Q.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 exit is permitted. Explain.

The effect of a demand curve shift on price and quantity differs significantly based on the market's ability to adjust the number of firms, which essentially distinguishes between the short run and the long run in perfect competition.

When the number of firms is fixed, the market is in the short run. The supply curve is upward sloping because existing firms can only adjust their output by changing variable inputs. An increase in demand (a rightward shift of the demand curve) will intersect this upward-sloping short-run supply curve at a higher price and a higher quantity. Both price and quantity change, with the magnitude depending on the elasticity of the short-run supply.

In contrast, when free entry and exit is permitted, the market is in the long run. In perfect competition, this condition ensures that firms earn zero economic profit. Consequently, the long-run market supply curve is typically perfectly elastic (horizontal) at the minimum average cost of production for the industry (assuming constant costs). If demand increases, the price initially rises, leading to positive economic profits for existing firms. This attracts new firms to enter the market. As new firms enter, the market supply increases, shifting the supply curve to the right. This process continues until the price falls back to the original long-run equilibrium price, where economic profits are again zero. The primary adjustment is in the number of firms and thus the total quantity supplied, with the price returning to its initial level. …

To understand how a shift in the demand curve affects price and quantity under different market conditions, we must consider the responsiveness of supply. The key difference lies in the ability of firms to enter or exit the market, which fundamentally alters the elasticity of the market supply curve.

Market Equilibrium and Supply Response

Market equilibrium is the state where the quantity demanded by consumers equals the quantity supplied by producers at a specific price. When the demand curve shifts (e.g., due to changes in consumer preferences, income, or prices of related goods), this equilibrium is disrupted. The market then adjusts to a new equilibrium. The extent to which price and quantity change depends crucially on how readily producers can adjust their output, which is captured by the elasticity of the supply curve.

Scenario 1: Fixed Number of Firms

When the number of firms in the market is fixed, we are typically considering the short run. In this period, existing firms can adjust their output by changing variable inputs (like labour or raw materials), but they cannot easily change their fixed inputs (like factory size or machinery), nor can new firms enter or existing firms exit.

1. Limited Supply Response: If demand increases, existing firms will respond by increasing their production. However, their capacity is limited by their fixed inputs. As they try to produce more, their marginal costs tend to rise steeply after a certain point due to diminishing returns to variable inputs.
2. Inelastic Supply: This limited ability to expand production means that the market supply curve is relatively inelastic (steep). A given percentage change in price will lead to a smaller percentage change in quantity supplied.
3. Impact on Price and Quantity: When an upward shift in the demand curve occurs against a relatively inelastic supply curve, the market price will increase significantly. The quantity exchanged will also increase, but by a comparatively smaller amount, because producers cannot rapidly or substantially expand their output. Firms in this situation might earn supernormal profits due to the higher prices.

Scenario 2: Free Entry and Exit of Firms

When there is free entry and exit of firms, we are typically considering the long run. In this period, firms can adjust all their inputs, and new firms can enter the market if they see profit opportunities, while existing firms can exit if they are incurring losses.

1. Dynamic Supply Response: If demand increases and existing firms start earning supernormal profits (as in Scenario 1), these profits act as a signal, attracting new firms to enter the market. The entry of new firms increases the overall productive capacity of the industry.
2. Elastic Supply: The entry of new firms shifts the entire market supply curve to the right. This additional supply response makes the long-run market supply curve much more elastic (flatter) than in the short run. In a perfectly competitive market with constant input costs, the long-run supply curve can even be perfectly elastic (horizontal). …