Why will an increase in the demand for organic tomatoes lead to a large price increase at first but a much smaller increase in the long run? The answer lies in the behavior of the industry supply curve, which represents the relationship between the price of a good and the total output of the industry as a whole. The industry supply curve is what we referred to in earlier modules as the supply curve or the market supply curve. But here we take some extra care to distinguish between the individual supply curve of a single firm and the supply curve of the industry as a whole.

As you might guess from the previous module, the industry supply curve must be analyzed in somewhat different ways for the short run and the long run. Let’s start with the short run.

Recall that in the short run the number of firms in an industry is fixed. You may also remember that the industry supply curve is the horizontal sum of the individual supply curves of all firms—you find it by summing the total output across all suppliers at every given price. We will do that exercise here under the assumption that all the firms are alike—an assumption that makes the derivation particularly simple. So let’s assume that there are 100 organic tomato farms, each with the same costs as Jennifer and Jason’s farm. Each of these 100 farms will have an individual short-run supply curve like the one in Figure 59.2 from the previous module, which is reprinted above for your convenience.

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At a price below $10, no farms will produce. At a price of more than $10, each farm will produce the quantity of output at which its marginal cost is equal to the market price. As you can see from Figure 59.2, this will lead each farm to produce 4 bushels if the price is $14 per bushel, 5 bushels if the price is $18, and so on. So if there are 100 organic tomato farms and the price of organic tomatoes is $18 per bushel, the industry as a whole will produce 500 bushels, corresponding to 100 farms × 5 bushels per farm. The result is the short-run industry supply curve, shown as S in Figure 60.1. This curve shows the quantity that producers in an industry will supply at each price, taking the number of farms as given.

The demand curve, labeled D in Figure 60.1, crosses the short-run industry supply curve at E_MKT, corresponding to a price of $18 and a quantity of 500 bushels. Point E_MKT is a short-run market equilibrium: the quantity supplied equals the quantity demanded, taking the number of farms as given. But the long run may look quite different because in the long run farms may enter or exit the industry.

Suppose that in addition to the 100 farms currently in the organic tomato business, there are many other potential organic tomato farms. Suppose also that each of these potential farms would have the same cost curves as existing farms, like the one owned by Jennifer and Jason, upon entering the industry.

When will additional farms enter the industry? Whenever existing farms are making a profit—that is, whenever the market price is above the break-even price of $14 per bushel, the minimum average total cost of production. For example, at a price of $18 per bushel, new farms will enter the industry.

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What will happen as additional farms enter the industry? Clearly, the quantity supplied at any given price will increase. The short-run industry supply curve will shift to the right. This will alter the market equilibrium in turn and result in a lower market price. Existing farms will respond to the lower market price by reducing their output, but the total industry output will increase because of the larger number of farms in the industry.

Figure 60.2 illustrates the effects of this chain of events on an existing farm and on the market; panel (a) shows how the market responds to entry, and panel (b) shows how an individual existing farm responds to entry. (Note that these two graphs have been rescaled in comparison to Figures 59.2 and 60.1 to better illustrate how profit changes in response to price.) In panel (a), S₁ is the initial short-run industry supply curve, based on the existence of 100 producers. The initial short-run market equilibrium is at E_MKT, with an equilibrium market price of $18 and a quantity of 500 bushels. At this price existing farms are profitable, which is reflected in panel (b): an existing farm makes a total profit represented by the green shaded rectangle labeled A when the market price is $18.

This profit will induce new producers to enter the industry, shifting the short-run industry supply curve to the right. For example, the short-run industry supply curve when the number of farms has increased to 167 is S₂. Corresponding to this supply curve is a new short-run market equilibrium labeled D_MKT, with a market price of $16 and a quantity of 750 bushels. At $16, each farm produces 4.5 bushels, so that industry output is 167 × 4.5 = 750 bushels (rounded). From panel (b) you can see the effect of the entry of 67 new farms on an existing farm: the fall in price causes it to reduce its output, and its profit falls to the area represented by the striped rectangle labeled B.

Although diminished, the profit of existing farms at D_MKT means that entry will continue and the number of farms will continue to rise. If the number of farms rises to 250, the short-run industry supply curve shifts out again to S₃, and the market equilibrium is at C_MKT, with a quantity supplied and demanded of 1,000 bushels and a market price of $14 per bushel.

Like E_MKT and D_MKT, C_MKT is a short-run equilibrium. But it is also something more. Because the price of $14 is each farm’s break-even price, an existing producer makes zero economic profit—neither a profit nor a loss, earning only the opportunity cost of the resources used in production—when producing its profit-maximizing output of 4 bushels. At this price there is no incentive either for potential producers to enter or for existing producers to exit the industry. So C_MKT corresponds to a long-run market equilibrium—a situation in which the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for producers to either enter or exit the industry. In a long-run market equilibrium, all existing and potential producers have fully adjusted to their optimal long-run choices; as a result, no producer has an incentive to either enter or exit the industry.

