Shifts in Demand
•Free entry and exit of the firms would imply that under all circumstances equilibrium price will be equal to the minimum average cost of the existing firms i.e. p = min AC
•Under this condition, even if the market demand curve shifts in either direction, at the new equilibrium, the market will supply the desired quantity at the same price.
Market Demand Curve
•In Figure shown,
•DD0 is the market demand curve which tells us how much quantity will be demanded by the consumers at different prices and
•p0 denotes the price which is equal to the minimum average cost of the firms.
•The initial equilibrium is at point E where the demand curve DD0 cuts the p0 = minAC line and the total quantity demanded and supplied is q0.
•The equilibrium number of firms is n0 in this situation.
Effect of Increase in Demand
•Assume that the demand curve shifts to the right for some reason.
•At p0 there will be excess demand for the commodity.
•Some consumers will be willing to pay higher price for the commodity, so the price tends to rise.
•This gives rise to a possibility of earning supernormal profit which will attract new firms to the market.
•The entry of these new firms will eventually wipe out the supernormal profit and the price will again reach p0.
•Once the price will again reach p0, higher quantity (q1) will be supplied at the same price.
•The new equilibrium number of firms n1 is greater than n0 because of the entry of new firms.
Effect of Decrease in Demand
•If there is a leftward shift of the demand, the new curve is DD2
•There will be excess supply at the price p0.
•In response to this excess supply, some firms, which will be unable to sell their desired quantity at p0, will wish to lower their price.
•The price tends to decrease which will lead to the exit of some of the existing firms and the price will again reach p0.
•Therefore, in the new equilibrium, less quantity will be supplied which will be equal to the reduced demand at that price.
•We know that in the new equilibrium, less quantity will be supplied which will be equal to the reduced demand at that price.
•Hence, the equilibrium number of firms, n2 is less than n0 due to the exit of some existing firms.
•Due to a shift in demand rightwards (leftwards), the equilibrium quantity and number of firms will increase (decrease) whereas the equilibrium price will remain unchanged.
•Hence, with free entry and exit, shift in demand has a larger effect on quantity than it does with the fixed number of firms.
•But unlike with fixed number of firms, here, we do not have any effect on equilibrium price at all.