Suppose that a perfectly competitive industry is in longrun

Suppose that a perfectly competitive industry is in long-run equilibrium, and demand increases. Explain the short- and long-run effects on the firm and the industry.

Solution

In a p perfectly competitive industry, each firm earns zero economic profit in the long run since it produces at the lowest point of its ATC where price equals ATC.

When demand increases, supply remaining unchanged, equilibrium price increases. This raises the price for individual firms (who are price takers). In the short run, higher price enables firms to fetch excess profit (since now price > ATC). Number of firms and total output remains the same for industry.

In the long run though, new firms get attracted by this short run profit and start entering the market. Such entry increases the number of firms and demand for individual firms go down, eroding the excess (economic) profit. This entry continues as long as all the firms\' economic profits are eroded to zero, and each firm earns only normal profit. For the industry, number of firms increases, output per firm decreases and total market supply remains the same or increases. Eventually, price falls to the original equilibrium level.