How would a perfectly competitive industry respond to a macroeconomic demand shock in the long run?

Question

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:

1. the equilibrium price remain the same while the equilibrium output adjust accordingly, as said in microeconomic textbooks, or
2. the equilibrium output remain the same while the equilibrium price adjust accordingly, as said in macroeconomic textbooks, or
3. both the equilibrium price and output change accordingly?

Answer 1

You indirectly answered your own question when you stated:

Of course, here I am comparing apples to oranges (somewhat deliberately).

You are trying to compare something that is incomparable

1. Demand shock on individual market $\neq$ shock to aggregate demand.

   For example, at the same time when aggregate demand is massively increasing, individual demand at some markets can be collapsing. Even the opposite is possible while aggregate demand is falling one individual industry might experience boom.

   Here anything can happen. If we take market for apples, and assume there was negative aggregate demand shock the following could happen to demand for apples:

   • demand for apples can decrease

   • demand for apples can increase

   • demand for apples can stay constant

   Apriori any of the above would be valid scenario even during negative shock to aggregate demand.

   Aggregate demand is in essence given by (See Blanchard et al Macroeconomics: An European Perspective pp 192):

$$AD = C+I+G+NX$$

where $C$ is consumption spending $I$ investment spending, $G$ government spending and $NX$ net export. Aggregate demand can fall because government demand falls $G$ while at the same time consumer spending $C$ can increase (just not as much to offset fall in G). Or you could decompose $C$ into consumer spending for apples, TVs, PCs etc. $C= \sum C_i$ where $i$ is any industry you can imagine. Clearly $C$ can fall even if one component, for example $C_{TV}$ grows, if just other $C_i$ fall more than $C_{TV}$ is growing.

2. individual market supply $\neq$ aggregate supply. Moreover, aggregate supply does not necessarily have the properties that individual supply has - assuming that is fallacy of composition.

   The long-run supply is given by the natural rate of output or full-employment output (see Mankiw Macroeconomics pp 449). This is not simply sum of all the micro long-run supplies curves. It is given by the sum of quantity supplied on all micro markets when macroeconomy (i.e. not necessarily when micro markets are) is in long-run.

3. Time to reach long-run on individual market $\neq$ time to reach long-run from macro perspective. Long-run is not some set period of time. In some individual market like in market for ice cream long-run might be few days, whereas in macro long-run will typically take several years or even a decade to reach (prices tend to be sticky).

   In microeconomics the long-run is sufficient long time so that firms can enter and exit the market (See Mankiw's Principles of Microeconomics pp 291). In some industries this might be just matter of days.

   In macroeconomics the long-run is defined as a sufficient time that all prices (including wages and other things that are prices just with different name) in the economy are fully flexible (see Mankiw Macroeconomics pp 240).

   Hence long-run in macro is not the same long-run you will see in micro textbooks. In micro, perfect competition all prices are always fully flexible, so technically there you are always in long-run as defined in macro.

So you are basically comparing things that are not comparable.

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Now below I will show you my best attempt of representing what happens to aggregate supply and aggregate demand, assuming there is only 1 market in the whole economy, so by definition $AD=D$ (otherwise we don't know what happens to $D$ when there is shock to $AD$). And that the single market is perfectly competitive (so price is fully flexible meaning there is no short-run AS - short-run AS can only exit if prices are not flexible). Also I plotted example of negative shock.

On a left you can see the micro view (i.e. view you would see in your micro textbook). On right you can see the macro view (i.e. view you would see in macro textbook if there is only 1 big perfectly competitive market in the whole economy).

You can see that because prices are fully flexible, in macro box we have only long-run aggregate supply. In the micro side we have both short and long-run.

Aggregate supply is vertical despite that it represent the supply on the market, because aggregate supply is the supply at full employment. With flexible prices and perfect markets economy always works at a full employment. So any time equilibrium on the perfectly competitive market changes the LRAS just shifts to the place given by $Q_i$.