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Chapter 24
Industry Supply

Supply From A Competitive Industry
uHow are the supply decisions of the many individual firms in a competitive industry to be combined
to discover the market supply curve for the entire industry?

Supply From A Competitive Industry
uSince every firm in the industry is a price-taker, total quantity supplied at a given price is the
sum of quantities supplied at that price by the individual firms.

Short-Run Supply
uIn a short-run the number of firms in the industry is, temporarily, fixed.
uLet n be the number of firms;
i = 1, … ,n.
uSi(p) is firm i’s supply function.

Short-Run Supply
uIn a short-run the number of firms in the industry is, temporarily, fixed.
uLet n be the number of firms;
i = 1, … ,n.
uSi(p) is firm i’s supply function.
uThe industry’s short-run supply function is

Supply From A Competitive Industry
p
S1(p)
p
S2(p)
Firm 1’s Supply
Firm 2’s Supply

Supply From A Competitive Industry
p
S1(p)
p
S2(p)
p
p’
p’
S1(p’)
S1(p’)
Firm 1’s Supply
Firm 2’s Supply
S(p) = S1(p) + S2(p)
Industry’s Supply

Supply From A Competitive Industry
p
S1(p)
p
S2(p)
p
S(p) = S1(p) + S2(p)
p”
p”
S1(p”)
S1(p”)+S2(p”)
S2(p”)
Firm 1’s Supply
Firm 2’s Supply
Industry’s Supply

Supply From A Competitive Industry
p
S1(p)
p
S2(p)
p
Firm 1’s Supply
Firm 2’s Supply
S(p) = S1(p) + S2(p)
Industry’s Supply

Short-Run Industry Equilibrium
uIn a short-run, neither entry nor exit can occur.
uConsequently, in a short-run equilibrium, some firms may earn positive economics profits, others
may suffer economic losses, and still others may earn zero economic profit.

Short-Run Industry Equilibrium
Market demand
Short-run industry
supply
pse
Yse
Y
Short-run equilibrium price clears the
market and is taken as given by each firm.

Short-Run Industry Equilibrium
y1
y2
y3
ACs
ACs
ACs
MCs
MCs
MCs
y1*
y2*
y3*
pse
Firm 1
Firm 2
Firm 3

Short-Run Industry Equilibrium
y1
y2
y3
ACs
ACs
ACs
MCs
MCs
MCs
y1*
y2*
y3*
pse
Firm 1
Firm 2
Firm 3
P1 > 0
P2 < 0
P3 = 0

Short-Run Industry Equilibrium
y1
y2
y3
ACs
ACs
ACs
MCs
MCs
MCs
y1*
y2*
y3*
pse
Firm 1
Firm 2
Firm 3
Firm 1 wishes
to remain in
the industry.
Firm 2 wishes
to exit from
the industry.
Firm 3 is
indifferent.
P1 > 0
P2 < 0
P3 = 0

Long-Run Industry Supply
uIn the long-run every firm now in the industry is free to exit and firms now outside the industry
are free to enter.
uThe industry’s long-run supply function must account for entry and exit as well as for the supply
choices of firms that choose to be in the industry.
uHow is this done?

Long-Run Industry Supply
uPositive economic profit induces entry.
uEconomic profit is positive when the market price pse is higher than a firm’s minimum av. total
cost;
      pse > min AC(y).
uEntry increases industry supply, causing pse to fall.
uWhen does entry cease?

Long-Run Industry Supply
S2(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
Suppose the industry initially contains
only two firms.
Mkt.
Supply

Long-Run Industry Supply
S2(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p2
p2
Then the market-clearing price is p2.

Long-Run Industry Supply
S2(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p2
p2
y2*
Then the market-clearing price is p2.
Each firm produces y2* units of output.

Long-Run Industry Supply
S2(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p2
p2
y2*
P > 0
Each firm makes a positive economic
profit, inducing entry by another firm.

Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p2
p2
Market supply shifts outwards.
y2*

Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p2
p2
Market supply shifts outwards.
Market price falls.
y2*

Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p3
Each firm produces less.
y3*
p3

Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p3
Each firm produces less.
Each firm’s economic profit is reduced.
y3*
p3
P > 0

Long-Run Industry Supply
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p3
Each firm’s economic profit is positive.
Will another firm enter?
y3*
p3
P > 0

Long-Run Industry Supply
S4(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p3
Market supply would shift outwards again.
y3*
p3

Long-Run Industry Supply
S4(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p3
Market supply would shift outwards again.
Market price would fall again.
y3*
p3

Long-Run Industry Supply
S4(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p4
Each firm would produce less again.
y4*
p4

Long-Run Industry Supply
S4(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p4
Each firm would produce less again.  Each
firm’s economic profit would be negative.
y4*
P < 0
p4

Long-Run Industry Supply
S4(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p4
Each firm would produce less again.  Each
firm’s economic profit would be negative.
So the fourth firm would not enter.
y4*
P < 0
p4

Long-Run Industry Supply
uThe long-run number of firms in the industry is the largest number for which the market price is
at least as large as min AC(y).
uNow we can construct the industry’s long-run supply curve.

Long-Run Industry Supply
uSuppose that market demand is large enough to sustain only two firms in the industry.


Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p2’
y2*
p2’

Long-Run Industry Supply
uSuppose that market demand is large enough to sustain only two firms in the industry.
uThen market demand increases, the market price rises, each firm produces more, and earns a higher
economic profit.

Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p2’
y2*
p2’

Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p2”
y2*
p2”

Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
y2*
p2”
p2”

Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
y2*
Notice that a 3rd firm will not enter since it
would earn negative economic profits.
p2”
p2”

Long-Run Industry Supply
uAs market demand increases further, the market price rises further, the two incumbent firms each
produce more and earn still higher economic profits -- until a 3rd firm becomes indifferent between
entering and staying out.

Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
y2*
p2”
p2”

Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
y2*
p2’”
p2’”

Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
y2*
A third firm can now enter, causing all firms
to earn zero economic profits.
p2’”
p2’”

Long-Run Industry Supply
uSo any further increase in market demand will cause the number of firms in the industry to rise to
three.

Long-Run Industry Supply
S2(p)
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
y2*
The only relevant part of the short-run
supply curve for n = 2 firms in the industry.
p2’”
p2’”

Long-Run Industry Supply
uHow much further can market demand increase before a fourth firm enters the industry?


Long-Run Industry Supply
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p3’
y3*
S3(p)
S4(p)
p3’

Long-Run Industry Supply
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
p3’
y3*
A 4th firm would now earn negative
economic profits if it entered the industry.
p3’
S3(p)
S4(p)

Long-Run Industry Supply
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
y3*
S4(p)
But now a 4th firm would earn zero
economic profit if it entered the industry.
p3’
p3’

Long-Run Industry Supply
S3(p)
Mkt. Demand
AC(y)
MC(y)
y
A “Typical” Firm
The Market
p
p
Y
y3*
S4(p)
p3’
p3’
The only relevant part of the short-run
supply curve for n = 3 firms in the industry.

Long-Run Industry Supply
uContinuing in this manner builds the industry’s long-run supply curve, one section at-a-time from
successive short-run industry supply curves.

Long-Run Industry Supply
AC(y)
MC(y)
y
A “Typical” Firm
The Market
Long-Run
Supply Curve
p
p
Y
y3*

Long-Run Industry Supply
AC(y)
MC(y)
y
A “Typical” Firm
The Market
Long-Run
Supply Curve
p
p
Y
y3*
Notice that the bottom of each segment of
the supply curve is min AC(y).

Long-Run Industry Supply
uAs each firm gets “smaller” relative to the industry, the long-run industry supply curve
approaches a horizontal line at the height of min AC(y).

