Question

A perfectly competitive market is initially in long-run competitive equilibrium. Then, market demand falls. By the time all adjustments have been made, price will be __________ its original level if the industry is a(n) __________ costs industry.

a. above; decreasing

b. at; constant

c. at; increasing

d. below; increasing

e. a and d

Answer 1

Answer C)

at ; increasing

A perfectly competitive market is initially in long-run competitive equilibrium, i.e. the market demand is equal to the market supply at the market price. Then, the market demand falls. The fall in market demand will cause two effects on price and quantity immediately,like,

1. Price will fall, as the market demand falls.

2. Individual firm's quantity demand or their market share will fall , as a fall in the market demand.

The fall in price and a fall in individual firm's quantity demand will decrease the marginal revenue (MR) of the firms. The fall in marginal revenue will decrease individual firm's amount of profit.The firms will continue production at the level where the new price is equal to the MR and marginal cost of production (MC).Again this new price must cover the average variable cost (AVC) of production of the firm.So after the adjustment the firm will produce at the point where, P=MR=MC , and again at this point, P>=AVC. If for some firms, price does not cover the AVC , i.e., if P<AVC, these firms will shut down their production and will exit from the industry. The exit of some firms will decrease the supply of the goods in the market. As a result, the market supply curve will shift leftward over time.

As the supply decreases, now the price will start to increase because of the shortage of supply or excess demand in the market.Now, as the price starts to rise, in the short-run, the existing firms' revenue(Price * Quantity) will start to rise. As a result of the rise in revenue, the existing firms' profit(total revenue - total cost) will rise.

Again, the increase of the profit of the existing firms' will attract the new firms, that are producing the same goods, to enter the market.The entry of the new firms will increase the supply of the goods in the market, and the supply curve will shift to the rightward.This will continue until all the firms again earn 'zero' economic profit (MR=MC) and comes back to the equilibrium point over time. At this point, P=ATC (average total cost of production). The entry of new firms will raise the cost of production by raising the demand for inputs, and as a result the input prices.

We have seen that in the first phase, the prices decreases with the decrease in the market demand. After the market mechanism, and free interplay of demand, and supply forces, in the second phase, we have seen that the price again rises. With the rise in the price of the good, individual firm's MR rises, and again with the rise in the cost of production, MC will also start to rise.So individual firm's equilibrium point (MR=MC)will be achieved. In the long -run ,the rise in the cost of production will raise the ATC of individual firm , and ultimately, price would be equal to the ATC.

So the price will come back to its original level, if the industry is an increasing cost industry, i.e., the cost of production of individual firm rises with the rise in the quantity of production.

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