Question

Draw a diagram showing a competitive industry in short-run equilibrium. Suppose this is the wool industry. The development of artificial fibres reduces the demand for wool. (a) Show what happens in the short run if all sheep farmers have identical costs. (b) What happens in the long run if there are high-cost and low-cost sheep farmers in the industry?

Short answer

Short-run: Demand decrease lowers price and quantity. Long-run: High-cost firms exit, supply decreases, stabilizing the price.

Step-by-step solution

Initial Short-Run Equilibrium

To represent the initial short-run equilibrium in a competitive industry like the wool industry, first draw a supply and demand diagram. Label the vertical axis as "Price" and the horizontal axis as "Quantity." Plot the demand curve (D0) sloping downwards and the supply curve (S) sloping upwards. The point where these two curves intersect is the initial short-run equilibrium (E0), where the initial price is P0, and the initial quantity is Q0.

Short-Run Effect of Decreased Demand

Now illustrate the impact of reduced demand for wool due to the development of artificial fibers. Shift the demand curve leftward from D0 to D1, indicating a decrease in demand. The new equilibrium in the short run is at the intersection of D1 and the unchanged supply curve S, marked as E1. At this point, the new equilibrium price is P1 (lower than P0), and the new equilibrium quantity is Q1 (lower than Q0).

Long-Run Adjustment with Cost Differences

In the long run, industries adjust through the entry and exit of firms and changes in production capacity. If sheep farmers face different costs, separate them into high-cost and low-cost producers. Low-cost producers will remain in the industry, while high-cost producers may exit due to low profitability at the reduced market price, P1. This results in a decrease in supply in the long run.

Long-Run Equilibrium

Draw a new, reduced supply curve (S') reflecting the exit of high-cost producers. The long-run demand curve stays at D1. The new long-run equilibrium occurs where this new supply curve S' intersects with the demand curve D1 at point E2. This results in a long-run equilibrium price P2 and quantity Q2. Typically, P2 could be higher than P1 but generally lower than P0, while Q2 is less than the original Q0.

Key concepts

Short-run Equilibrium

In a short-run equilibrium, the market balances supply and demand at a given point where both meet. For a competitive industry like wool, this involves setting the price level where the quantity of wool that consumers want to buy matches the quantity that producers are willing to sell. Initially, this is represented on a graph where the demand curve (D0) intersects with the supply curve (S) at equilibrium point E0. Here, the price is P0, and the quantity is Q0. However, when there's a market shift—such as a decrease in demand due to artificial fibers—the demand curve shifts leftward to D1. The new intersection point at E1 shows a lower price P1 and reduced quantity Q1, indicating a short-term market adjustment.

Long-run Adjustment

Long-run adjustments occur as markets have time to adapt to new conditions. In our example of the wool industry, if demand decreases, adjustments don't stop with the initial short-run response. Producers might react differently over time, particularly if they face varying production costs. Those unable to sustain lower profit margins—typically high-cost producers—might exit the market. Conversely, low-cost producers, who can maintain efficiency despite lower prices, will remain. As high-cost producers leave, the overall supply decreases, represented by a new, reduced supply curve (S'). This results in a long-run equilibrium, typically at a different price and quantity than the short-run equilibrium.

Demand and Supply Analysis

Demand and supply analysis is fundamental in understanding market dynamics and determining equilibrium. Demand illustrates consumers' desire for a product at different price levels, typically forming a downward-sloping curve on a graph. Meanwhile, supply reflects producers' willingness to sell at various prices, often creating an upward-sloping curve. The interaction of these curves indicates market equilibrium, where supply equals demand. In the wool industry scenario, a shift in the demand curve due to external factors, like the introduction of artificial fibers, causes changes in equilibrium. The extent and direction of these shifts inform producers and consumers alike about necessary adjustments, affecting pricing and production decisions.

Cost Differences in Producers

Producers within any industry often face different cost structures. In our wool industry example, some farmers might produce wool at lower costs due to factors like better technology, more efficient practices, or scale economies. In contrast, high-cost producers may have older equipment or smaller operations. When external pressures such as decreased demand arise, these cost differences become crucial. Low-cost producers can adapt more comfortably, maintaining operations and potentially gaining market share. High-cost producers, however, may not sustain viable operations at the new, lower market prices and therefore choose or be forced to exit. This exit alters the supply curve, leading to a new market balance over the long run.