Economics: Deriving Long-Run Market Supply Curve

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This is the last lecture in our series in productivity, costs and profits. In this lecture, we'll be looking at the effects of the expansion of an industry and we'll be deriving a tool that we call the long run supply curve. Let's start with revisiting the relationship between the market and the individual firm that we derived last time. So, here we have the market equilibrium, the demand curve, which is the behavior of households and consumers, and the short run supply curve, which is the sum of the marginal cost curves of the individual firms. In the short run, the supply curve and the demand curve intersect and give us an equilibrium point, we'll call this P[0] and a market quantity, we'll call this Q[0].
Now, if we take this price over into the diagram for the individual firm, we see that in long run equilibrium, the firm is making zero economic profit and the firm is producing at the point of efficient scale. This is a long run equilibrium. The only way we can have a long run equilibrium is if no firm wants to change its behavior. In this case, the firm is maximizing profit by producing where price is equal to marginal cost and the firm is breaking even by producing where price is equal to average cost. There is zero economic profits and therefore no tendency for entrance or exit. Everything is stable in this market. Let's upset the equilibrium now, by changing the demand for the product. If we change the demand for the product, and the demand curve shifts up to this new point D prime. Then we had an excess demand for the product at the old price and the bidding mechanism then, will push the price up, so that firms supply a larger quantity and the quantity demanded decreases. So that the price goes up to this point here. Now, that would be the short run equilibrium and the firm would move along its short run marginal cost curve over here in this diagram.
I'm not going to draw the short run marginal cost because my focus here is on a different story. I want to know what happens as new firms enter the market. What happens to the cost of production? As new firms enter the market and the short run supply curve shifts outwards, representing an increase in the number of firms offering trucking services, it may be that as these new firms enter the market that they drive up the cost of production for all firms. Suppose that truck drivers are in short supply. If truck drivers are in short supply, then as trucking companies try to expand their operation, they're going to be bidding up the salaries of truck drivers. And, as the salaries of truck drivers rise, then the cost of production for every firm in the trucking industry are going to increase.
When this happens, the cost curves shift upward and the costs that firms can afford to operate at will be rising. That is, the point of minimum long run average costs will be shifting upwards. So, what we have then, as the short run supply curve shifts outwards and firms enter the industry and compete for a strictly limited resource, like talented truck drivers, the cost of production will shift upwards and we will get something like this. A new long run average cost curve at a higher level. If expansion in an industry causes the cost curves to shift upward, like this, we say that this is an increasing cost industry. If the expansion of the industry causes the cost curves to shift upwards, we call it an increasing cost industry.
What we're saying is, as the industry expands, competition for a strictly limited resource, will in fact increase the costs of all firms in the industry. This was the case in the computer industry in the late 1970's, early 1980's, when there was a limited supply of talented computer programmers. It took awhile for students to go to school and learn computer programming and of course, those students were attracted by the promise of higher salaries. But in the short run, as computer companies tried to expand their operation, competing for a pool of talented programmers, they pushed up programmer's salaries through competition and that raised the cost of production for all of the companies.
Now what does this mean? It means that there will be a limited amount of entry before the price falls to the point at which firms can just afford to cover their costs. The break-even point for firms has shifted upward as the cost of production has increased. That means the price for the product cannot fall back to its original level, but can only fall as low as the new point of minimum average cost. That new point of minimum average cost might be not eight cents a mile for trucking service, but 12 cents a mile for trucking service. The increase in costs limits the amount by which the short run supply curve can shift outwards. This new price P[1] has to be the new equilibrium price, it's the new price that's given by the intersection of short run supply and demand, it's the new price that we have in long run equilibrium. Firms are breaking even and the quantity supplied equals the quantity demanded.
If I connect these two dots, I get what we call in Economics the long run supply curve. The long run supply curve shows what happens to minimum average cost as an industry expands. In our case, we were talking about an increasing cost industry. When an increasing cost industry expands, the minimum average cost of production rises as firms compete for a strictly scarce resource and push up the cost of production. The long run supply curve in this case is upward sloping. It is possible that you have what's called a constant cost industry. A constant cost industry would be one, where as the industry expands, the costs of production do not change for the individual firms.
In that case, the short run supply curve would keep shifting outward, until our price fell back to eight cents per mile, the original minimum long run average cost. In that case, the long run supply curve would be a horizontal line. The short run supply curve would keep shifting out, until it intersected the demand curve at the original price. The original minimum long run average cost. One more possibility. What if the expansion of an industry actually decreases the cost of production for individual firms? What if we have a decreasing cost industry? What if a large number of firms in an industry actually lowers the cost for each firm in that industry?
That could be the case, say in software design, where you have a bunch of software engineers who work in a market and with more people trying to solve the same kinds of problems, they're able to solve them faster. They share ideas. Everyone's working on the same problem and therefore it takes less time to solve it. In an industry like that, a large number of talented software designers lower the cost for each other, by working on common problems and sharing insights with each other. That leads to what's called a decreasing cost industry. As the industry expands, the costs of production actually fall. And in that case, the long run supply curve would be downward sloping. So, a quick summary.
The long run supply curve tells us about the relationship between the size of an industry and the cost of production for an individual firm in that industry. If expansion of the industry pushes up costs for individual firms, we call it an increasing cost industry and the long run supply curve slopes upwards. That will be the case if expansion in the industry heats up competition for a strictly scarce resource, like talented programmers or certified truck drivers. It's also possible that expansion of the industry leaves costs unchanged. That's what we call a constant cost industry and that would give us a long run supply curve that's horizontal. Finally, it could be that expansion of an industry actually reduces costs for the individual firms. This will be the case if growth in the industry allowed communications among the participants or other ways of economizing on costs. External economies of scale we call it sometimes in Economics, where the growth of an industry lowers cost for everyone. In that case, the long run supply curve would be downward sloping.
Perfect Competition
Market Supply
Deriving the Long Run Market Supply Curve Page [2 of 2]