Suppose that the pen-making industry is perfectly competitive. Also suppose that all current firms and any potential firms that might enter the industry have identical cost curves, with minimum ATC = $1.25 per pen.
If the market equilibrium price of pens is currently $1.50, what would you expect the equilibrium price to be in the long run?
A. $1.00
B. $1.50
C. $0.25
D. $1.25
Answer (2)
Firms enter the market if the price is above the minimum ATC.
Entry increases supply, driving down the price.
Equilibrium is reached when the price equals the minimum ATC.
The long-run equilibrium price is $1.25 .
Explanation
Understanding the Market In a perfectly competitive market, firms will enter the market if the market price is higher than their minimum average total cost (ATC). This is because they can make a profit at that price.
Market Adjustment The entry of new firms increases the market supply, which drives down the market price. This process continues until the market price equals the minimum ATC. At this point, firms are making zero economic profit, and there is no incentive for new firms to enter or existing firms to exit.
Long-Run Equilibrium Since the minimum ATC is $1.25 , the long-run equilibrium price will be $1.25 .
Examples
Consider a local farmer's market where many vendors sell similar produce. If one vendor starts selling their tomatoes at a much higher price than others, new vendors will be encouraged to sell tomatoes as well, increasing the supply and eventually driving the price down to a competitive level where only a normal profit is earned. This illustrates how competitive markets tend towards an equilibrium price based on the cost of production.
In a perfectly competitive market with a minimum ATC of $1.25 and a current price of $1.50, firms will enter the market to capitalize on profits. This will increase supply, causing the equilibrium price to drop to the minimum ATC. Thus, the long-run equilibrium price will be $1.25.
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