7.3 The Industry Supply Curve

The industry supply curve shows the relationship between the price of a good and the total output of the industry as a whole.

Why will an increase in the demand for Christmas trees 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—the relationship between the price and the total output of an industry as a whole. The industry supply curve is what we referred to in earlier chapters 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 section, 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.

The Short-Run Industry Supply Curve

Recall that in the short run the number of producers in an industry is fixed—there is no entry or exit. And you may also remember from Chapter 3 that the market supply curve is the horizontal sum of the individual supply curves of all producers—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 producers are alike—an assumption that makes the derivation particularly simple. So let’s assume that there are 100 Christmas tree farms, each with the same costs as Noelle’s farm.

The short-run industry supply curve shows how the quantity supplied by an industry depends on the market price given a fixed number of producers.

Each of these 100 farms will have an individual short-run supply curve like the one in Figure 7-4. At a price below $10, no farms will produce. At a price of $10 or more, 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 7-4, this will lead each farm to produce 40 trees if the price is $14 per tree, 50 trees if the price is $18, and so on. So if there are 100 tree farms and the price of Christmas trees is $18 per tree, the industry as a whole will produce 5,000 trees, corresponding to 100 farms × 50 trees per farm, and so on. The result is the short-run industry supply curve, shown as S in Figure 7-5. This curve shows the quantity that producers will supply at each price, taking the number of producers as given.

Figure 7.5: FIGURE 7-5 The Short-Run Market Equilibrium
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Figure 7.5: The short-run industry supply curve, S, is the industry supply curve taking the number of producers—here, 100—as given. It is generated by adding together the individual supply curves of the 100 producers. Below the shut-down price of $10, no producer wants to produce in the short run. Above $10, the short-run industry supply curve slopes upward, as each producer increases output as price increases. It intersects the demand curve, D, at point EMKT, the point of short-run market equilibrium, corresponding to a market price of $18 and a quantity of 5,000 trees.

There is a short-run market equilibrium when the quantity supplied equals the quantity demanded, taking the number of producers as given.

The demand curve D in Figure 7-5 crosses the short-run industry supply curve at EMKT, corresponding to a price of $18 and a quantity of 5,000 trees. Point EMKT is a short-run market equilibrium: the quantity supplied equals the quantity demanded, taking the number of producers as given. But the long run may look quite different, because in the long run farms may enter or exit the industry.

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The Long-Run Industry Supply Curve

Suppose that in addition to the 100 farms currently in the Christmas tree business, there are many other potential producers. Suppose also that each of these potential producers would have the same cost curves as existing producers like Noelle if it entered the industry.

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

What will happen as additional producers 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, in turn, alter the market equilibrium and result in a lower market price. Existing firms will respond to the lower market price by reducing their output, but the total industry output will increase because of the larger number of firms in the industry.

Figure 7-6 illustrates the effects of this chain of events on an existing firm and on the market; panel (a) shows how the market responds to entry, and panel (b) shows how an individual existing firm responds to entry. (Note that these two graphs have been rescaled in comparison to Figures 7-4 and 7-5 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 EMKT, with an equilibrium market price of $18 and a quantity of 5,000 trees. At this price existing producers are profitable, which is reflected in panel (b): an existing firm makes a total profit represented by the green-shaded rectangle labeled A when market price is $18.

Figure 7.6: FIGURE 7-6 The Long-Run Market Equilibrium
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Figure 7.6: Point EMKT of panel (a) shows the initial short-run market equilibrium. Each of the 100 existing producers makes an economic profit, illustrated in panel (b) by the green rectangle labeled A, the profit of an existing firm. Profits induce entry by additional producers, shifting the short-run industry supply curve outward from S1 to S2 in panel (a), resulting in a new short-run equilibrium at point DMKT, at a lower market price of $16 and higher industry output. Existing firms reduce output and profit falls to the area given by the striped rectangle labeled B in panel (b). Entry continues to shift out the short-run industry supply curve, as price falls and industry output increases yet again. Entry of new firms ceases at point CMKT on supply curve S3 in panel (a). Here market price is equal to the break-even price; existing producers make zero economic profits, and there is no incentive for entry or exit. So CMKT is also a long-run market equilibrium.

