Question

Consider a competitive market with identical firms that is in long-run equilibrium. Which of the following statements captures the sequence of events from the short run to the long run after demand increases?

a.When demand increases, price rises in the short run, causing each firm to produce more and earn a profit. The profit induces entry of new firms into the market until price returns to its initial value and each firm earns zero profit.

b.When demand increases, price falls in the short run, causing each firm to produce less and incur economic losses. The losses induce exit of existing firms from the market until price returns to its initial value and each firm earns zero profit.

c.When demand increases, price rises in the short run, causing each firm to produce more and earn a profit. The price remains high and firms continue to earn profit.

Answer 1

The answer is (a)

An increase in demand will lead to excess demand at the existing price and thus the price will rise. In the short run the firms will make profits. But since we have a competitive industry, new firms will see the profit-making opportunity and will enter the market. This would eventually lead to driving down the profits to 0 and price will return to the original level.

(b) is wrong as the price will not fall due to increased demand.

(c) is wrong as the firms can not continue to make profits forever in a competitive market.