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To explore further the difference between short-run and long-run equilibrium, consider the effect of an increase in demand on an industry with free entry that is initially in long-run equilibrium. Panel (b) in Figure 60.3 shows the market adjustment; panels (a) and (c) show how an existing individual firm behaves during the process.

In panel (b) of Figure 60.3, D₁ is the initial demand curve and S₁ is the initial short-run industry supply curve. Their intersection at point X_MKT is both a short-run and a long-run market equilibrium because the equilibrium price of $14 leads to zero economic profit—and therefore neither entry nor exit. It corresponds to point X in panel (a), where an individual existing firm is operating at the minimum of its average total cost curve.

Now suppose that the demand curve shifts out for some reason to D₂. As shown in panel (b), in the short run, industry output moves along the short-run industry supply curve, S₁, to the new short-run market equilibrium at Y_MKT, the intersection of S₁ and D₂. The market price rises to $18 per bushel, and industry output increases from Q_X to Q_Y. This corresponds to an existing firm’s movement from X to Y in panel (a) as the firm increases its output in response to the rise in its demand curve (which also represents price and marginal revenue) from D_F1 to D_F2.

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But we know that Y_MKT is not a long-run equilibrium because $18 is higher than minimum average total cost, so existing firms are making economic profit. This will lead additional firms to enter the industry. Over time entry will cause the short-run industry supply curve to shift to the right. In the long run, the short-run industry supply curve will have shifted out to S₂, and the equilibrium will be at Z_MKT—with the price falling back to $14 per bushel and industry output increasing yet again, from Q_Y to Q_Z. Like X_MKT before the increase in demand, Z_MKT is both a short-run and a long-run market equilibrium.

The effect of entry on an existing firm is illustrated in panel (c), in the movement from Y to Z along the firm’s individual supply curve. The firm reduces its output in response to the fall in the market price, which lowers the firm’s demand curve from D_F2 to D_F3. The firm ultimately arrives back at its original output quantity, corresponding to the minimum of its average total cost curve. In fact, every firm that is now in the industry—the initial set of firms and the new entrants—will operate at the minimum of its average total cost curve, at point Z. This means that the entire increase in industry output, from Q_X to Q_Z, comes from production by new entrants.

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The line LRS that passes through X_MKT and Z_MKT in panel (b) is the long-run industry supply curve. It shows how the quantity supplied by an industry responds to the price, given that firms have had time to enter or exit the industry.

In this particular case, the long-run industry supply curve is horizontal at $14. In other words, in this industry supply is perfectly elastic in the long run: given time to enter or exit, firms will supply any quantity that consumers demand at a price of $14. Perfectly elastic long-run supply is characteristic of a constant-cost industry. In a constant-cost industry, the firms’ cost curves are unaffected by changes in the size of the industry, either because there is a perfectly elastic supply of inputs, or because the industry’s input demand is too small relative to the overall input market to influence the input price. For example, the wooden pencil industry can expand without causing a significant increase in the price of wood.

In an increasing-cost industry, even the long-run industry supply curve slopes upward. The usual reason for this is that producers must use a significant amount of an input that is in limited supply (that is, their supply is at least somewhat inelastic). As the industry expands, the price of that input is driven up. Consequently, the cost structure for firms becomes higher than it was when the industry was smaller. An example is the cotton clothing industry, an expansion in which could drive up the price of cotton. Figure 60.4 illustrates the short-run and long-run effects of an increase in demand in an increasing-cost industry. In panel (b), D₁ is the initial demand curve for cotton pants and S₁ is the initial short-run industry supply curve. The market equilibrium at point X_MKT corresponds to point X in panel (a), where an individual firm is operating at the minimum of its average total cost curve.

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Now suppose that the demand curve shifts out to D₂. As shown in panel (b), in the short run, industry output expands along the short-run industry supply curve, S₁, to the new short-run market equilibrium at Y_MKT, the intersection of S₁ and D₂. The market price rises from $30 to $42 per pair, and industry output increases from Q_X to Q_Y. This corresponds to an existing firm’s movement from X to Y in panel (a), as it increases its output in response to the increase in its demand curve from D_F1 to D_F2.

At the new market price, existing firms earn economic profit, so additional firms enter the industry. Entry shifts the short-run industry supply curve to the right and lowers the price of pants. At the same time, increasing demand for cotton drives up the cost of this input. The resulting rise in input costs shifts the marginal and average total cost curves upward for firms. This process continues until the falling market price and the rising minimum average total cost meet somewhere in between the initial price of $30 and the short-run price of $42. In Figure 60.4, that occurs at a price of $35, after the short-run supply curve has shifted out to S₂ and the cost of making each pair of pants has risen by $5.

