Question

Suppose that during the COVID-19 pandemic, the demand for shared rides decreased substantially. As a result, the price plummeted and drivers are now making negative economic profits. In 6 - 8 sentences, describe what will happen in the long run (assume a rather grim scenario that the pandemic will be around in the foreseeable future and the market demand will stay depressed). Will there be an exodus or influx of sellers in this market? What will happen to the market price and economic profits? Illustrate your answer with two diagrams: one depicting a single seller, and the other depicting the market.

Answer 1

Consider the scenario before the pandemic, where the market was in equilibrium with demand curve D and supply curve S (Figure 1 (a)) with equilibrium price P1 and equilibrium quantity Q1. With a competitive price P1, as shown in Figure 1 (b), a typical firm was earning a super normal profit since, price > AC, i.e., Aq1 > Bq1.

Due to pandemic, the market demand falls and the demand curve shifts to D' as shown in Figure 1(a). As a result of which price falls to P2. At this price, it can be observed that average cost > price for a firm (Figure 1(b)). Hence, firm incurs loss and the production level for firm also declines. This is reflected in fall in market quantity also.

In the longrun, some firms will exit the market because of economic loss, specially those firm who will not be available to cover their average variable cost, i.e., if a firms, AVC > price. Subsequently, supply falls and the supply curve would shift to left in the market, which will raise the price. This process will continue till average cost of the firms become equal to price so that economic profit will be zero in the longrun.