Solution

Question 3 MC S1


A. As illustrated above, the market starts out in the long-run competitive equilibrium.
Initially, there is no incentive for firms to enter or exit the market. With a decrease in
consumer income, the demand for normal good will decrease resulting in the left ward
shift in the demand curve that is from (D0-D1). Thus quantity falls and the market
experience economic loss. Due to the change in market condition, individual firms will
make necessary adjustments to keep its economic loss at a minimum, that is to keep at
MC=P0. Due to the adjustment, the market is now in short run equilibrium but not longrun
equilibrium. An economic loss is a signal for some firms to exit the market. As firms
leave the short run market supply will decrease, which results in a leftward shift from (S0-
S1). With decrease in market supply, the market price rises as indicated by the arrows
along D1. At a higher market price, firm’s profit maximizing output is greater so the firms
remaining increases market output. Thus, each firm slides up its MC or supply curve.
That is due to exit of some firms, market output falls, and individual firms output
increases. Eventually, enough firms leave the market for the market supply to have
shifted to S1. For that, the market price has returned to its original level, P0.
B. Since firms are now making zero economic profit, no firms will be induced to enter or exit
the market. Therefore, the market supply remains at S1 and output at Q2. The market is
again in long run equilibrium.