Consider a perfect competitive market. Analyze in detail using graphical tools what would happen to the number of firms and firm profitability in short run and long run if demand for product falls and if it rises
In a perfectly competitive market, the number of firms and firm profitability can be analyzed using graphical tools such as the supply and demand curves. Let's first analyze what happens when the demand for a product falls in the short run and long run.
1. Short Run:
In the short run, when the demand for a product falls, the market demand curve shifts to the left, resulting in a lower equilibrium price and quantity.
a. Graphically, the demand curve shifts to the left, intersecting the existing supply curve at a lower price and quantity.
b. The decrease in demand leads to excess supply, creating a surplus in the market.
c. To restore equilibrium, firms will reduce their production levels, but they may not be able to adjust their output immediately due to fixed factors of production.
d. As a result, firm profitability decreases since the lower market price may not cover the average total cost of production.
e. In the short run, existing firms are likely to incur losses, but they may continue operating as long as revenues cover their variable costs.
2. Long Run:
In the long run, firms have more flexibility to adjust their production levels as all factors of production become variable. In response to the falling demand, the following adjustments occur:
a. Decreased profitability in the short run causes some firms to exit the market. As a result, the number of firms decreases.
b. As fewer firms operate, the market supply decreases, which gradually shifts the supply curve to the left.
c. With time, the supply curve continues shifting until a new equilibrium is reached, where market price and quantity are lower than in the initial situation.
d. In the long run, firms can adjust their production levels fully, leading to higher efficiency and lower costs.
e. The remaining firms that survive in the market experience improved profitability, as the diminished competition allows them to regain some market power.
Now, let's analyze the situation when the demand for a product rises:
1. Short Run:
When demand rises, the market demand curve shifts to the right, resulting in a higher equilibrium price and quantity.
a. Graphically, the demand curve shifts to the right, intersecting the existing supply curve at a higher price and quantity.
b. The increase in demand leads to excess demand, creating a shortage in the market.
c. To restore equilibrium, firms increase their production levels, but they may not be able to adjust their output immediately due to the fixed factors of production.
d. The higher market price enables firms to generate increased revenues, leading to higher profitability.
e. In the short run, existing firms are likely to earn profits, especially if the price increase covers the average total cost of production.
2. Long Run:
In the long run, firms have time to adjust their production levels as all factors of production become variable. In response to rising demand, the following adjustments occur:
a. Increased profitability in the short run attracts new firms to enter the market. As a result, the number of firms increases.
b. The entry of new firms increases market supply, shifting the supply curve to the right.
c. The supply curve continues shifting until a new equilibrium is reached, where the market price and quantity are higher than the initial situation.
d. With increased competition, firms' profitability gradually decreases, although they are likely to still earn normal profits in the long run.
e. Existing firms may respond by improving their efficiency or differentiating their products to retain some market power and maintain profitability.
In summary, in a perfectly competitive market, changes in demand impact the number of firms and firm profitability in both the short run and the long run. In the short run, firm profitability may decline due to a decrease in demand, resulting in losses. In the long run, firms can adjust their production levels more fully, leading to changes in the number of firms and returning profitability to normal. Conversely, if demand increases, firm profitability may increase in the short run, attracting new firms to enter the market, which eventually leads to adjustments in the number of firms and a gradual decline in profitability in the long run.