Question

Assume now that the demand for recycled paper increases and that the company is earning short-run economic profits. Relative to this short-run situation, explain what happens to profits in the long run and why?

Answer 1

As a result of an increase in the demand for recycled paper, the demand curve will shift rightwards, resulting in an increase in equilibrium quantity and price. This will lead to the firms earning abnormal profits in the short run.

Seeing the abnormal profits, more firms will enter the industry, resulting in an increase in supply. The new supply intersects the new demand curve at an increased equilibrium quantity but the same price as before the demand increase. Thus, all the economic profits will flow out and the firms will earn only normal profits in the long run.

In the long run, firms only earn normal profits due to the freedom of entry and exit in the industry (perfect competition).