Assume the market for a good produced by perfectly competitive firms i

Assume the market for a good produced by perfectly competitive firms is currently in equilibrium (economic profit = 0). Now assume there is a decrease in market demand for the good.

Analyze the short-run effects of the decrease in demand on equilibrium market price and output. What has happened to the profits of each of the firms in the industry? Over time, what will happen to the number of firms in the industry? Why?

ANSWER

In the short run, the decrease in market demand, which is illustrated graphically by a leftward shift of the market demand curve, will cause market price and output to decrease. This will result in losses for existing firms, since price will fall below the average total costs of production. Over time, some of the firms in the industry will leave, causing market supply to decrease (shift left) and market price to rise until the remaining firms are once again earning zero economic profit and there is no more incentive for firms to exit the market.