Columbia University

Graduate School of Business

Managerial Economics (B6006)

Classes 6-8

Industry Analysis:
Perfect Competition in the Short Run

I. Introduction.
In this class we start the second section of the course, industry analysis. Our objective is to
understand how buyers and sellers interact in different market environments, how prices and
quantities are determined, and what forces cause changes in prices and quantities.

Understanding the environment under which the firm operates is crucial, because it provides us
with a framework to predict and understand important issues such as the determinants and
dynamics of prices and quantities, the growth of the industry, and probably what is extremely
important from managerial point of view, the determinants of profitability.

We will conduct our industry analysis along two dimensions. On the first dimension we will
study two broad types of market environments, competitive and imperfectly competitive markets.
For each of these market environments we will divide our analysis along the time dimension,
introducing two notions of time horizon, the short run and the long run.

II. Competitive and Imperfectly Competitive Markets.

We use two, very broad, categories to define market environments1. This will provide us with a
very useful and powerful framework to analyze a large variety of businesses. We start by
defining the main features of competitive and imperfectly competitive markets:

a) Perfect Competition.
In perfectly competitive markets the product is homogenous and both sellers and buyers are
price-takers, i.e., they take the market price as given. As we explain later, the price-taking
assumption is the outcome of more fundamental and primitive features of perfectly competitive
markets.

b) Imperfect Competition.
In imperfectly competitive markets sellers have some degree of market power. The degree of
market power can vary a considerably from a pure monopoly market, where a unique seller
provides the entire market supply, to a “monopolistic competitive” market, where several
differentiated producers compete for the customers of an industry (e.g., cereals, NYC
restaurants). However, the common salient feature of imperfectly competitive markets is the
price setting behavior of the sellers. Once again, the latter is the product of other features of this

1
We will use the terms “market” and “industry” interchangeably.
1
type of environment.

III. Short-run vs. Long-run Analysis.

The terms “short run” and “long run” are fairly abstract and do not have any clear, pre-defined,
notion in terms of days, months, or years.

An analysis of the industry in the short run is defined as an analysis where the number of firms
in the industry is assumed to be constant. A long-run analysis, on the other hand, takes into
account entry and exit of firms.

A simple example can illustrate this important distinction:

When venture capitalists read business proposals there are two types of information that they are
looking for, or questions that they are most likely to ask. The first will include information about
the demand for the product or service, how large is the market, what are the prices that can be
charged, how the competition looks like, what are the predicted market shares, sales, revenues,
profits, etc.
Having received satisfactory answers to these questions, the following questions should follow:
“Given that this is a great business idea with huge potential profitability, how long will it take
someone else to come up with a similar product or service and compete with us? And taking into
account that such entry will take place, what is then likely to happen to the industry, our
business, and most important, our profitability?”
The analysis required to answer the first set of questions is what we call a short-run analysis,
while in order to answer the second set of questions a long-run analysis is called for.

IV. Perfect Competition in the Short Run.

We start the analysis with a bench-mark scenario called “perfect competition.”
We define a perfectly competitive market as a market in which buyers and sellers don’t have any
“market power”. In other words, both sellers and buyers take the product or service price as
given (“price takers”).

This characterization sounds counterintuitive and is in contrast with some of our daily
experiences. We are used to see firms setting prices for their products (e.g., supermarkets,
airlines) and frequently, as buyers, we have a say about the price (e.g., housing, E-Bay). We,
therefore, have to be more precise about the conditions under which nobody has a market power.
In addition, it should be noted that we are describing a bench mark case that could be useful if it
either “approximates” the real world close enough, or if it helps us understand how deviations
from it will affect outcomes. Perfect competition is important because it meets both conditions.

Moving to the analysis of perfect competition in the short run, we combine our earlier definitions
of “perfect competition” and the “short-run” to come up with the following characteristics:

1. Homogeneous product.
2. Many buyers (consumers) and sellers (firms), where the volume of activity by either
buyers or sellers is negligible compared to the market size (e.g., no market makers).
3. The cost of search for buyers is zero.
4. Sellers and buyers are price takers.
5. The number of firms in the industry is fixed (remember, we are in the short run).

