d Economics - University of Minnesota .2-1: Equilibrium Adjustments Facing Shocks, Long-run Supply Curve for a CCI: Consider a perfectly competitive industry below. The left panel of the diagram depicts the industry's aggregate supply and demand curves, while the right panel depicts the cost curves of a typical profit-maximizing firm in this industry. Assume that the cost structure will stay constant as industry expands or contracts. That is, this is a constant cost industry (CCI). Price Industry Individual Firm SA MC ATC $15 $12 $13 $13 $13 -- $12 $12 - $10 $11 10 +$11 $10 5M 19M 12M 9K 8M 8K 10K Market Quantity, Q (in millions) Representative Firm Quantity, q (in thousands) 1) With the supply and demand curves being Si and Di, respectively, the industry is currently at Point ? (see the left panel). With P = $10 at 0, answer the following three questions: (i) What is the representative firm's output quantity? Answer: q = K Units (ii) What is the representative firm's total profit? Answer: profit = $_ K (iii) Is Point Q a long-long equilibrium? Yes or no? Answer: 2) Now, let's disturb the equilibrium! Let's shift the demand curve from Di to Dz (say, due to an increase in population). With the new demand curve D2 and the "yet to change" supply curve S1, the market has moved from Point ? to Point T, where the letter T is used to emphasize that this latter point is only a transient solution. With P = $13 at T, answer the following three questions: (i) What is the representative firm's new output quantity? Answer: q = K Units (ii) What is the representative firm's total profit? Answer: Profit = $_ K (iii) Is Point T a long-long equilibrium? Yes or no? Answer: 3) Given your answer in (2-ii), will there be entry or exit? Answer: Then, will the supply curve (currently, at S1) shift right or left? Answer:2-3: Th B.2-2: Price Individual Firm Industry MC ATC 51 $15 $12 $13 $13 $13 $ 12 $12 $11 $10 *$11 $10 $104 D1 5M 19M 12M 9K 8K 10K 8M Market Quantity, Q (in millions) Representative Firm Quantity, q (in thousands) 4) Entry or exit will continue until the representative firm's economic profit is driven down or driven up, respectively, to zero. From the right panel, at what price would the profit-maximizing firm's economic profit be zero? Answer: $ 5) (i) Draw the new industry supply curve on the left diagram that would result in the equilibrium price you indicated in (4) and label it as Sz. (ii) What is the industry's new equilibrium price? (iii) What is the industry's new equilibrium quantity? Answer: pnew = $ Qnew = M Units 6) Given pnew, what is the firm's new profit-maximizing output quantity? (Hint: right panel) Answer: qnew = K Units 7) Given (6), what is firm's profit per unit of output? Answer: $ 8) Has long-run equilibrium been re-established? (Yes or no?) Answer: 9) Denote in the left panel the new equilibrium point by E. 10) The market has moved from the previous long-run equilibrium point of ? to the new long-run equilibrium point of E, facing population shock (recall: the population increase has caused the demand to shift out from Di to D2). At 0, (P, Q) = ($10, 5M), and at E, (P, Q) = ($10, 12M). Clearly, the population increase has caused the industry to (Pick: expand or contract?) Answer:2-3: The diagram and the three bullet points below summarizes the analysis in B.2-1 and 2-B.2. First, the market is originally at Point Q (P = $10) which is a long-run equilibrium; the representative firm in the right panel is making zero economic profit when P = $10. Second, the population shocks shift the demand curve from Di to Dz in the left panel, moving the market from Point Q to Point T (P = $13). Point T is transient because it is not a long-run equilibrium; the representative firm in the right panel is making positive economic profit with P = $13. New firms will enter. With entry, the supply curve shifts from S1 to $2, moving the market from Point T to Point & (P = $10). Point & is a long-run equilibrium because the old equilibrium price of P = $10 is restored; the representative firm in the right panel is making zero economic profit. Price Industry Individual Firm $13 $13- $10 $10 D2 5M 8M 12M 8K 10K Market Quantity, Q (in millions) Representative Firm Quantity, q (in thousands) 11) Connecting Point Q and Point E, we trace out the industry' long-run supply curve. (i) Label the industry's long-run supply curve as LR Supply Curve. (ii) Is the LR supply curve an upward sloping line or a horizontal line? Answer: 12) The horizontal long-run supply curve is due to the assumption that the industry is a constant cost industry. Under this assumption the original equilibrium price of $10 is restored once the industry reaches new equilibrium. The supposition of constant cost industry assumes that the firm's cost structure will stay the same as the industry expands or contracts. For example, it assumes that the economy's wage rates will stay the same as this single industry expands or contracts. This assumption is appropriate insofar as the industry in question is relatively , compared to the size of the economy as a whole. (Pick: small or large?)