Question

1. Suppose that a perfectly competitive industry is at a long-run equilibrium (each individual firm producing a quantity corresponding with minimum average cost). This implies that the following condition holds P = MC = AC. Assume that all firms have identical cost structures and the cost of inputs used in production (such as labor, raw material, intermediate goods, etc.) stays the same as the industry expands or contracts (i.e. constant-cost industry). a. Show with graphs and explain with words what would happen if demand decreased due to an economic downturn which reduced the overall wealth of consumers (negative demand shock).

Answer 1

Under a perfectly competitive market, given the mentioned assumption, price of the good is supply determined. That is, irrespective of the demand, the price will be equal to the cost of making the good, that is = average cost = marginal cost.

Then what is the role of demand?

Demand determines the output of the good. Since in a perfectly competitive industry, the producers have no control over the price, they adjust to the prevailing demand conditions by varying the output they produce. In case of a negative demand shock, they understand that consumers will purchase less. Since they cannot lower the price of the good they produce, they react to the adverse shock by lowering their produce.

In the diagram below, the producers cut their production from Q_E to Q'.

P P-Me-Ae P Pr