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We first want to understand why the combined effect of 1-3 is a market or industry where all
transactions take place at a unique price and both sellers and buyers are price takers.

Since sellers supply a homogenous product, buyers do not display any sort of brand or customer
loyalty. Thus, they want to buy at the lowest available price. Furthermore, since search costs are
negligible (think about the Internet or the stock market) they will be able to find it. A seller
trying to sell at a price higher than the market price will not be able to attract any customers.
Thus all transactions take place at one price, the market price. Given the second characteristic, of
many buyers and sellers, neither will be able to affect the price by either changing their spending
patterns or supply decisions, respectively. For example, it is very likely that none of the students
in your class is wealthy enough to affect the price of IBM shares tomorrow morning by buying
any amount of shares they could buy, or selling any amount of IBM shares that they currently
hold. It is also obvious that if you wanted to sell, tomorrow morning, 100 shares of IBM you will
not be able to sell it at a price which is above the market price. And since you will be able to sell
all the shares at the market price, there is no reason in the world why you should offer the shares
at a price below the market price. The same logic will hold if you wanted to buy 100 shares of
IBM tomorrow morning. So, both sellers and buyers take the market price as given and decide,
given the price, how many units they want to sell or buy.

V. Short-run Equilibrium
We turn now to analyze how prices are determined in a competitive market.
The common short answer given by economists to this question is: “By the interaction of
demand and supply”.
In order to understand the meaning and implications of this statement, we start by looking first at
what the terms “market demand” and “market supply” mean, followed by an analysis of the
“interaction” of demand and supply.

Market Demand
Our analysis of market demand in this course will be extremely brief. Interested students are
encouraged to read more about this topic in any microeconomic textbook.

As a first step we will attempt to construct a typical market demand curve in class by conducting
a survey that resembles a Dutch auction. All students will be asked to “bid” for a particular item
(e.g., a two bedroom rental apartment in the Upper West). As the price of the item decreases
(that’s how a Dutch auction is conducted), more and more students will be willing to buy the
item (rent the apartment). We assume that each individual has a “reservation price” in mind, and
will raise their hand (be willing to rent the apartment) as soon as the price falls below their
reservation price. Plotting the different prices and the number of students that “join the market”
at each price, will yield a graph similar to the following:

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 Price

Apartments

As the number of buyers in a market increases, the demand curve will most likely become
smoother and smoother. Therefore, a typical market demand curve could look like the graph
below:

Price

Apartments

Notice that on the vertical axis we have the price per unit, and on the horizontal axes the
quantity, or number of units demanded.
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The intuition is simple. As the price per unit decreases (and remember, our product is
homogeneous, so quality and other features are always the same), the number of units that
consumers will buy will increase. Therefore, for the remaining of this course we will assume that
market demand curves are downward sloping, as in the above figure. There are exceptions to this
rule, but for all practical purposes they are pathologies and, therefore, can be ignored.

What are the factors that determine the exact shape of any specific demand curve? In other
words, why some people are willing to pay more while other are willing to pay less? If you think
about any product or service that you buy (or don’t buy), try to spell out what are the factors that
determine whether you want to buy it, how much you are willing to pay, and how much you will
consume, given different prices. When asking, for example, students in class what affected the
decision if and when to raise their hands (when asked about the rental apartment), the common
answers, reflecting what economists usually assume to determine the demand curve, are:
1. Tastes.
2. Level of income.
3. Prices of substitutes.
4. Prices of complements.
While it is quite intuitive why personal taste is an important determinant of what consumers want
to buy and how much they are willing to pay, the role played by the other three items requires
some discussion. We do it below, when discussion changes in demand.

Individual Demand Curve

In the above example we constructed the market demand curve directly. There is, however,
another way to construct a demand curve. Think, for example, about an individual buyer
(yourself) and his monthly consumption of movies. It is quite intuitive to agree that, all other
things being constant, as the price of the movie ticket goes down, the typical buyer will go more
often to the movie theater, reducing, may be, their spending on other forms of entertainment
(e.g., jazz concerts, restaurants, golf, watching TV). The opposite will happen if the price of a
movie ticket goes up. Since this is true for the typical buyer, it will be true as well for the
aggregate market demand.
Again, it seems reasonable and intuitive that as the price of a product or a service goes down
(up), the quantity, or number of units, that individuals will want to buy will increase (decrease).

