Question

Consider the market for a good q with price p.

(a) What are the conditions characterizing a constant cost industry? Draw a typical long-run supply curve for the industry and for a firm in this market. Assume homogeneous firms here and in part (b) below. For the firm, also draw the corresponding average cost function. Explain.

(b) Now assume that the industry faces increasing costs and a downward sloping demand D. Draw a picture with the corresponding industry supply and demand curve. How much profits are made in this industry?

Answer 1

Assumption :

A market with price (P) & quantity (Q)

(a)Conditions characterizing a constant cost industry :

i) Market output rises, price of input remains unchanged.

ii) Entry of new firm does not affect input prices.

iii) Cost curve remain same.

iv) Long-run market supply is a horizontal curve.

v) The industry can expand/contract wothout change in input prices.

If we assume that there are 10,000 identical firms in the industry, then the industry output would be Oq × 10,000 firms = OQ (shown in panel b). Since these firms are making only normal profit at the price OP, the industry is in equilibrium with an output OQ.

Now, let us suppose that there is an increase in market demand to D1D1 following an increase in money income or a change in the taste of buyers. As a result, market price rises from OP to OP1 and the firm’s demand curve is now represented by P1 = AR1 = MR1 line.

The firm will now expand its output to OQ1. It will earn supernormal profit equal to the shaded area since P = LMC = MR1 = AR1> LAC. Existence of this profit implies that the industry is out of equilibrium. This will then act as an incentive for new firms to join the industry.

Two things will now happen. Firstly, demand for resources will go up. But, being a constant cost industry, input prices will remain unchanged. Thus, entry of firms will have no effect on cost curves. LAC and LMC curve will stay at the old level.

However, firms will continue to enter until excess profit disappears. Secondly, entry of new firms in the industry will shift the supply curve to S1S1. Industry equilibrium will now occur at point ‘N’ where the old price OP will be re-­established. At the price OP, OQ1 output will be supplied in the industry.

Increasing-Cost Industry: Long-Run Supply Curve :

The long-run supply curve in an increasing-cost industry is an upward- sloping curve SL. When demand increases, initially causing a price rise, P2, the firms increase their output from q1 to q2.

Decreasing-Cost Industry:

The industry supply curve can also be downward-sloping. In this case, the unexpected increase in demand causes industry output to expand as before. If industry becomes larger, it can take advantage of its scale of operation to obtain some of its input cheaply. For example, a large industry may allow for an improved transportation system or for a better, less expensive financial network.

In such a situation the firm’s AC curves shift downward, and the market price of the product falls. The lower price and the lower AC of production induce a new long-run equilibrium with more firms, a lower price and more output. Thus, in a decreasing-cost industry, the long-run supply curve is downward-sloping.

The long-run, downward-sloping supply curve also arises when expansion itself lowers input prices or when firms can use scale economies to produce at lower cost.

Profits are made in this industry :