Long-Run Industry Supply
AC(y)
MC(y)
y
A “Typical” Firm
The Market
Long-Run
Supply Curve
p
p
Y
y3*
Notice that the bottom of each segment of
the supply curve is min AC(y).

Long-Run Industry Supply
AC(y)
MC(y)
y
A “Typical” Firm
The Market
Long-Run
Supply Curve
p
p
Y
y*
The bottom of each segment of the supply
curve is min AC(y).  As firms get “smaller”
the segments get shorter.

Long-Run Industry Supply
AC(y)
MC(y)
y
A “Typical” Firm
The Market
Long-Run
Supply Curve
p
p
Y
y*
In the limit, as firms become infinitesimally
small, the industry’s long-run supply
curve is horizontal at min AC(y).

Long-Run Market Equilibrium Price
uIn the long-run market equilibrium, the market price is determined solely by the long-run minimum
average production cost.

   Long-run market price is

Long-Run Implications for Taxation
uIn a short-run equilibrium, the burden of a sales or an excise tax is typically shared by both
buyers and sellers, tax incidence of the tax depending upon the own-price elasticities of demand
and supply.
uQ: Is this true in a long-run market equilibrium?

Long-Run Implications for Taxation
LR supply (no tax)
p
X,Y
Mkt. demand
Qe
pe

Long-Run Implications for Taxation
LR supply (no tax)
p
X,Y
Mkt. demand
Qe
ps=pe
LR supply (with tax)
Qt
pb =
pe+t
t

Long-Run Implications for Taxation
LR supply (no tax)
p
X,Y
Mkt. demand
Qe
ps=pe
LR supply (with tax)
Qt
pb =
pe+t
t
In the long-run the
buyers pay all of a
sales or an excise tax.

Fixed Inputs and Economic Rent
uWhat if there is a barriers to entry or exit?
uE.g., the taxi-cab industry has a barrier to entry even though there are lots of cabs competing
with each other.
uLiquor licensing is a barrier to entry into a competitive industry.

Fixed Inputs and Economic Rent
uQ: When there is a barrier to entry, will not the firms already in the industry make positive
economic profits?

Fixed Inputs and Economic Rent
uQ: When there is a barrier to entry, will not the firms already in the industry make positive
economic profits?
uA:  No.  Each firm in the industry makes a zero economic profit.  Why?

Fixed Inputs and Economic Rent
uAn input (e.g. an operating license) that is fixed in the long-run causes a long-run fixed cost,
F.
uLong-run total cost, c(y) = F + cv(y).
uAnd long-run average total cost,
         AC(y) = AFC(y) + AVC(y).
uIn the long-run equilibrium, what will be the value of F?

Fixed Inputs and Economic Rent
uThink of a firm that needs an operating license -- the license is a fixed input that is rented but
not owned by the firm.
uIf the firm makes a positive economic profit then another firm can offer the  license owner a
higher price for it.  In this way, all firms’ economic profits are competed away, to zero.

Fixed Inputs and Economic Rent
uSo in the long-run equilibrium, each firm makes a zero economic profit and each firm’s fixed cost
is its payment for its operating license.

Fixed Inputs and Economic Rent
y
$/output unit
AC(y)
AVC(y)
MC(y)
y*
pe
The firm’s economic
profit is zero.

Fixed Inputs and Economic Rent
y
$/output unit
AC(y)
AVC(y)
MC(y)
y*
pe
F
The firm’s economic
profit is zero.
F is the payment to the owner of the fixed
input (the license).

Fixed Inputs and Economic Rent
uEconomic rent is the payment for an input that is in excess of the minimum payment required to
have that input supplied.
uEach license essentially costs zero to supply, so the long-run economic rent paid to the license
owner is the firm’s long-run fixed cost.

Fixed Inputs and Economic Rent
y
$/output unit
AC(y)
AVC(y)
MC(y)
y*
pe
F
The firm’s economic
profit is zero.
F is the payment to the owner of the fixed
input (the license); F = economic rent.