When the market reaches long-run equilibrium at Z_MKT, each firm faces a demand curve of D_F3 as shown in panel (c). Firms earn zero economic profit and there is no incentive for additional entry. Assuming that the cost increase is the same for each unit of output, each firm (that is not new) ends up making the same quantity of output as it did before the increase in demand. If the cost increase is not the same for each unit of output, the cost curves will not shift straight up as they did here, so the new profit-maximizing quantity of output could be more or less than before. The upward-sloping line LRS that passes through X_MKT and Z_MKT in panel (b) is the long-run industry supply curve for this increasing-cost industry.

A decrease in demand triggers the same process in reverse: the lower market price causes losses and the exit of firms, which lowers the cost of inputs and shifts the cost curves down until the falling minimum of average total cost meets the rising market price.

Finally, it is possible for the long-run industry supply curve to slope downward, a condition that occurs when the cost structure for firms becomes lower as the industry expands. This is the case in industries such as the electric car industry, in which increased output allows for economies of scale in the production of lithium batteries and other specialized inputs, and thus lower input prices.

A downward-sloping industry supply curve indicates a decreasing-cost industry. Figure 60.5 illustrates the short-run and long-run effects of an increase in demand in a decreasing-cost industry. In panel (b), D₁ is the initial demand curve for electric cars and S₁ is the initial short-run industry supply curve. If the demand curve shifts out to D₂, the new short-run market equilibrium is Y_MKT. The market price rises from $40,000 to $49,000 per electric car, and industry output increases from Q_X to Q_Y. This corresponds to an existing firm’s movement from X to Y in panel (a), caused by the increase in its demand curve from D_F1 to D_F2.

At the new market price, economic profit attracts additional firms. Entry shifts the short-run industry supply curve to the right and lowers the price of electric cars. At the same time, increasing demand for lithium batteries allows for economies of scale in battery production, and lowers the cost of this input. The resulting decrease in input costs shifts the marginal and average total cost curves downward for firms. This process continues until the falling market price catches up to the falling minimum average total cost somewhere below the initial price of $40,000. In Figure 60.5, that occurs at a price of $36,000, after the short-run supply curve has shifted out to S₂ in panel (b).

At the long-run equilibrium of Z_MKT, each firm faces a demand curve of D_F3 as shown in panel (c). Firms earn zero economic profit and there is no incentive for additional entry. Assuming that the cost decrease is the same for each car produced, each firm ends up making the same quantity of cars as it did before the increase in demand. The downward-sloping line LRS that passes through X_MKT and Z_MKT in panel (b) is the long-run industry supply curve for this decreasing-cost industry.

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Regardless of whether the long-run industry supply curve is horizontal, upward-sloping, or downward-sloping, the long-run price elasticity of supply is higher than the short-run price elasticity whenever there is free entry and exit. As shown in Figure 60.6, the long-run industry supply curve is always flatter than the short-run industry supply curve. The reason is entry and exit: a high price caused by an increase in demand attracts entry by new firms, resulting in a rise in industry output and an eventual fall in price; a low price caused by a decrease in demand induces existing firms to exit, leading to a fall in industry output and an eventual increase in price.

The distinction between the short-run industry supply curve and the long-run industry supply curve is very important in practice. We often see a sequence of events like those shown in Figures 60.3, 60.4, and 60.5: an increase in demand initially leads to a large price increase, but prices return to a more moderate level once new firms have entered the industry. Or we see the sequence in reverse: a fall in demand reduces prices considerably in the short run, but they return to a more moderate level as producers exit the industry.

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Our analysis leads us to three conclusions about the cost of production and efficiency in the long-run equilibrium of a perfectly competitive industry. These results will be important in our upcoming discussion of how monopoly gives rise to inefficiency.

First, in a perfectly competitive industry in equilibrium, all firms produce the quantity of output at which the marginal cost equals the market price. This P = MC outcome leads to allocative efficiency, meaning that it yields the mix of goods and services that society most values, as discussed in Module 3. This efficiency comes from the production of more of the good until the price consumers are willing to pay—an indication of the marginal benefit received from the good—equals the marginal cost of making it. After that point, the marginal cost exceeds the marginal benefit, so additional units should not be made.

Second, in a perfectly competitive industry with free entry and exit, each firm will have zero economic profit in the long-run equilibrium. Each firm produces the quantity of output that minimizes its average total cost—corresponding to point Z in panel (c) of Figures 60.3, 60.4, and 60.5. Because the total cost of producing the industry’s output is minimized, a perfectly competitive industry achieves productive efficiency.

Third, in the long-run market equilibrium of a perfectly competitive industry, the consumers who are willing to pay an amount greater than or equal to the sellers’ marginal cost actually get the good. No mutually beneficial transactions go unexploited because the market price matches the consumers who are willing to pay the most for the good with the sellers who have a cost of production that is less than or equal to the market price.

So the long-run equilibrium of a perfectly competitive industry delivers efficiency. There is allocative efficiency because P = MC; there is productive efficiency because costs are minimized and no resources are wasted; and the goods are distributed to those who are willing to pay the most for them. Moreover, these conditions tend to persist over time as the environment changes: the force of competition makes producers responsive to changes in consumers’ desires and to changes in technology.

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