Question

A shift in demand curve has a larger effect on price and smaller effect on quantity when the number of firms is fixed compared to the situation when free entry and exist is permitted. Explain.

Answer 1

The above figure depicts both the cases when the number of firms is fixed (in short run) and when the number of firms is not fixed (in long run). P = min AC represents the long run price line; D₁D₁ and D₂D₂ represents the demand in the short run and the long run respectively. The point E₁ represents the initial equilibrium, where the demand and the supply intersect each other.

Let us suppose that the demand curve shifts, assuming that the number of firms is fixed. Now, the new equilibrium will be at E_S (as it is short run equilibrium), where the supply curve and the demand curve D₂D₂ intersect each other. The equilibrium price is P_s and equilibrium quantity is q_s.

On the other hand, under the assumption of free entry and exit, an increase in demand will shift the demand curve rightwards to D₂D₂. The new equilibrium will be at E₂ (as it is a long run equilibrium) with the 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 the same. The price is lower than that of the short run equilibrium price (P_s); whereas, the long run equilibrium quantity (q_L) is more than that of the short run equilibrium quantity (q_s).

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