Suppose bicycles are produced by a competitive constant-cost industry, which is initially in a long-run equilibrium. For each of the following situations, design a supply-demand diagram that shows how market price and quantity will be affected in both the short run and the long run. In your diagrams, show the short-run supply, long-run supply, and demand curves, along with any shifts in these curves. Label the initial long-run equilibrium E0, the new short-run equilibrium E1, and the new long-run equilibrium E2.

Question

(i) New health regulations require each bicycle firm to purchase an air purification system to reduce hazardous fumes in the workplace. Who pays for this increased cost in the short run? Who pays in the long run?
(ii) The cost of titanium alloy rises, which adds $10 to the cost of manufacturing each bicycle frame. Who pays for this increased cost in the short run? Who pays in the long run?
(iii) Bicycling declines in popularity as more and more people take up in-line skating. How are the profits of bicycle manufacturers affected in the short run? How are their profits affected in the long run?

Answer 1

(i) The air purification system is a fixed cost that does not depend on the number of bicycles produced. Thus there is no shift in short-run supply and no short-run change in the equilibrium price and quantity of bicycles. The new fixed cost will, however, lower firms' profitability and raise their break-even price, causing the long-run supply curve to shift up. Some firms will exit the industry and the short-run supply curve will shift to the left, causing the long-run price of bicycles to rise and the quantity to fall as zero profits are reestablished. Therefore, bicycle firms bear the entire cost in the short run, while consumers bear the entire cost in the long run. This situation is illustrated in the accompanying diagram.



(ii) In this situation, marginal cost has increased by $10 per bicycle. Thus the short-run supply curve shifts up by $10 per bicycle, so the equilibrium price rises and the equilibrium quantity falls. However, the price does not rise by the full $10 per bicycle, so the increased cost is split between consumers and firms in the short run. Firms' break-even price has also risen by $10 per bicycle, so the new short-run price is less than firms' new break-even price, which causes some firms to exit the industry in the long run. The short-run supply curve will shift further to the left, causing a further increase in the price and decrease in the quantity. The entire cost of $10 per bicycle is paid for by consumers in the long run. This situation is illustrated in the accompanying diagram.



(iii) The demand for bicycles falls, causing the market price and quantity to fall. The new price is below firms' break-even price, so bicycle firms have short-run losses. Some firms will exit in the long run, which shifts the short-run supply curve to the left. The price of bicycles rises back up to firms' break-even price, and the quantity of bicycles bought and sold declines further. The profits of the firms remaining in the industry are restored to zero. This situation is illustrated in the accompanying diagram.