Question

Starting from a generalized long-run equilibrium scenario for a perfectly competitive constant-cost industry, describe in words and support with the appropriate firm- and market-level graphs how you would derive the long-run industry supply curve after a decrease in market demand. Label and explain all steps as we did in class when we considered an increase in market demand.

Answer 1

Initial equilibrium is at E1 where demand D equals supply S. The equilibrium price is P1 and a typical firm produces q1 because price is equal to marginal cost at this level. It is at long run equilibrium as price equals marginal cost and average cost. The firm earns zero economic profit and there is no incentive to enter or leave the industry.

A decrease in demand shifts the demand curve to D2 that causes price to decline to P2. This lower price creates losses in the industry and firms exit the market. This shifts the supply curve leftwards to S2. The price increases till P1 in the long run however the quantity decreases to Q3. The new equilibrium is at E3.

E1E3 represents the long run supply curve. Along the long run supply curve output is decreased by the decreasing number of firms, each producing q2.