Shine Car Wash is one firm in a perfectly competitive industry. We assume that t

Question

Shine Car Wash is one firm in a perfectly competitive industry. We assume that the firm has a very simple cost function: c(y) = cy, with c > 0. As for the market demand, we assume that it takes the simple linear form p = a - bY, with a > c > 0 and b > 0, where Y is the total production in the industry. What will happen to price and output in the car wash industry and Shine's profits in the short run and the long run if the municipality raises water prices (c increases)? What happens to the number of firms in short run and long run? Forget part (a). How do perfect competition price and quantity vary if there is a positive demand shock (a increases)? What happens to the number of firms in short run and long run?

Explanation / Answer

a. If the water prices increases in the short run, the cost of production rises. Thus, the profits of the firms will fall in the short run.

In the long run, the firms which ware not able to cover their average variable cost will exit the industry. This will shift the supply curve leftwards and the curve will keep on shifting until the new price level determined in the market rises and left over firms start earning normal profits again.

b. If there is positive demand shock, then prices determined in the market will rise. This rise in the prices will raise the profits of the firms in the market and the firms will be earning super normal profits in the short run.

In the long run, new firms will enter the market. Thus supply curve will shift rightwards and prices will fall until the equilibrium condition of prices equal to minimum of average cost is reached and all firms are earning normal profits.

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