Suppose a competitive market is comprised of firms that face identical cost curves. The firms experience an increase in demand that results in positive profits for the firms. Which of the following events are then most likely to occur? i) New firms will enter the market.
Ii) In the short run, price will rise; in the long run, price will rise further.
Iii) In the long run, all firms will be producing at their efficient scale.

Question

Quizplus · Accepted Answer

If firms are earning positive profits due to an increase in demand, it signals to potential new entrants that there is an opportunity for profit. Thus, it is likely that new firms will enter the market (i).

In the short run, firms may increase their prices to capture some of the extra profits, but in the long run, the increased competition from new entrants will result in price falling back to the level of minimum average total cost. Therefore, in the long run, price will not rise further, as stated in option (ii), but it will be equal to the minimum average total cost.

In the long run, all firms will be producing at their efficient scale since they face identical cost curves. So, option (iii) is correct.

Suppose a Competitive Market Is Comprised of Firms That Face