Entry, Exit, and Supply Curves: Constant Costs

Okay -- this talk is going to be a bit more involved. What we're going to show is how a constant cost industry generates a flat supply curve. Let's begin.

A constant cost industry is one where it's very easy to expand output without pushing up costs. So for example, pencils, rutabagas, domain name registration -- these are all constant cost industries. Think about pencils. We can easily increase the supply of pencils by quite a bit without pushing up the cost of producing pencils. Why not? Well, what do we need to produce more pencils? We need more wood, we need more graphite, we need more rubber. However, we'd need just a little bit more wood relative to the total world supply of wood. Just a little bit more graphite relative to the world supply of graphite. And just a little bit more rubber relative to the world supply of rubber.

In other words, we can increase the number of pencils produced, but only increase the demand for the inputs by a small and non-appreciable amount. We're not going to be pushing up the price of wood, for example, when we produce more pencils. The story would be different if it was housing. If we want to produce more housing, that's a big demander of wood. That would require a lot more wood and could potentially push the price of wood up. As we'll see, that would correspond to an increase in cost industry.

What about rutabagas? Again, the idea's the same. We can easily increase the supply of rutabagas by a lot without increasing the price of the input, such as land or fertilizer. Rutabagas are simply too small a portion of the market for land or the market for fertilizer to have an appreciable effect on the price of these inputs, even if we were to increase the supply of rutabagas by a lot.

Same thing with domain name registration. As the internet has expanded, tremendously, it still costs about six or seven dollars to register a domain name, since it's very cheap to do that with just a few additional computers. A little bit more computer resources -- very small portion of the total number of computers -- and we can increase the supply of domain name registrars very, very easily. The implication of all this is that long run supply curves for these goods, for goods like pencils, rutabagas, and domain name registration, the long run supply curve is going to be flat.

Let's take a closer look with a diagram. So in this diagram, we're going to show how a constant cost industry adjusts to a shift in increase in demand. And in so doing, we'll in fact show why it's a constant cost industry. We're going to do so by looking at two things simultaneously: the market and the representative firm. So there are lots of firms in this industry and we're going to pick just one of them to represent them all.

Now we're going to begin with the market side, with which we're very familiar. Here is our demand curve and here is our short run supply curve. The quantity demanded is equal to the quantity supplied -- that determines our initial or short run equilibrium. In fact, this is also going to be the long run equilibrium for reasons which will become clear. Now we also want the representative firm to be in equilibrium. So the firm is profit maximizing, so that means the price is going to be equal to marginal cost. And in addition, price will be equal to average cost, because the firm is going to be earning normal, or zero economic profits. Normal profits. So this is our initial equilibrium for the market side -- quantity demanded is equal to the quantity supplied. And on the firm side, price is equal to marginal cost, so firms are profit maximizing, and price is equal to average cost, so profits are normal or zero.

Okay, now let's look at what happens when we increase demand. Two things are going to happen on the market side -- of course the demand curve will shift out pushing up the price to a new equilibrium. On the firm side, as the price goes up the firm will be expanding along its marginal cost curve. Let's look at the market -- both of these things are going to happen simultaneously -- let's look at what happens in the market and then we'll do it again to focus on the representative firm. So here we go -- an increase in demand -- the price shifts up, we come to a new equilibrium at point B on the market side, and as I said each firm expands along its marginal cost curve so we have a new equilibrium for the representative firm, also at point B.

Now in case you missed it, let's show that again. For the representative firm, looking now at the representative firm. Now looking at the representative firm, here is the increase in demand -- it drives price up as it does so each firm expands along its marginal cost curve. In fact, the reason why the supply curve in the short run is upward sloping is precisely that each firm currently in the industry is expanding as price increases along its marginal cost curve. By the short run, what we actually mean, is the time period before new firms have a chance to enter into the industry. So the entire increase in supply in the short run is being driven by the increased output of currently existing firms as they expand to take advantage of the increase in price.

Now notice that initially, the representative firm was making zero economic profit, it was making normal profits. With the increase in demand, they're making positive, above normal profits. Remember profit is price minus average cost times quantity. So profit here is positive, it's above normal. And those above normal profits are going to attract other firms. Other firms are going to say, "I want a piece of the action. I want a piece of the pie." Remember when price is above average cost, that's when new firms enter into the industry.

So what is that entry going to do? Well, it's going to do two things. On the market side, it's going to shift out the short-run supply curve. It's going to shift the short-run supply curve to the right, and as that happens, price is going to be pushed down. As price is pushed down, each firm will contract along its marginal cost curve, profits falling all the way until we reach a point of normal economic profits once again. So let's show this again, we'll show it twice, first of all we can look at the market side and then we'll look at the representative firm. So, profits in the short run are going to attract new entry. As we get new entry, the supply curve in the short run expands, shifts outward, pushing down the price until we reach a new long run equilibrium which is here and until profits are zero over here.

Again, now let's look at this again for the representative firm. Okay here's the representative firm on the right. As profits attract entry entry is going to push price down and here we go, let's see what happens. As the price goes down, each firm contracts along its marginal cost curve. In fact, we can now see why the long run cost curve is flat. Because we begin at point A at the minimum point of the average cost curve, and we end at point C, here's point C, which is also at the minimum point of the average cost curve. So the long run supply curve is flat at the minimum point of the average cost curve.

Now where does our assumption of constant industry cost come in? It comes in right here. Because the idea is that when the industry expands with new entry, that isn't driving up the representative firm's costs. And the reason that is, is that this industry is small relative to its input markets. So when this industry expands, it doesn't drive up the price of its inputs. That means that this average cost curve isn't changing as the industry expands or contracts. Because this cost curve for the representative firm isn't changing, the only equilibrium with zero economic profit is at the minimum point, is when price is equal to average cost. So that's always going to -- price is going to be driven down in the long run to the minimum of this average cost curve, to the point where there's zero economic profits. So A and C are along a long-run industry supply curve, which is flat.

All right, that's a huge amount to take in. Let's just go over it briefly using this diagram. We began with an initial equilibrium at point A, an increase in demand pushed us in the short run to point B, where each firm was making positive profits. Those profits attracted new firms into the industry. Those new firms shifted to the right, the short-run supply curve, pushing prices down until we reach a new point of long-run equilibrium. That new point of long-run equilibrium is precisely when we're back to zero or normal economic profits at the minimum point of the average cost curve. The average cost curve isn't shifting because input prices aren't changing as this industry expands or contracts, and that's why the long-run supply curve is flat. Whew!

All right. That was a lot. What else? So we've now shown how an increase in cost industry leads to an upward sloped supply curve. A constant cost industry leads to a flat or horizontal supply curve. And we're about to show how a decreasing cost industry, the unusual case, leads to a downward sloped supply curve, at least over some range. Let's do that next.