These profits 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 producers has increased to 167 is S2. Corresponding to this supply curve is a new short-run market equilibrium labeled DMKT, with a market price of $16 and a quantity of 7,500 trees. At $16, each firm produces 45 trees, so that industry output is 167 × 45 = 7,500 trees (rounded).

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From panel (b) you can see the effect of the entry of 67 new producers on an existing firm: 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 firms at DMKT means that entry will continue and the number of firms will continue to rise. If the number of producers rises to 250, the short-run industry supply curve shifts out again to S3, and the market equilibrium is at CMKT, with a quantity supplied and demanded of 10,000 trees and a market price of $14 per tree.

A market is in long-run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur.

Like EMKT and DMKT, CMKT is a short-run equilibrium. But it is also something more. Because the price of $14 is each firm’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 40 trees. At this price there is no incentive either for potential producers to enter or for existing producers to exit the industry. So CMKT 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 significance of 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 7-7 shows the market adjustment; panels (a) and (c) show how an existing individual firm behaves during the process.

Figure 7.7: FIGURE 7-7 The Effect of an Increase in Demand in the Short Run and the Long Run
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Figure 7.7: Panel (b) shows how an industry adjusts in the short and long run to an increase in demand; panels (a) and (c) show the corresponding adjustments by an existing firm. Initially the market is at point XMKT in panel (b), a short-run and long-run equilibrium at a price of $14 and industry output of QX. An existing firm makes zero economic profit, operating at point X in panel (a) at minimum average total cost. Demand increases as D1 shifts rightward to D2 in panel (b), raising the market price to $18. Existing firms increase their output, and industry output moves along the short-run industry supply curve S1 to a short-run equilibrium at YMKT. Correspondingly, the existing firm in panel (a) moves from point X to point Y. But at a price of $18 existing firms are profitable. As shown in panel (b), in the long run new entrants arrive and the short-run industry supply curve shifts rightward, from S1 to S2. There is a new equilibrium at point ZMKT, at a lower price of $14 and higher industry output of QZ. An existing firm responds by moving from Y to Z in panel (c), returning to its initial output level and zero economic profit. Production by new entrants accounts for the total increase in industry output, QZ − QX. Like XMKT, ZMKT is also a short-run and long-run equilibrium: with existing firms earning zero economic profit, there is no incentive for any firms to enter or exit the industry. The horizontal line passing through XMKT and ZMKT, LRS, is the long-run industry supply curve: at the break-even price of $14, producers will produce any amount that consumers demand in the long run.

In panel (b) of Figure 7-7, D1 is the initial demand curve and S1 is the initial short-run industry supply curve. Their intersection at point XMKT 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 YMKT, the intersection of S1 and D2. The market price rises to $18 per tree, and industry output increases from QX to QY. 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 the market price.

But we know that YMKT is not a long-run equilibrium, because $18 is higher than minimum average total cost, so existing producers are making economic profits. This will lead additional firms to enter the industry.

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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 ZMKT—with the price falling back to $14 per tree and industry output increasing yet again, from QY to QZ. Like XMKT before the increase in demand, ZMKT 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, ultimately arriving 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 QX to QZ, comes from production by new entrants.

The long-run industry supply curve shows how the quantity supplied responds to the price once producers have had time to enter or exit the industry.

The line LRS that passes through XMKT and ZMKT 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 producers 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, producers will supply any quantity that consumers demand at a price of $14. Perfectly elastic long-run supply is actually a good assumption for many industries. In this case we speak of there being constant costs across the industry: each firm, regardless of whether it is an incumbent or a new entrant, faces the same cost structure (that is, they each have the same cost curves). Industries that satisfy this condition are industries in which there is a perfectly elastic supply of inputs—industries like agriculture or bakeries.

In other industries, however, even the long-run industry supply curve slopes upward. The usual reason for this is that producers must use some input that is in limited supply (that is, inelastically supplied). As the industry expands, the price of that input is driven up. Consequently, later entrants in the industry find that they have a higher cost structure than early entrants. An example is beachfront resort hotels, which must compete for a limited quantity of prime beachfront property. Industries that behave like this are said to have increasing costs across the industry.

