The firms in a perfectly competitive industry had been earning zero economic profits. However, the firms have recently experienced a large decrease in the cost of energy that enables them to substantially reduce the marginal cost and average total cost of producing each unit of output. The market demand for the product is pretty elastic. On the other hand, short-run efforts to increase production run into severely diminishing returns with respect to the employment of additional variable inputs.
Draw two average total cost curves (ATC) for a typical firm. One curve should represent ATC before the fall in the cost of energy. The other curve should represent ATC after the fall in the cost of energy. Assume that the fall in the cost of energy does not affect the minimum efficient scale (MES) of production. Draw short-run marginal cost curves on the same diagram to show both the fall in the cost of energy and the severely diminishing returns to the employment of additional variable inputs.
Next to the diagram for a typical firm, draw a supply-demand diagram for the industry. The slope of the demand curve should reflect the elasticity of demand for the product. The short-run supply curve should reflect the presence of severely diminishing returns with respect to the employment of additional variable inputs. The original equilibrium price in this diagram should line up with the minimum point of the original ATC curve for a typical firm.
Properly shift demand or supply to reflect the fall in the cost of energy. Note the change in the market equilibrium. How does the magnitude of the change in the market price compare to the magnitude of the shift in ATC? Explain. Do firms now experience short-run economic profits? In the long-run, can entry of new firms be expected in this industry? If we have a decreasing-cost industry, show in your diagrams where the cost curves, the market price, and the equilibrium market quantity end up. Fully explain what has happened. Does the equilibrium quantity end up changing much in comparison to the magnitude of the overall change in price? Why or why not?