Question

Compare the effect of shift in the demand curve on the equilibrium when the number of firms in the market is fixed with the situation when entry-exit is permitted.

Answer 1

The above figure depicts the cases when the number of firms is fixed (in the short run) and when the number of firms is not fixed (in the long run). ‘P = min AC’ represents the long run price line, D₁D₁ and D₂D₂ represent the demands in the short run and the long run. The point E₁ represents the initial equilibrium where the demand curve and the supply curve intersect each other. Now, let us suppose that the demand curve shifts under the assumption that the number of firms are fixed; thus, the new equilibrium will be at E_S (in the short run), where the supply curve S₁S₁ and the new demand curve D₂D₂ intersect each other. The equilibrium price is P_s and equilibrium quantity is q_s.

Now let us analyse the situation under the assumption of free entry and exit.

The increase in demand will shift the demand curve rightwards to D₂D₂. The new equilibrium will be at E₂. It is the long run equilibrium with equilibrium price (P) = min AC and equilibrium quantity q_L.

Therefore, on comparing both the cases, we find that when the firms are given the freedom of entry and exit, the equilibrium price remains same and the price is lower than the short run equilibrium price (P_s); whereas, the long run equilibrium quantity (q_L) is more than that of the short run equilibrium (q_s).

Similarly, for leftward demand shift, it can be noted that the short run equilibrium price (P_s) is less than the long run equilibrium price and the short run equilibrium quantity (q_s) is less than the long run equilibrium quantity q_L.