Today LR industry supply

– Constant cost– Increasing cost

Implications of LR equilibrium

Industry Supply in the Long Run

The Key to understanding the long run is firm entry and exit.

Case 1: Constant Cost Industry

Assumes that firms’ costs are independent of the size of the market. Expanding or contracting demand yields the same price in the long run.– Firms’ cost curves do not shift as industry

output changes.

Leads to a horizontal long-run industry supply curve.

Initial LR Equilibrium

q Q

D

PP Typical Firm Industry or Market

Thought experiment: What happens to the industry LR equilibrium as market demand expands?

MC

ATC

SRS

P

Qq

LRATC

SR Response to Increase in Demand

q Q

D

PP Typical Firm Industry or Market

SR: price rises. Firms earn profits. Why isn’t this a new LR equilibrium?

MC

ATC

SRS

P

Qq

LRATC

D’

Q’q’

LR Response to Increase in Demand

q Q

D

PP Typical Firm Industry or Market

LR: Firms enter until no more profits can be made. Given our assumption, that is when price falls to its original level. Second LR equilibrium.

MC

ATC

SRS

P

Q”q”

LRATC

D’

SRS’

Q

0

1

20

1

2

q’

LR Industry Response to an Increase in Demand Assuming that firms’ costs do not depend

on the size of the industry, and Beginning in LR equilibrium and increasing

demand:– in the SR, price rises, firms’ profits and outputs

rise.– In the LR, price returns to original level, firms

earn zero profits, each firm makes same q as before, but market output is higher.

LR Response to Increase in Demand

q Q

D

PP Typical Firm Industry or Market

Case 1: Horizontal Long-Run Supply Curve

MC

ATC

P

Q”q

LRATC

D’

Q

LRS

Significance of Result For these industries, growing demand

(ceteris paribus) will not result in higher (or lower) prices. – Remember LRS is not predicting how prices

change over time.

For these industries, there is a constant opportunity cost of producing this good.

Case 2: Increasing Cost Industry

Assumes rising opportunity cost as an industry (or market) expands, causing firms’ costs to rise.– Ex: market for milk & price of dairy land

Results in an upward-sloping long-run industry supply curve

Case 2 & LR Industry Supply

q Q

D

PP Typical Firm Industry or Market

Case 2: Upward-sloping Long-Run Supply Curve

P

Q1

LRATC(Q0)

D’

Q0

LRSLRATC (Q1)SRSSRS’

Significance of Case 2 Growing demand for milk forces up the

price of milk. Less productive land is converted to dairy

farming. Opportunity cost of producing milk rises. Price of milk rises in the long run, even

though there are more milk farms. ***Result comes from the underlying

scarcity of dairy land.***

Profits for New Dairy Farms

Consider the dairy farms that have opened because of higher milk prices.

Do they make profits, losses, or break even in the long run? How do you know?

Profits for Old Dairy Farms.

Consider the dairy farms that were in business prior to the increase in demand.

Will they make profits, losses, or break even in the new long run equilibrium? – What about dairy farmers who rent their land?– What about dairy farmers who buy land that

has always been used for dairy farming?– What about dairy farmers who already owned

dairy farms?

Coming Up: Prepare for second midterm exam.

Group Work

Profits for Coal Mines

Coal Mining

Assume the coal mining industry is perfectly competitive.

Consider two mines:– Alpha mine has rich, easily accessible deposits.– Beta mine has less desirable deposits. Its

marginal cost of producing coal is everywhere twice as high as for Alpha.

Profits for Alpha & Beta Mines

Assume the price of coal is high enough that Beta mine is actively mining coal.

Will Beta mine make economic profits, economic losses or break even in the long run?

Suppose the total coal deposits in the two mines are equal. What can you say about the likely price of Alpha mine compared to Beta mine?

Profits for Alpha & Beta Mines, Cont’d. Will the two mines have the same fixed

costs? Will Alpha mine make economic profits,

economic losses or break even in the long run? How do you know?