No Such Thing as a Free Lunch: Principles of Economics (Part 41)

"True individual freedom cannot exist without economic security and independence. People who are hungry and out of a job are the stuff of which dictatorships are made."

Franklin D. Roosevelt

Long-Run Cost and Output Decisions

(Part C)

by

Charles Lamson

The Short-Run Industry Supply Curve

Supply in a competitive industry is simply the sum of the quantity supplied by the individual firms in the industry at each price level. The short-run industry supply curve is the sum of the individual firm supply curves---that is, the marginal cost curves [above AVC (average variable cost)] of all the firms in the industry. Because quantities are being added---that is, because we are finding the total quantity supplied in the industry at each price level---the curves are added horizontally.

Figure 4 shows the supply curve for an industry with just three firms. At a price of $6, firm 1 produces 100 units, the output where P (price) = MC (marginal cost). Firm 2 produces 200 units, and firm 3 produces 150 units. The total amount supplied on the market at a price of $6 is thus 450 (100 + 200 + 150). At a price of $5, firm 1 produces 90 units, firm 2 produces 180 units, and firm 3 produces 120 units. At a price of $5, the industry thus supplies 390 units (90 + 180 + 120).

Two things can cause the industry supply curve to shift. In the short run, the industry supply curve shifts if something---an increase in the price of some input, for instance---shifts the marginal cost curves of all the individual firms simultaneously. For example, when the cost of producing components of home computers decreased, the marginal cost curves of all computer manufacturers shifted downward. Such a shift amounted to the same thing as an outward shift in their supply curves. Each firm was willing to supply more computers at each price level because computers were now cheaper to produce.

In the long run, an increase or decrease in the number of firms---and, therefore, in the number of individual firm supply curves---shifts the total industry supply curve. If new firms enter the industry, industry supply curve moves to the right; if firms exit the industry, the industry supply curve moves to the the left.

We return to shifts in industry supply curves and discuss them further when we take up long-run adjustments in a later post.

Long-Run Directions: A Review

Table 4 summarizes the different circumstances that perfectly competitive firms may face as they plan for the long run. Profit-making firms will produce up to the point where price and marginal cost are equal in the short run. If there are positive profits, in the long run there is an incentive for firms to expand their scales of plant and for new firms to enter the industry. 

TABLE 4

Firms suffering losses will produce if, and only if, revenues are sufficient to cover variable costs. If a firm can earn a profit on operations, it can reduce the losses it would suffer if it shut down. Such firms, like profitable firms, will also produce up to the point where P = MC. If firms suffering losses cannot cover variable costs by operating, they will shut down and bear losses equal to fixed costs. Whether or not a firm that is suffering losses decides to shut down in the short run, it has an incentive to contract in the long run. The simple fact is that when firms are suffering losses, they will generally exit the industry in the long run.

In the short run, a firm's decision about how much to produce depends on the market price of its product and the shapes of its cost curves. Remember that the short-run cost curves show costs that are determined by the current scale of plant. In the long run, however, firms have to choose among many potential scales of plant.

The long-run decisions of individual firms depend on what their costs are likely to be at different scales of operation. Just as firms have to analyse different technologies to arrive at a cost structure in the short run, they must also compare their costs at different scales of plant to arrive at long-run costs. Perhaps a larger scale of operations will reduce production costs and provide an even greater incentive for a profit-making firm to expand, or perhaps large firms will run into problems that constrain growth. The analysis of long-run possibilities is even more complex than the short run analysis, because more things are variable---scale of plant is not fixed, for example, and there are no fixed costs because firms can exit their industry in the long run. In theory, firms may choose any scale of operation, and so they must analyze many possible options.

In the next post, we turn to an analysis of cost curves in the long run. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 178-180*

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