In microeconomics, we are taught that in a perfectly competitive industry, the long-run industry supply curve is horizontal. This is because new firms would enter or exit until the profit is driven to zero, at which point the price is equal to the marginal cost. Thus, if there is an industry demand shock, then in the long run, the equilibrium price would remain the same, while the equilibrium output would adjust accordingly.
In macroeconomics, we are taught that in an economy with no factor growth, the long-run aggregate supply curve is vertical. This is because nominal variables have no effect on the economy in the long run, in which the real output depends only on factors of production. Thus, if there is an aggregate demand shock, then in the long run, the equilibrium output would remain the same, while the equilibrium price would adjust accordingly.
Two completely opposite conclusions about the long-run supply curve!
Of course, here I am comparing apples to oranges (somewhat deliberately). In the microeconomic case, we are doing partial equilibrium analysis on a particular industry, while in the macroeconomic case, we are doing general equilibrium analysis on the broad economy.
Nevertheless, we would expect changes in macroeconomic conditions to eventually affect all industries. A macroeconomic shock in aggregate demand should somehow transmit down to the industries. If we combine the two kinds of analysis above, what can we say about how a perfectly competitive industry would respond to an aggregate demand shock in the long run? Would:
- the equilibrium price remain the same while the equilibrium output adjust accordingly, as said in microeconomic textbooks, or
- the equilibrium output remain the same while the equilibrium price adjust accordingly, as said in macroeconomic textbooks, or
- both the equilibrium price and output change accordingly?