Changes in Demand
The term “change in demand” can be highly misleading because there are two, very different,
types of changes that one could think about.

a. Movement Along the Demand Curve.

The first change concerns a change in the price that consumers face. In such a case all that has
happened is a movement along the demand curve from one point to another. To differentiate this
type of change from other changes, economists prefer to call it “change in the quantity
demanded”.
In the graph below, if the industry price, for some reason increases from P1 to P2 we conclude,
following the demand curve, that buyers will decrease their total demand from Q1 to Q2.

5
 P

P2

P1

Q
Q2 Q1

b. Movement of the Demand Curve.

Substitutes
Consider, for example, the market demand for a soft drink (e.g., Coke) and suppose that the price
of a close substitute (e.g., Pepsi) goes down. Nothing has happened (yet) to the price of Coke.
However, given that Pepsi and Coke are very similar (and for many consumers almost
indistinguishable)1 it is likely that some buyers will substitute Coke for Pepsi, decreasing the
consumption of Coke, and increasing the consumption of Pepsi. We, therefore, call these two
different drinks “substitutes”.
How do we represent this change in terms of the demand curve for Coke?
At any given price of Coke, the quantity that consumers will buy will decrease, given the
availability of a cheaper substitute. The result, therefore, is a shift of the demand curve to the
left, as can be seen in the graph below.
Similarly, if the price of a substitute goes up the shift in the demand curve will be to the right.

1
We understand that for various reasons many consumers have a strong preference towards one
of the products, but for our discussion it is enough that there is a significant number of
consumers that couldn’t care less, care a little bit, or, at least, when the price gap is high enough,
will switch to the cheaper one.
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P Market Demand for Coke

D1
Decrease in price of Pepsi

D2
Q

Complements
Why do many analysts follow so closely the price of crude oil? Think for example about the
market demand for passengers’ cars in the US. What is likely to happen to the demand for cars if
the price of gasoline goes up? The graph below illustrates it.
Since driving cars requires gasoline, the cost of having a car is affected by oil prices. Therefore,
if there is an increase in oil prices, then at any given price (of cars) the quantity of cars that
consumers will want to buy will decrease. The effect of this change in oil price on the demand
for cars is depicted in the graph below. The opposite, of course, will happen when the price of
gasoline will decrease. Since oil is a complement to many important products, changes in its
price are likely to affect many markets.
There are numerous examples of other complements that you can read about in any
microeconomics textbook.

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P Market Demand for Automobiles

D1
Increase in price of Gasoline

D2
Q

Income Effect
Market analysts, marketing directors, and policy makers, among others, are concerned with how
different markets will be affected by “the market”. For, example, what will happen to the
housing market if the recession continues? In other words, looking at a specific market, we want
to know what will happen to the demand curve when consumers’ income changes.
The answer will depend on the nature of the product or service.
If, following an increase (decrease) in income, there is an increase (decrease) demand for the
good, we call this good a “normal good”. Most of the goods and services that we are familiar
with fall under this category.
There are, however, goods and services for which consumers’ reaction, following a change in
their income, is the opposite. As their income increase they buy less of such goods and substitute
them for other (mostly higher quality) goods or services (e.g., bus rides, Budweiser, boxed
macaroni and cheese). When consumers’ income is increasing the market demand curve for an
inferior product will shift to the left.

Industry Supply
What happens to the quantity that suppliers will produce and supply to the market as the market
price increases?
In this course we devote a substantial amount of time to formally derive the firm and market
supply curves. At this point, however, we just want to develop the simple intuition that the
market supply curve in a competitive market is upward sloping, as the graph below illustrates.

8
 P
Market Supply

Consider our earlier example where we derived the students’ demand curve for rental
apartments. Imagine now that all the students in class are currently living in such an apartment.
Someone knocks on their door and asks them to move out (and sublet their apartment). It is
reasonable to assume that as the offer price increases more and more students will agree to sublet
their apartment. In general, as the price of the product or service sold in a competitive market
increases, the quantity that sellers will supply will also increase.

