Entry, Exit, and Supply Curves: Increasing Costs

Now that we understand a firm's cost curves, and its entry and exit decisions, we're able to show how supply curves are actually derived from these more fundamental considerations. Let's take a closer look.

The supply curve is built upon firm entry and exit decisions and the effect of these decisions on industry costs. And the key question is this, as industry output increases, what happens to costs? There are three possibilities. First, an increase in cost industry. That is industry costs increase with greater output. Second, constant cost industry. Industry costs are flat, they don't change with greater or lesser output. And finally a decreasing cost industry, industry cost falls with greater output. As we'll see, the first and second are quite common, the third is quite uncommon, but is nevertheless important and interesting in order to understand economic geography, which we'll come to a bit later.

Let's show how the industry supply curve is derived from the entry and exit and cost curves of individual firms. We can do this for an increase in cost industry very easily with just a two firm example. Suppose that Firm one is a producer of oil, where its oil is very close to the surface, so it has a quite low average cost curve. It's pretty cheap for this firm to produce oil. On the other hand, Firm two has a much higher average cost curve because for Firm two is located in a part of the world where it has to drill much deeper in order to get the oil.

Now, given these figures what's the industry supply curve of oil if the price of oil is below $17? Well, if the price of oil is below $17, neither of these firms can make a profit. That's below the minimum point of the average cost curve for both of these firms. So neither of these firms is going to want to be in the industry. So if the price of oil is below $17, the industry supply is just going to be zero, right here, zero.

Now what happens at $17? Well at $17, Firm one just breaks even. So we'll say Firm one will just enter the industry. So at $17, the industry output is the same as the output of Firm one, namely four units. Notice that at $17, Firm two doesn't enter the industry because the price is still too low. Firm two is not going to make a profit, will take a loss at that price. Indeed as the price of oil increases, the output from Firm two will increase as it moves along its marginal cost curve. That will continue to happen so industry output will increase along with the output of Firm one until we reach a price of $29.

At the price of $29, Firm two just breaks even and it enters the industry. So at $29, total industry output is six units from Firm one and five units from Firm two for a total of 11 units from the industry. As the price goes above $29 both Firm one and Firm two expand along their marginal cost curves so the industry output is then the sum of the output from both firms. So what we see here is that the industry supply curve is upward sloping because the cost curves of these firms are different. Because in order to attract more firms into this industry, the only way we can do that is by attracting higher cost firms. So the industry supply curve is upward sloping.

Any industry where it's difficult to exactly duplicate the productive inputs is going to be an increase in cost industry. I've already mentioned oil, but copper, gold, silver, all the mining industries are very similar. We can't just duplicate another gold mine. If we want another gold mine we're going to have to dig deeper, we're going to have to look elsewhere, it's going to be more expensive to produce it than it is now.

Coffee is another example, because there's really only a limited number of places in the world where we could produce great coffee. If we want coffee from other places than Brazil or Guatemala, it's going to be lower quality. We're going to have to go down further on the mountain. It's going to require more inputs.

Nuclear engineers -- very hard to expand the supply of nuclear engineers. There's a limited number of people who can be a nuclear engineer. If we want more nuclear engineers, we're really going to have to pull them from other industries where they have very high opportunity cost. So it's hard to expand the supply of nuclear engineers without pushing up the wages of nuclear engineers. That's an increasing cost industry.

Moreover, any industry that buys a large fraction of the output of an increasing cost industry will also be an increasing cost industry. So pretty obviously gasoline is an increasing cost industry because if we want more gasoline that requires more oil, and oil is an increasing cost industry. Electricity will primarily be an increasing cost industry to the extent that we generate our electricity from coal. So if we want a lot more electricity we're going to require more coal and that's going to push the price of coal up, which is going to push the cost of producing electricity up.

So what we just showed is that for an increasing cost industry, you can derive a upward sloped supply curve. We're now going to do a constant cost industry for which we'll show you actually get a flat supply curve, and then a decreasing cost industry, which as you might expect, will give you now a downward-sloped supply curve. We'll do these in separate lectures. Thanks.