Suppose there is an increase in demand for a particular good, X. Show graphically and explain the response of a perfectly competitive firm in the short run to this change in demand. Show graphically and explain the long-run response by representative firm to this increase in demand.

Note to student: The upper two diagrams would be given on the test and you would modify them as shown in the bottom two diagrams.  Also, the question may be conditioned on a decrease in demand rather than an increase as shown here.

The increase in demand creates a condition of excess demand at the current price of P₁. The excess demand allows an increase in price to the market clearing level of P₂.  The firm reacts in the short-run to the increase in price by increasing its profit maximizing output  from q₁ to q₂. The increased supply by existing firms in shown in the market diagram as an increase in output from Q₁ to Q₂. At P₂ with output q₂, the typical firm earns positive economic profit (the shaded area in the firm diagram). 

In the long-run, the positive profit attracts entry and additional supply (shown in the market diagram as a rightward shift in supply, S₁ to S₂). The added supply pushes price down until the typical firm earns zero profits. The firm reacts to the falling price by reducing its output from q₂ to q₁. Long-run equilibrium is restored in the market at a price of P₁ and output Q₃. In the long-run, the initial price is restored because the increase in demand is assumed to occur in a constant-cost industry. If the industry was characterized by increasing cost, the long-run equilibrium price would exceed the initial price, and if the industry was characterized by decreasing cost, the long-run equilibrium price would be less than the initial price. 

The output of the typical firm is the same as before the increase in demand, q₁, but total output is larger reflecting the larger number of firms in the industry.