Important Points: When we talk about the quantity that sellers supply or the quantity that
buyers buy we must have in mind a time frame. These quantities are flows. We cannot talk about
demand for gasoline without specifying whether it’s per day, per week, or per year. Also, when
talking about “industry” or “market”, we usually have some geographic boundaries in mind. We
talk, for example, about the housing market in Boston, the gasoline market in the US, or the
world market for crude oil.

Market Equilibrium
Now, that we have developed the intuition for the shapes of the demand and supply curves in a
competitive market, we can see what happens when both sellers and buyers interact.

We define a short-run equilibrium as a market price at which the quantity that buyers want to
buy is equal to the quantity that sellers want to supply.
Consider the figure below. Point A is the intersection of the demand and supply curves. At this
point the market price is P*. At this price, as can be easily seen, the quantity that all firms in the
market want to supply is equal to Q*. It is also the same quantity that all buyers, jointly, want to
buy at this price.

9
 P
Market Equilibrium

P*

Q
Q*
We call P* the market equilibrium price (sometimes called the market clearing price), and argue
that market forces will “push” the price and quantity towards P* and Q*. The following
discussion will develop this argument intuitively.

Consider the figure below, and assume that the industry is operating at a price which is above P*,
for example P2 in the figure below. At this price the quantity that buyers want to buy is
represented by QD. However, according to the supply curve, the quantity that producers want to
sell at this price is QS. The difference, QS - QD, reflects excess supply.

P
Price Above Market Equilibrium

P2

P*

Q
QD Q* QS
These are units of output produced, but not sold. Where do they go? Most likely they will
10
increase the level of inventories1. Obviously this situation cannot persist. As inventories
accumulate it is likely that some firms will start cutting sale prices. However, given that the
product homogenous, as soon as some firms start cutting prices, they will be immediately
followed by other firms that would risk otherwise to be left out of the market. Thus, if the price
is above equilibrium, economic forces are likely to bring it down. A classical example of a
market where the price is set above equilibrium is the labor market for low skilled jobs, under a
minimum wage law.

Different forces are at work when the price is below equilibrium. Consider the graph below: For
some reason the market price that buyers and sellers face is P2, a price which is below the
equilibrium price. At this price, buyers demand QD units of output, while firms supply QS units.
The difference QD - QS measures the excess demand. Those are units of output that buyers would
like to buy, but are not met by the actual industry production. Thus, either some buyers are
rationed, or there is a process of inventories reduction, or both. Firms will start increasing prices
and, since buyers will not be able to find output at lower prices, this will push prices up toward
the equilibrium level. A typical example of a market where the price is set below equilibrium is a
housing market that is subject to rent control.

P
Price Below Market Equilibrium

P*
P2
D

Q
QS Q* QD
Although it is quite unrealistic to think that a competitive industry operates exactly at an
equilibrium point, we have good reasons to believe that the industry gravitates towards and
around that point. When looking at competitive (or near competitive) industries, in order to
understand whether the prevailing price is “close” to an equilibrium price, above or below
equilibrium, look at the dynamics of inventories (this point is important, because in real life you
are not likely to see demand and supply curves but rather have to rely on other indicators to
assess whether prices are above or below equilibrium).

1
In other markets excess supply could be reflected differently. In the motels market, for example,
an increase in “Vacancy” signs is likely to indicate a price above equilibrium.
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 VI. Industry Supply: The General Case
In the analysis above we used an upward sloping supply curve, justifying its shape on intuitive
grounds. At this point we move to a more formal derivation of the industry or market supply
curve.

“The market supply curve is the horizontal summation of all individual supply curves”

However, we have already analyzed extensively the individual firm’s supply curve.
Therefore, all we have to do, at this point, is to see how to aggregate the individual supply curves
into a market supply curve.

To make the analysis as clear as possible, we will distinguish between two different scenarios:
a. All firms have identical technologies.
b. Different firms have different technologies.

a. Identical Technologies
We start with a very simple example of a market that has only two (identical) firms. The supply
curve of each of the firms is in the first two panels below. Notice, that for both firm, the Min AC
is at $45 per unit. Therefore, if the price is below $45, neither firm will supply to the market. In
other words, for prices below $45, the supply of each firm is zero. Let’s pick another price, $100,
for example. At this price each firm will supply 1100 units per period.