It is possible for the long-run industry supply curve to slope downward. This can occur when an industry faces increasing returns to scale, in which average costs fall as output rises. Notice we said that the industry faces increasing returns. However, when increasing returns apply at the level of the individual firm, the industry usually ends up dominated by a small number of firms (an oligopoly) or a single firm (a monopoly).

In some cases, the advantages of large scale for an entire industry accrue to all firms in that industry. For example, the costs of new technologies such as solar panels tend to fall as the industry grows because that growth leads to improved knowledge, a larger pool of workers with the right skills, and so on.

Regardless of whether the long-run industry supply curve is horizontal or upward sloping or even 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 7-8, 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 producers, 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.

Figure 7.8: FIGURE 7-8 Comparing the Short-Run and Long-Run Industry Supply Curves
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Figure 7.8: The long-run industry supply curve may slope upward, but it is always flatter—more elastic—than the short-run industry supply curve. This is because of entry and exit: a higher price attracts new entrants in the long run, resulting in a rise in industry output and a fall in price; a lower price induces existing producers to exit in the long run, generating a fall in industry output and an eventual rise 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 that shown in Figure 7-7: an increase in demand initially leads to a large price increase, but prices return to their initial level once new firms have entered the industry. Or we see the sequence in reverse: a fall in demand reduces prices in the short run, but they return to their initial level as producers exit the industry.

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The Cost of Production and Efficiency in Long-Run Equilibrium

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 discussion in Chapter 8 of how monopoly gives rise to inefficiency.

  1. In a perfectly competitive industry in equilibrium, the value of marginal cost is the same for all firms. That’s because all firms produce the quantity of output at which marginal cost equals the market price, and as price-takers they all face the same market price.

  2. In a perfectly competitive industry with free entry and exit, each firm will have zero economic profit in long-run equilibrium. Each firm produces the quantity of output that minimizes its average total cost—corresponding to point Z in panel (c) of Figure 7-7. So the total cost of production of the industry’s output is minimized in a perfectly competitive industry.

    The exception is an industry with increasing costs across the industry. Given a sufficiently high market price, early entrants make positive economic profits, but the last entrants do not as the market price falls. Costs are minimized for later entrants, as the industry reaches long-run equilibrium, but not necessarily for the early ones.

  3. The long-run market equilibrium of a perfectly competitive industry is efficient: no mutually beneficial transactions go unexploited. To understand this, recall a fundamental requirement for efficiency: all consumers who have a willingness to pay greater than or equal to sellers’ costs actually get the good. We also learned that when a market is efficient (except under certain, well-defined conditions), the market price matches all consumers with a willingness to pay greater than or equal to the market price to all sellers who have a cost of producing the good less than or equal to the market price.

So in the long-run equilibrium of a perfectly competitive industry, production is efficient: costs are minimized and no resources are wasted. In addition, the allocation of goods to consumers is efficient: every consumer willing to pay the cost of producing a unit of the good gets it. Indeed, no mutually beneficial transaction is left unexploited. Moreover, this condition tends 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.

PITFALLS

ECONOMIC PROFIT, AGAIN

Some readers may wonder why a firm would want to enter an industry if the market price is only slightly greater than the break-even price. Wouldn’t a firm prefer to go into another business that yields a higher profit?

The answer is that here, as always, when we calculate cost, we mean opportunity cost—that is, cost that includes the return a firm could get by using its resources elsewhere. And so the profit that we calculate is economic profit; if the market price is above the break-even level, no matter how slightly, the firm can earn more in this industry than they could elsewhere.

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ECONOMICS in Actionimage

From Global Wine Glut to Shortage

image | interactive activity

If you were a wine producer still in business in 2012, you were probably breathing a big sigh of relief. Why? Because that is when the global wine market went from glut to shortage. This was a big change from the years 2004 to 2010, when the wine industry battled with an oversupply of product and plunging prices, driven first by a series of large global harvests and then by declining demand due to the global recession of 2008. After years of losses, many wine producers finally decided to exit the industry.

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A wine shortage may soon become a wine glut as growers respond by planting more vineyards.
Thinkstock/Getty Images

By 2012, wine production capacity was down significantly in Europe, South America, Africa, and Australia, and inventories were at their lowest point in over a decade. Moreover, 2012 was a year of bad weather for wine producers. And that same year, American wine consumption started growing again, while China’s wine consumption was surging, quadrupling over the previous five years. So combine a significant drop in capacity, a weather-induced fall in supply, and an increase in demand and—voilà!—a wine shortage appears.

