Question

If new technology in a perfectly competitive market brings about a substantial reduction in costs of production, how will this affect the market?

Short answer

In summary, a substantial reduction in production costs in a perfectly competitive market leads to an initial decrease in the equilibrium price and an increase in market supply, while demand remains unchanged. In the long-run, new firms enter the market, increasing competition and supply, driving the price down further until economic profits are eliminated. The market then reaches a new long-run equilibrium with a lower price and higher quantity.

Step-by-step solution

Understand the characteristics of a perfectly competitive market

In a perfectly competitive market, there are a large number of buyers and sellers, homogeneous products, and free entry and exit of firms. Firms are price takers, meaning that they cannot influence the market price. In such a market, firms will produce at the point where price equals marginal cost (P=MC) to maximize their profits.

Analyze the effect of reduced production costs on individual firms

A substantial reduction in production costs implies that the costs of inputs or the technology used in production have decreased. This will cause a decrease in the firm's marginal cost (MC) and average total cost (ATC). As a result, firms will produce more output at a lower cost.

Determine the short-run changes in market supply and demand

As individual firms produce more output at a lower cost, the market supply will increase. In a perfectly competitive market, the market demand remains unchanged because the reduction in production costs is not directly linked to a change in consumers' preferences or income. The increase in market supply will cause a surplus in the market.

Analyze the market's adjustment process

In response to the surplus, the equilibrium price in the market will decrease to clear the market. The decrease in price will lead to an increase in the quantity demanded by consumers, and as a result, the market will reach a new equilibrium with a lower price and higher quantity.

Consider the effect on firm profits and long-run adjustments

In the short-run, the reduction in production costs will lead to higher profits for firms. However, in a perfectly competitive market, positive economic profits attract new firms to the market. The entry of new firms increases competition and causes the market supply to increase further. This process continues until economic profits are eliminated, and the market reaches a new long-run equilibrium where price equals minimum average total cost (P= min ATC). In conclusion, a substantial reduction in production costs in a perfectly competitive market will initially cause the equilibrium price to decrease, market supply to increase, and demand to remain unchanged. In the long-run, this attracts new firms to the market, driving the price down further until economic profits are eliminated and the market reaches a new long-run equilibrium with a lower price and higher quantity.