Long Run Supply Curve Under Increasing, Constant and Decreasing Cost Industry – Notes

Useful Notes on Long Run Supply Curve Under Increasing Cost Industry, Constant Cost Industry and Decreasing Cost Industry:

The entry and exit of the firms is ruled out in the short run. However, in the long run, firms enter and exit from the industry on account of price changes. This results into upward and downward shifts in the cost curves respectively.

So, unlike the short-run supply curve of a competitive industry, its long-run supply curve cannot be derived by the horizontal summation of the long run supply curves (i.e., LMC curves above LAC curves) of the individual firms.

The long run supply in the industry is determined by the variation in the number of firms in the industry as well as consequent changes in their optimum size (i.e., output corresponding to minimum point of the LAC curve) in the long run.

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The long-run supply curve shows the output, firms will be willing to offer for sale at different equilibrium prices in the long-run, when all demand induced changes including entry or exist have occurred. Only one point of the LMC curve corresponding to given demand conditions is relevant for getting a point on the long-run supply curve of the industry.

It is the point, where the LMC curves of the competitive firms cut their LAC curves from below. The long-run supply curve connects different long-run equilibrium positions corresponding to different levels of industry demand and hence different equilibrium prices.

With the given supply curve in the short-run, price will rise, if the industry demand increases. This will increase the quantity supplied in the short-run due to an expansion of the production by the existing firms. Consequent excess profits made by the established firms will however, tempt new firms to enter the industry.

The influx of firms will shift the industry supply curve to the right and will result in fall in the price below the short-run equilibrium level. The new long-run equilibrium price may be greater than (Fig. 13.11), equal to (Fig. 13.12) or less than (Fig. 13.13) the original price, depending upon whether the industry operates under increasing, constant or decreasing cost conditions. Accordingly, the long-run supply curve of the industry will be upward sloping, horizontal or downward sloping in the three cases respectively.

The cost conditions of the industry are reflected in the change in factor prices, as the industry expands. With the expansion of the industry in the long-run, cost curves of the firms shift on account of external economies and diseconomies.

The size of the shift in the industry supply depends upon the level of the cost curves of the firms as well as the number of firms in the industry at a given demand and price of the product. The shape of the long-run supply curve of the competitive industry and hence the phenomenon of rising costs (increasing cost industry), constant costs (constant cost industry) and falling costs (decreasing cost industry), depend upon the net result of external economies and diseconomies. In all these cases, the shift in demand will be met by greater adjustments in output and smaller adjustments in price.

Increasing Cost Industry:

Art industry is an increasing cost industry, if the price of factors of production increase as the industry expands its output, since; the external diseconomies outweigh the external economies of production. The process of adjustment of the industry supply to the rising industry demand and hence derivation of long-run supply curve of the competitive industry is explained with the help of Fig. 13.11.

Suppose the industry is in long-run equilibrium (left panel of Fig. 13.11) at point E_Q, where the industry demand curves D₀D₀ and industry supply curve S₀S₀ intersect each other (the long-run equilibrium also implies short-run equilibrium). The typical competitive firm is in equilibrium at point E₀, where P_Q = MR_Q, = LMC_Q = SMC₀= LAC₀ = SAC₀. Hence, only normal profits are earned in this industry producing OQ₀ output.

As the demand for the product rises, the short-run effect is for price to rise from OP₀ to OP, and output of industry to rise from OQ₀ to OQ₁, to equate demand, with industry’s short-run supply (left panel of Fig. 13.11). Each firm will now expand output to OQ, to satisfy the increased demand until its short-run marginal cost once again equals price.

This happens at point E, in the right panel of Fig. 13.11. Here, the firms may be in short-run equilibrium, but, they are not in long-run equilibrium, as the firms are working their plant beyond their optimal capacity. The rise in price gives profits to each firm.

So, new firms will enter the industry, expanding its size in the long-run. This shifts the short-run supply curve to the right. The entry continues, until all firms are once again just covering long-run average cost (LAC) and once again earn only normal profits.

The new (long-run) equilibrium of the industry (and firm) is at point ‘E’ in the left (right) panel of Fig. 13.11ⁿ. At the new long-run equilibrium point ‘E’ of the competitive firm, P = MR = SMC = LAC = SAC.

The rightward shift of the supply curve will lead to a fall in equilibrium price to OP, as compared with the short-run level OP₁. In any case, the new market price will be higher than the original level.

When output is expanded in the industry, more inputs are required. The increase in demand for these inputs bids up their prices. Consequent increasing scarcity of these inputs also raises their prices. Thus, with the industry expansion under increasing cost industry, the cost curves rise up (diseconomies in production).

Increase in the production cost of existing output reduces the profitability and ultimately neutralises the short -run increase in profitability. When the firms were just covering their cost before the increase in demand, the price at which they now supply has to rise enough to cover any increases in factor prices they pay.

