Principles of Microeconomics / Unit 7 MIC 0627 worked example, 60 to 90 seconds
Tracing a Demand Decrease
The idea
Start from long-run equilibrium and shift demand left. The price falls. Each firm moves down its marginal cost curve and takes a loss. Apply the shutdown test: firms whose price is still above average variable cost operate at a loss; firms below it shut down at once. Losses drive exit; market supply shifts left; the price recovers. Exit stops when the price is back at minimum average total cost, with fewer firms and lower industry output, each remaining firm at its original output.
In practice
Worked example: from twenty-five dollars and seven flats a farm, demand falls and the price drops to twenty. Each farm grows six flats, since marginal cost of twenty matches the price, and loses thirty dollars, one twenty against one fifty. Twenty exceeds average variable cost of fifteen, so farms keep operating while losing. Over time some sell up; the price climbs back to twenty-five; the survivors return to seven flats and zero profit, and the industry is smaller.
Where people slip
Two cautions. A price that stays above average variable cost keeps every farm operating in the short run; the exits come later, from the long-run loss. And exit raises the price for the survivors, which is why the last firms out are not the ones who were losing most; they are the ones whose fixed inputs came free soonest.
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