Question

4.Suppose the market for hamburger (restaurants) is perfectly competitive. Suppose the government provides an unit subsidy to hamburger. Explain with the aid of detail diagrams, the immediate effect and long run effect on the following 4 variables:

i)Ps

ii)Pc

iii)Qm

iv)Qi

and

v) # of firms

Answer 1

The left hand side diagram shows the market demand and supply situation. Consider the initial equilibrium price and quantity were Pe and Qe, corresponding to the intersection of the market demand and market supply curve. So, the price Pe is considered as given by all the producers and consumers of the competitive market. As shown in the right side panel, the competitive market was in long run equilibrium where price = LAC = LMC.

When a unit subsidy was provided, the supply curve shifts to the right. At this scenario, the consumer pays a price of Pc, but the producer gets a price of Ps. The difference between Pc and Ps is the subsidy provided by the government. In the short run, the producer enjoys profit (highlighted area) as the new price Ps > average cost corresponding to the profit maximizing level of output, where price = MR = MC. So , individual firm will produce Oq' level of output.

So, the market output (Qm) will also increase.

Since individual firms are earning profit in the short-run, new firms will enter into the market and the price level will come down to its original level where economic profit becomes zero.