Question

A perfectly competitive market is in long run equilibrium. At present there are 100 identical firms each producing​ 5,000 units of output. The prevailing market price is​ $20. Assume that each firm faces increasing marginal cost. Now suppose there is a sudden increase in demand for the​ industry's product which causes the price of the good to rise to​ $24. Which of the following describes the effect of this increase in demand on a typical firm in the​ industry? A. In the short​ run, the typical firm increases its output but its total cost also rises.​ Hence, the effect on the​ firm's profit cannot be determined without more information. B. In the short​ run, the typical firm increases its output and makes an above normal profit. C. In the short​ run, the typical firm increases its output but its total cost also​ rises, resulting in no change in profit. D. In the short​ run, the typical​ firm's output remains the same but because of the higher​ price, its profit increases.

Answer 1

Answer: B. In the short​ run, the typical firm increases its output and makes an above normal profit.

Explanation:

I have attached a graph to explain.

Originally the Perfectly Competitive Market is in a long run Equilibrium.

This means that at 5000 units the $20 selling price was as a result of Marginal Revenue being equal to Marginal Cost.

Now a sudden change in Demand has taken the price up which then forces the Marginal Revenue Curve upwards.

This will culminate with the Marginal Revenue Curve now intersecting the Marginal Cost curve at a higher point being point F so that profit can be maximised.

This higher level will thus lead to a higher output than 5000 units at point Q as the firm will increase output.

Notice that at that point the Marginal Revenue is higher than Average Total Cost meaning that an Above normal profit is being made.

Do react or comment if you need any clarification.