Question

Assume that the oil industry is in long-run competitive equilibrium at a price of $100 per barrel and that the oil industry is constant-cost. Use a carefully labeled set of two graphs to explain what would happen in the long run to the number of firms and to the production of each firm as a result of the drop-in price from $100 to $76, assuming it reflected a decrease in demand. Be sure to define constant-cost and describe what it means for the long-run supply curve.

Answer 1

The intial equilibrium in the market and firm occurs at point E1 where price = minimum ATC. A decrease in demand will shift the demand curve of the market leftwards to D'D' and thus new short run equilibrium occurs at point E1 where both prices and quantity has decreased and for the firm prices have decreased to P2 leading to losses for the firm.

This will lead to exit of some firms from the industry and the supply curve will shift leftwards to S'S" until prices rise again to OP1 and losses are eliminated from the market. At this new equilibrium in the long run, the equilibrium market quantity has decreased to Q3 and this leads to a horizontal shape long run supply curve which is horizontal at the current price level P1.