This increased level of industry output OQ is available at increased price OP. The locus of long run equilibrium point E₀ and ‘E’ trace out the long run supply (LRS) curve of the industry. The long-run supply curve of the industry will be upward sloping and all the firms in the industry earn normal profits.

That is, an increasing cost industry can expand output in the long run only at an increasing price. The rising long-run supply curve of the industry is a characteristic of sharp and rapid growth.

It is important to note that in the new market equilibrium, the output of each individual firm may be small, greater or equal to the level of output in the original equilibrium depending on the shift of the cost curve. However, the market output will always change in the direction of change in the demand.

Constant Cost Industry:

An industry is called a constant cost industry, if the prices of factors of production do not change, when the industry expands its output. The expansion of constant cost industry creates neither external economies nor external diseconomies.

Alternatively, external economies and external diseconomies are of equal strength and cancel each other, such that the prices of factors of production employed by the competitive industry remain constant, as industry output expands.

The derivation of the long-run supply curve of a constant cost industry is illustrated in Fig. 13.12. The industry is in equilibrium (in long-run as well as short-run) at point E_Q producing an output OQ₀ at price OP₀. The typical competitive firm constituting the industry is in long-run equilibrium at point E_Q (producing OQ₀ output), where its demand curve is tangent to the long-run and short-run average cost curves at their minimum points.

Thus, it is earning zero economic profit. Now, suppose the industry demand curve shifts to the right from D₀D₀ to DD due to increase in the demand for the product. In the short-run, price increases to OP₁, since, short-run supply curve of the industry is upward sloping.

The industry output expands to OQ₁. The existing firms operating their plant above full capacity at point E, by moving along SMC curve, produce expanded output OQ₁, and earn profits.

The tempted entry of firms into the industry will not alter the cost curves of the existing and new firms, though the demand for factor of product will rise with the expansion of the industry, since it is a constant cost industry.

The LAC curve does not shift upward and all the firms will face the same LAC conditions. The entry will continue until the new (right shifted) supply curve SS intersects the shifted demand curve at the original price. The economic profits are wiped out at the new long-run equilibrium point ‘E’.

The long-run supply curve of the industry is, thus, a horizontal straight line parallel to the quantity axis at the initial price level obtained by joining original and new long-run equilibrium points E_Q and ‘E’ of the industry. Given time to adjust, the constant cost industry can expand output the horizontal long-run supply curve without any increase in cost and price. At every point on this supply curve, the firm earn only normal profit.

Decreasing Cost Industry:

A decreasing cost industry is the one for which the prices of factors of production decline, as the industry expands. The decreasing cost industry is quite unusual case. But, it is theoreti­cally conceivable, since an industry might enjoy decreasing cost due to the net external econo­mies, i.e., external economies outweighing external diseconomies, enabling the industry to ex­pand put in the long-run at decreasing price.

The derivation of the long-run supply curve of a decreasing cost industry is illustrated in Fig. 13.13. Suppose, to begin with the industry is in long-run equilibrium as well as short-run equilibrium point E_Q (Fig. 13.13 (a)). The corresponding point for typical firm’s equilibrium is E_Q (Fig. 13.13 (b)).

Here, the firm produces an output OQ₀ at price OP₀. As the market demand curve shifts from D₀D₀ to DD, on account of rise in the demand for the product, price increases to OP, in the short-run, as the industry moves along its short-run supply curve S₀S₀.

The industry is in short-run equilibrium at point E₁, where the new demand curve DD and supply curve S₀S₀ intersect each other. In this situation, the typical firm expands it supply from OQ₀ to OQ₁. Consequently, short-run profits attract entry into the industry.

Increased demand in the industry also raises the demand for inputs. Being decreasing cost industry, the ensuing increased de­mand for factors encourages their suppliers to innovate and improve the skills. This will reduce the factor prices.

As a result, the cost curves shift downward, until a new long-run equilibrium is established with such a number of firms in the industry that are able to meet the increased demand by producing output corresponding to the minimum point of the long-run average cost curves.

The industry supply curve shifts so far to the right that price in the long run falls to OP below the original level. The quantity supplied rises to OQ. The new long-run equilibrium point is ‘E’ for the industry and firm (Fig. 13.13).

The locus of the shifting long-run equilibrium caused by the change in demand conditions trace out the long-run supply (LRS) curve, which is a falling curve in the case of decreasing cost industry. Here, all the abnormal profits are wiped out.

Therefore, the long period normal price can be higher, lower or equal to the original price, depending upon the supply conditions and the relative strengths of the internal and external econo­mies of scale.

However, long period normal price can never be higher than the short period normal price, since in the long-run, the supply of the firms in the industry can be fully adjusted to meet the changes in demand.