Question

Sweaters are produced by a competitive increasing cost industry. Determine how each of the following circumstances would affect the price of sweaters and the quantity of sweaters sold by the Better Sweater Company. (a) The government announces that it will pay $500 per year to any firm engaged in making sweaters. Answer both in the short run and in the long run. (b) The government announces that it will pay $5 per sweater to any company engaged in making sweaters. Answer in both the short run and the long run, and be precise as possible about the size of the price changes.

Answer 1

a)

This is case of lump sum benefits to firms. Firm may not enter the market in short run due to fixed cost and there may be entry of few firms in long run to take advantage of incentive. Existing firms are not likely to increase output. Increase in output will drag down price and profits. Hence, in short run there would not be let up in output but in long run other firms may enter market and increase output.

b)

Per unit benefit will definitely increase output level. Provision of per unit benefit will increase shut down point of firm. Per unit benefit will partially compensate average variable cost. Firms who are not even able to recover variable cost may stay in market due to per unit benefit. In long run, there shall be influx of more firms and output will rise further, it may bring down price level thereby reducing economic profits to zero.