Question

Using diagrams for both the industry and a representative firm, illustrate competitive long-run equilibrium. Assuming constant costs, employ these diagrams to show how ( \(a\) ) an increase and \((b)\) a decrease in market demand will upset that long-run cquilibrium. Trace graphically and describe verbally the adjustment processes by which long-run equilibrium is restored. Now rework your analysis for increasingand decreasing-cost industries and compare the three long-run supply curves.

Short answer

In constant-cost industries, supply curves are flat, while in increasing-cost industries, they are upward sloping, and in decreasing-cost industries, they are downward sloping.

Step-by-step solution

Understanding Competitive Long-Run Equilibrium

In a competitive market, long-run equilibrium occurs when the industry supply equals demand, resulting in firms earning zero economic profit. Diagrammatically, the industry is in equilibrium when the market price is at the minimum point of the average total cost (ATC) curve for a representative firm. At this point, each firm's marginal cost (MC) equals its ATC, and revenue equals total cost.

Industry and Firm Diagrams

Begin by sketching the industry supply and demand curves for the whole market, crossing at the equilibrium price and quantity. On the representative firm's diagram, draw the MC curve crossing the ATC curve at its lowest point, representing the equilibrium condition where MC = ATC = Price.

Increase in Market Demand

When market demand increases, the industry demand curve shifts to the right. This raises the market price above the equilibrium, causing firms to earn positive economic profits as the price now exceeds the ATC at the current quantity. In the firm's diagram, the price line will shift upwards, resulting in production at a quantity where the new price equals MC.

Adjustment for Increased Demand

The positive economic profit attracts new firms into the industry, increasing supply over time. As supply increases, the market price begins to fall back towards the original long-run equilibrium price. The entry of new firms continues until economic profits are zero again, restoring equilibrium.

Decrease in Market Demand

If market demand decreases, the industry demand curve shifts leftward. This lowers the price below the original equilibrium, leading firms to incur losses as the price is now below the ATC at the output level. In the firm's diagram, the price line shifts downward.

Adjustment for Decreased Demand

The losses cause some firms to exit the industry, reducing market supply. The reduction in supply increases the market price until it returns to the original long-run equilibrium level. Firm exit proceeds until the remaining firms earn zero economic profit once again.

Reworking for Increasing-Cost Industries

In an increasing-cost industry, the long-run supply curve is upward sloping. An increase in market demand causes input prices to rise as new firms enter, leading to a higher equilibrium price compared to a constant-cost industry. A decrease in demand reduces input prices, but equilibrium is still at a higher price than initially due to the industry's structure.

Reworking for Decreasing-Cost Industries

For decreasing-cost industries, the long-run supply curve is downward sloping. Increased demand leads to lower input costs due to economies of scale as firms expand, resulting in a lower equilibrium price than the original. Decreased demand has the opposite effect: prices rise, but not to the level they would in a constant-cost industry.

Comparing Long-Run Supply Curves

In a constant-cost industry, the long-run supply curve is flat. Increasing-cost industries have upward sloping supply curves due to escalated input prices with increased demand, while decreasing-cost industries have downward sloping curves as costs fall with increased industry output.

Key concepts

Long-run Equilibrium

In economics, long-run equilibrium in a competitive market is reached when there is a perfect balance between supply and demand. This means that all firms in the market are earning zero economic profit.
This happens because the market price equals the minimum point of the average total cost (ATC) curve for a typical firm.
At this point, each company's marginal cost (MC) is equal to its ATC, and total revenue matches total cost. Think about it like balancing well on a seesaw: there's no extra profit teetering the balance.
Any profit opportunities due to higher prices attract new competitors, while losses would cause some to leave, both pushing the market back toward equilibrium.

Constant-Cost Industry

A constant-cost industry can experience changes without its long-run supply curve being altered.
When demand increases, firms in this industry see positive profits as prices rise above the original equilibrium point. Here's the key: as new firms enter to capitalize on profits, costs stay constant.
This influx restores the price to its original long-run equilibrium as supply increases.
Conversely, if demand decreases, prices dip below equilibrium causing losses.

• Firms exit the industry to recover balance.
• In time, less supply nudges the price back up.

This seesaw action ensures the long-run supply curve stays flat, always ready to return to its original position.

Increasing-Cost Industry

Increasing-cost industries behave differently as they adjust to changes. Here, the long-run supply curve slopes upwards.

• When demand increases, firms expand production, pushing up input prices.
• This causes the new equilibrium price to be higher than the initial one.

As firms scramble to meet demand, the more it costs them to produce extra goods.
Even after entry of new firms, input prices continue to rise, maintaining a steeper price curve.
Conversely, a decrease in demand allows prices to settle at a higher point than the starting equilibrium due to the increased costs.

Decreasing-Cost Industry

In a decreasing-cost industry, the long-run supply curve slopes downward.
When demand picks up, firms in this sector benefit from economies of scale. Essentially, the larger they grow, the cheaper it becomes to produce each unit.
This means increased demand results in lower prices than the original equilibrium. The opposite holds true for reduced demand: prices incline, but not to the level seen in constant-cost scenarios.
Costs sink as production scales up, providing efficiency benefits, hence a descending price trend.
This dynamic invites a lower equilibrium price than initially observed whenever the demand shifts upwards, demonstrating an efficient market system at work.