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.

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.

Each of these 100 farms will have an individual short-run supply curve like the one in Figure 12-4. 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 12-4, 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 12-5. This curve shows the quantity that producers will supply at each price, taking the number of producers as given.

The demand curve D in Figure 12-5 crosses the short-run industry supply curve at E_MKT, corresponding to a price of $18 and a quantity of 5,000 trees. Point E_MKT 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.

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 12-6 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 12-4 and 12-5 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 E_MKT, 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.

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 D_MKT, 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).

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 D_MKT 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 C_MKT, with a quantity supplied and demanded of 10,000 trees and a market price of $14 per tree.

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 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 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.

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 12-7 shows the market adjustment; panels (a) and (c) show how an existing individual firm behaves during the process.

In panel (b) of Figure 12-7, 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 tree, 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 the market price.

But we know that Y_MKT 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.

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 tree 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, 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 Q_X to Q_Z, comes from production by new entrants.

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 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 12-8, 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.

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 12-7: 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.

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 13 of how monopoly gives rise to inefficiency.

First, 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.

Second, 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 12-7. 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.

The third and final conclusion is that the long-run market equilibrium of a perfectly competitive industry is efficient: no mutually beneficial transactions go unexploited. To understand this, we need to 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.