Question

Explain what occurs in the long run in a constantcost industry, an increasing- cost industry, and a decreasing-cost industry when the market demand declines (shifts in).

Short answer

Question: Explain the impact of a decline in market demand on the market price, output level, and industry size for constant cost, increasing cost, and decreasing cost industries. Answer: In a constant cost industry, when market demand declines, the equilibrium price remains unchanged, and the output level and industry size decrease. In an increasing cost industry, a decreased market demand results in a lower equilibrium price and quantity, and the industry size reduces as some firms exit the market. In a decreasing cost industry, market demand decline leads to a decrease in the equilibrium quantity demanded but the market price remains unchanged, and the industry size may shrink while firms continue to operate at a lower cost per unit of production.

Step-by-step solution

Understand the Constant Cost Industry

In a constant cost industry, the costs of production do not change as the output increases or decreases. As a result, the supply curve of a constant cost industry appears horizontal, since the price does not increase with the increase in output.

Analyze the Market Demand Decline in a Constant Cost Industry

When the market demand declines in a constant cost industry, the overall quantity demanded decreases and the equilibrium price does not change. This is because the cost per unit of production remains constant and the supply is perfectly elastic at the initial market price.

Understand the Increasing Cost Industry

In an increasing cost industry, production costs increase as output increases and the supply curve is upward sloping. This industry experiences economies of scale up to a certain output level, after which further increase in output leads to increasing costs per unit of production.

Analyze the Market Demand Decline in an Increasing Cost Industry

When the market demand declines in an increasing cost industry, the demand curve shifts inwards, leading to a decrease in the equilibrium quantity and price. Some firms may exit the market as their costs become higher than the market price, resulting in a decrease in the total output and industry size.

Understand the Decreasing Cost Industry

In a decreasing cost industry, production costs decrease as output increases, and the supply curve is downward sloping. This industry experiences economies of scale throughout its production process, where an increase in output leads to a decrease in the average cost of production.

Analyze the Market Demand Decline in a Decreasing Cost Industry

When the market demand declines in a decreasing cost industry, the demand curve shifts inwards, leading to a decrease in the equilibrium quantity demanded. However, as the production costs decrease with the drop in market demand, the market price remains unchanged. The industry size may shrink due to the reduced demand, but the firms within the industry continue to operate at a lower cost per unit of production.

Key concepts

Constant Cost Industry

A constant cost industry is unique in that the production costs remain fixed, no matter how much the industry expands or contracts. Imagine each firm can increase or decrease their output without affecting the overall cost per unit of production. This is because resources necessary for production are abundant and perfectly adaptable. Therefore, the industry’s supply curve is horizontal, meaning it is perfectly elastic.

When the demand decreases in such an industry, the equilibrium quantity demanded declines. However, the remarkable feature here is that the price does not fall. This is because the cost conditions remain unchanged, allowing firms to continue producing at the original price level. Essentially, the market absorbs the shift in demand by adjusting the quantity, not the price, maintaining stability in unit cost and pricing. The industry retains its structure, and firms do not face increased competitive pressures to either enter or exit.

Increasing Cost Industry

In an increasing cost industry, the story is different. Here, costs rise as the industry expands output. This happens because resources become scarcer or less adaptable as more firms enter the market. The supply curve slopes upwards, indicating that increased production leads to escalating costs.

When market demand declines, firms face a new challenge. The demand curve shifts inward, causing both the equilibrium price and quantity to decrease. Firms with higher production costs may struggle to break even, leading to possible exits from the market. This retrenchment causes the total output of the industry to reduce, effectively shrinking the industry’s size.

• The rising production costs create a pressure that impacts firm profitability.
• The competition becomes fierce as firms seek to operate efficiently to survive.

The result? Only the most efficient firms remain, while those unable to adapt to rising costs may exit the market altogether.

Decreasing Cost Industry

In contrast, a decreasing cost industry benefits from declining costs with rising output. These industries enjoy substantial economies of scale, allowing costs per unit to fall as production ramps up. The supply curve here is downward sloping due to these efficiencies.

When a drop in demand occurs, the demand curve shifts inward, leading to a lower equilibrium quantity. Interestingly, despite the drop in market demand, the price can stay the same due to the lower production costs. Firms continue to benefit from economies of scale, even as the industry contracts somewhat.

• The persistent low cost per unit helps maintain firm stability.
• Though some firms may choose to exit, those remaining can operate at lower costs.

As a result, firms can still compete effectively even when market conditions tighten, as they leverage their low-cost advantage.