Question

1. Choose the single best answer, explain your reasoning, and illustrate with graphs.

World wool consumption has been declining and has caused a long-term decline in wool production in Australia. Assume that the wool industry in Australia is perfectly competitive and consists of firms with U-shaped long-run average cost curves. Suppose the industry was originally in long-run equilibrium. Now consider a permanent downward shift in demand for wool. Assume this is a constant cost industry. We can expect that in the new long-run equilibrium, compared to the original equilibrium:

1. the equilibrium price and output per firm will fall.
2. the equilibrium price and total industry output will fall in the short run but eventually return to their original level.
3. the equilibrium price and output per firm will fall in the short run but eventually return to their original level.
4. the number of firms will increase, and the equilibrium market price will fall

Answer 1

Initial equilibrium E1 has market price P0, market quantity Q0 and firm level output q0.

Demand shifts down to DD1 in short run. New short run equilibrium is at E2.

This brings a reduction in market quantity to Q1, market price to P1 and firm level output to q1

In the long run as firms leave the market due to short run losses, supply curve shifts left to SS1

New equilibrium at E3 has same price P0 and same firm level quantity q0 but market quantity is Q2

Correct option is C.