Entry, Exit, and Supply Curves: Constant Costs

Entry, Exit, and Supply Curves: Constant Costs


♪ [music] ♪ – [Alex] 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. – [Narrator] If you want
to test yourself, click “Practice Questions,” or if you’re ready to move on,
just click, “Next Video.” ♪ [music] ♪

7 Comments

  1. Iven Tu says:

    Thank you so much! Great explanations!

  2. Chanfleandote says:

    Awesome videos! however, you forgot to explain the long run curve for an increasing costs industry! There is a video labelled as it however you don´t explain it in that video and then you move on to explaining the constant cost industry curve in the long run. Thank you

  3. neliswa mbulawa says:

    great explanation i am writting 0n the 9th hey!i wish myself all the best..Economics is not a childs play.

  4. Neema Totoonchi says:

    respect

  5. Rowan Belt says:

    You have such a clear way of explaining difficult concepts…if I could I would subscribe 10 times 🙂 Thank you!!

  6. felice rylander says:

    No idea how I would have passed the exam without you guys! Very thankful!

  7. C Tee says:

    THIS WAS SO GOOD.THANK YOU

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