AS-MDS diagram - how will an economy move to a long run equilibrium after a tax cut?

Question

Assume that the ii schedule has not/will not change.

I need to draw a diagram for this, so instructions on how to do that would be great! :) I already know how to draw the tax cut, but how would I do it for the question?

Answer 1

In the long-run, increases (decreases) in demand in a competitive market will cause increases (decreases) in output. Initially, markets with an increase (decrease) in demand will have firms experiencing economic profits (losses). Over time, markets with firms experiencing economic profits (losses) will have additional firms enter (existing firms will exit) the market, and prices will decrease (increase) towards previous levels. If cost conditions remain the same, then prices will revert to what they were before the increase (decrease) in demand.

If the market price falls below a firm's average total cost, the firm will incur economic losses.  The firm may be able to lower its average total cost by changing to a different plant size. Suppose a firm increases its plant size, and lowers its average total costs. If other firms follow, then the industry supply curve will shift to the right. This will result in lower prices and less economic profit.

If a firm does not expect market conditions to improve then it may decide to go out of business. This would be the preferred option as, by selling out, neither fixed nor variable costs would be incurred.