Question

(a) What do economists mean by the phrase “the Long Run (LR) equilibrium?” (b) Draw the relevant diagram for the classical model to indicate a point where the relationship described in 1(c) holds as the LR equilibrium. (c) Provide one clue from 2 (b) that helps us to infer that the LR equilibrium GDP may change over time even without any policy intervention. (d) Under what condition, the LR equilibrium GDP becomes the LR steady state GDP? (e) Draw the basic diagram of the Solow’s (1956) model without any growth in population or technology (such as the slide 19 on page 38 of the Coursebook) to indicate the steady state per capita income. Mark another point different from the steady state on that same graph to indicate a LR equilibrium in the classical model.

Answer 1

(a) Assumption: In the long run firms can enter and exit the industry.

Theory: A situation is a long run equilibrium if

• no firm in the industry wants to leave
• no potential firm wants to enter.

Implications: Given the definition of economic profit, the theory implies that in a long run equilibrium

• no existing firm makes a loss
• any potential firm that entered would make a loss

Assuming that the technology (and hence cost functions) of every firm are the same, and ignoring the discrete change that may occur in the firms' maximal profits when a firm enters, the theory thus implies that

in a long run equilibrium every firm's maximal profit is zero

or, equivalently,

price is equal to minimum average cost.

(b) Since 1(c) is not defined, I am assuming some values. You can change them accordingly

(C) Change in technology is when, the LR equilibrium GDP may change over time even without any policy intervention.

(d) When savings rate are constant and unchanged.

(e)