The Long Run Supply Curve

THE LONG RUN COMPETITIVE SUPPLY CURVE

In the short run, firms maximize profit when they produce that output at which MR = MC .

But in the long run, entry by firms will produce a situation where the typical firm is earning normal profits only, even when they try to maximize profits. So not only does the MR = MC condition apply (profits are maximized), but also the statement P = ATC applies as well (the price per unit covers all costs per unit including a normal profit, but no more).

Next the question must be answered, "What does the long run supply curve look like in a competitive industry?" Suppose (as on p. 309) the industry is in long run equilibrium where

P =ATC. Suppose an increase in demand (from D₁ to D₂) occurs, raising the price which the typical firms receives, as set by the broad market. The firm will, in the short run, adjust production from Q₁ to Q₂, where it is again maximizing its profits–and is now making economic (above-normal) profits! (Middle panels on p. 309)

But these profits attract entry, again. So market supply starts increasing as new firms enter, and the price line starts coming down, eventually eliminating economic profits, as before. (Bottom panels on p. 309) Only this time, we have to recognize that as new firms are formed, they will increase demand for the scarce resources which are needed by the new firms. So in the resource markets, increasing demand for engineers, raw materials, skilled labor of various kinds, and many other resources, may increase the prices of these resources. Since our formula for average cost of production is P_L/AP_L, an increase in the price of these resources will raise costs for all firms (both established ones and new ones), and shift up the ATC curve. The minimum point of the ATC curve will be higher than before, so the price can never come back as low as its former level. New firms will stop entering, and the market supply curve will stop shifting to the right, before the market price falls back as low as its original level. This is the case of the increasing cost industry, because in the long run more output can be had by society (in response to the initial increase in demand) only at a higher price. The long run supply curve of the good slopes upward to the right.

The case actually depicted on p. 309 is the constant cost industry, in which the supply of resource(s) is horizontal (perfectly elastic), at the current price of those resources, and new firms can buy as much as they want of the resource(s) at the same price, so there is no effect on costs. The price line will be driven back down to its original level through the entry of new firms, and market price of the good will not change in the long run. The long run supply curve for the good is horizontal.

Occasionally the long run supply curve may slope downward to the right, as new firms congregate where existing firms are located, and expansion of the industry actually decreases costs for everyone (economies of scale in the production of resources): the ATC curve of the typical firms shifts downward, permitting market price to fall: the decreasing cost industry.

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This page was last updated on Friday, July 21, 2006.