Question

Given ACi = f (qi, w, v, t) where t is technology and technology is cost-reducing, as t increases:

A)    What will be the long run effect on market price, P, and quantity, Q, and the number of firms in the industry, N, if it is a constant cost industry. Draw a graph of the long run supply and demand. On what will the size of the change in Q depend?

B)    If this is an increasing cost industry, how will your answer change (magnitude of changes in Q and P)? Draw it.

Answer 1

Given ACi = f (qi, w, v, t) where t is technology and technology is cost-reducing, as t increases.

Whenever there is expansion of an industry, it experiences external economies and diseconomies. The long run adjustment of the industry in terms of price and output depends on whether the industry is constant cost, increasing cost or decreasing cost.

A) To take advantage of cost reducing technology, there is expansion of the industry. In a constant cost industry, the external economies and diseconomies are of equal measure and there is no effect on the cost structure of the industry.

Refer to Figure 1 (attached). Suppose the industry is in equilibrium at point A where price is P and quantity is Q1. Suppose there is an increase in demand which shifts the demand curve from D to D1. This raises the price to P' and output to Q3. Opportunity to earn supernormal profits leads to expansion of industry with the entry of new firms in the industry. Therefore supply curve also shifts right to S'. Thus, in the long run, in constant cost industry, in response to increase in demand, there will be an increase in equilibrium output from Q1 to Q2 but equilibrium price will remain unchanged at P. The number of firms will increase only until the normal profits are reached. Long run Supply curve is LRAS, i.e. horizontal for a constant cost industry.

B) In case this is an increasing cost industry, the external diseconomies outweigh the external economies. After the expansion of demand and the resulting entry of new firms in the industry, both price as well as output rises. With the increase of firms, the share of each firm in output falls. This is because in an increasing cost industry; higher level of output can be attained only at a higher price. See Figure 2.

When demand expanded, firms entered the industry to earn supernormal profits. But this they could use only at higher cost as this is an increasing cost industry. That is why cost rose for the firm from LAC to LAC1. Price rose from P to P', this led to increase in output from Q to Q' for the industry but the share of firms fall from N to N'. The new firms lured by higher price and super-normal profits would continue entering the industry till all the firms are left only with normal profit.