reaches a minimum at $4, where output is 100 units. The current market price of the good is $4. Since the current price has reached minimum ATC, it implies no profit or loss (economic) and so the industry is in long-run equilibrium.

Suppose that the industry is a constant-cost industry. The government announces that this product is harmful to consumer health, so the consumer demand falls. Initially this will reduce the quantity demanded at every price so the market demand shifts to the left. In the short run, at the initial price level $4, there is excess supply which generates an downward pressure on the price so the price falls from $4 to a level of P2 which is less than $4

With lower prices each firm now produces less and earns an economic loss so production falls. Market quantity traded also falls from Q1 to Q2.  

In the long run when exit is possible, firms start leaving the market and this shifts the market supply curve to the left. This entry continues till the market price is reduced to $4 where each firm now earns a no economic profit and produces the same quantity. There are now only fewer firms in the long run after exit.