The correct option is 2 only
Explanation
The question pertains to the long-run adjustment mechanism in a perfectly competitive market characterized by free entry and exit. In the long-run equilibrium of such a market, the price ($P$) settles at the minimum point of the Average Cost ($AC$) curve, meaning firms earn zero economic profit.
Statement-wise Analysis:
- Statement 1 is Incorrect: A shift of the demand curve to the left indicates a decrease in demand. In the short run, this leads to a reduction in the market price. Since the market was originally in equilibrium at the minimum average cost, the new lower price will fall below the minimum average cost, causing firms to incur economic losses.
- Statement 2 is Correct: Rational firms enter a market only when there are economic profits (Price > Average Cost). Since the price has fallen below the average cost, existing firms face losses. Consequently, firms will exit the market rather than enter it.
- Statement 3 is Incorrect: As firms exit the market due to losses, the aggregate market supply decreases. This causes the supply curve to shift to the left. The reduction in supply drives the price back up. This process continues until the price returns to the minimum average cost. Therefore, supply decreases, it does not increase.
Key Takeaway:
In a market with free entry and exit, a decrease in demand leads to short-run losses and the exit of firms. This exit reduces supply, eventually restoring the price to the minimum average cost level in the long run.