But as industry analysts noted, many vintners are cheering. The lack of production in other parts of the world and surging demand in China have opened opportunities for expansion. As the CEO of Washington State’s Chateau Ste. Michelle winery, Ted Bessler, commented, “Right now, we have about 50,000 acres in the state. I can foresee that we could have as much as 150,000 or more.”

Hold onto your wine glasses—the present shortage could turn into a glut once again.

Quick Review

  • The industry supply curve corresponds to the supply curve of earlier chapters. In the short run, the time period over which the number of producers is fixed, the short-run market equilibrium is given by the intersection of the short-run industry supply curve and the demand curve. In the long run, the time period over which producers can enter or exit the industry, the long-run market equilibrium is given by the intersection of the long-run industry supply curve and the demand curve. In the long-run market equilibrium, no producer has an incentive to enter or exit the industry.

  • The long-run industry supply curve is often horizontal, although it may slope upward when a necessary input is in limited supply. It is always more elastic than the short-run industry supply curve.

  • In the long-run market equilibrium of a perfectly competitive industry, each firm produces at the same marginal cost, which is equal to the market price, and the total cost of production of the industry’s output is minimized. It is also efficient.

Check Your Understanding 7-3

Question 7.4

1. Which of the following events will induce firms to enter an industry? Which will induce firms to exit? When will entry or exit cease? Explain your answer.

  1. A technological advance lowers the fixed cost of production of every firm in the industry.

    A fall in the fixed cost of production generates a fall in the average total cost of production and, in the short run, an increase in each firm’s profit at the current output level. So in the long run new firms will enter the industry. The increase in supply drives down price and profits. Once profits are driven back to zero, entry will cease.

  2. The wages paid to workers in the industry go up for an extended period of time.

    An increase in wages generates an increase in the average variable and the average total cost of production at every output level. In the short run, firms incur losses at the current output level, and so in the long run some firms will exit the industry. (If the average variable cost rises sufficiently, some firms may even shut down in the short run.) As firms exit, supply decreases, price rises, and losses are reduced. Exit will cease once losses return to zero.

  3. A permanent change in consumer tastes increases demand for the good.

    Price will rise as a result of the increased demand, leading to a short-run increase in profits at the current output level. In the long run, firms will enter the industry, generating an increase in supply, a fall in price, and a fall in profits. Once profits are driven back to zero, entry will cease.

  4. The price of a key input rises due to a long-term shortage of that input.

    The shortage of a key input causes that input’s price to increase, resulting in an increase in average variable and average total costs for producers. Firms incur losses in the short run, and some firms will exit the industry in the long run. The fall in supply generates an increase in price and decreased losses. Exit will cease when losses have returned to zero.

Question 7.5

2. Assume that the egg industry is perfectly competitive and is in long-run equilibrium with a perfectly elastic long-run industry supply curve. Health concerns about cholesterol then lead to a decrease in demand. Construct a figure similar to Figure 7-7, showing the short-run behavior of the industry and how long-run equilibrium is reestablished.

In the following diagram, point XMKT in panel (b), the intersection of S1 and D1, represents the long-run industry equilibrium before the change in consumer tastes. When tastes change, demand falls and the industry moves in the short run to point YMKT in panel (b), at the intersection of the new demand curve D2 and S1, the short-run supply curve representing the same number of egg producers as in the original equilibrium at point XMKT. As the market price falls, an individual firm reacts by producing less—as shown in panel (a)—as long as the market price remains above the minimum average variable cost. If market price falls below minimum average variable cost, the firm would shut down immediately. At point YMKT the price of eggs is below minimum average total cost, creating losses for producers. This leads some firms to exit, which shifts the short-run industry supply curve leftward to S2. A new long-run equilibrium is established at point ZMKT. As this occurs, the market price rises again, and, as shown in panel (c), each remaining producer reacts by increasing output (here, from point Y to point Z). All remaining producers again make zero profits. The decrease in the quantity of eggs supplied in the industry comes entirely from the exit of some producers from the industry. The long-run industry supply curve is the curve labeled LRS in panel (b).

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Solutions appear at back of book.