What happens when we aggregate both supply curves? The market supply will remain zero as
long as the price is below $45. If the price is above $45, both firms supply positive quantities.
What is the aggregate supply at $100? It is the sum of all individual supplies, which in our case
is 2200. That’s where the term “horizontal summation” is coming from.

When the price is equal to $45, both firms are indifferent between producing 300 units and not
producing at all. Thus the aggregate supply at $45 can be any of the following three quantities: 0
(when both firm do not produce), 300 (when one firm produces 0, while the other one 300), 600
(when both firms produce 300).
The third panel below shows the aggregated supply curve.

P P P
Firm #1 Supply Curve Firm #2 Supply Curve Aggregate Supply Curve

S1 S2

S1+2
$100 $100 $100

$45 $45 $45

Q Q
300 1100 300 1100 0 300 600 2200 Q

In the more general case there is a large number of firms, let’s say N firms.
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We denote the supply curve of each firm by s(p). If the market price is P1 and P1>MinAC (like
the $100 in the above example), each firm supplies q1 = s(p1) (like the 1100 in the example), and
the total market supply at this price is S(p1) = N*s(p1) = N*q1 = Q1 (like the 2200 in the
example). If the market price is P’<minAC, each firm supplies zero, s(P’)=0, and hence, the
aggregate supply is zero, i.e., S(P’) = Ns(P’) = N*0 = 0. When the price is equal to the MinAC,
each firm is again indifferent between producing q*, the output level corresponding to the
minAC (300 in the example), and 0. Thus, the aggregate supply at the minAC can be any of N+1
quantities: 0 (when all firm do not produce), q* (when one firm produces q*, while the other N-1
produce 0), 2q* (when two firms produce q*, while the remaining N-2 produce 0),…, Nq*
(when all firms produce q*).
Since in competitive markets the number of firms is very large (e.g., N=1,000), we should draw,
in correspondence of the minAC, N+1 points each of them q* units apart. For all practical
purposes we might as well draw a line connecting 0 to Nq* as shown in the picture below. This
is what is customary done in textbooks (and problem sets).

P
Aggregate Supply Curve

S1+2
$100

MinAC

Nq* N*1100 Q
Examples

Example 1: identical costs I

Consider an industry with 100 identical firms. Each firm is facing the following total cost
function:
C(q) = 16 + 2q + (q)2

The industry demand curve, QD, is given by the following expression

QD = 10,000 - 50p.

You are asked to find: 1) the short-run equilibrium and 2) the profits realized by each firm.

Answer:

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In order to solve for a short-run equilibrium of the industry, we need I) to construct the industry’s
supply curve, II) equate the industry demand to the industry supply, and III) find each firm’s
profits.

I) Industry short-run supply:

The industry short-run supply is nothing else that the sum of all the supply curves of the firms in
the industry. Hence, we first have to find the individual firm's supply curve. The firm supply
curve coincides with its MC-curve whenever the market price is above the minimum average
cost, while it is identically equal to zero if the market price is below the minimum average cost.
Hence, we proceed by finding: i) the average cost curve, ii) the marginal cost curve, iii) the
minimum average cost and its corresponding output, and iv) firm's supply curve.

i) The average total cost is:

AC(q) = C(q)/q = (16/q) + 2 + q.

ii) The marginal cost is the derivative of the total cost with respect to Q:

MC(q) = dC(q)/dq = 2 + 2q

iii) The average cost reaches its minimum at output level q* where MC(q*) = AC(q*). Hence, q*
solves the following equation:

16/q + 2 + q = 2 + 2q
or q2 = 16.

Therefore, the minimum average cost is reached when output q* = 4. The value of the minimum
average cost is obtained by substituting q* = 4 in the average (or marginal) cost expression, i.e.:

min AC = AC(4) = (16/q*) + 2 + q* = 10.

iv) As already said, no production activity will take place for prices below the min AC, i.e., if p <
10. For p > 10, (as discussed in class) the profit maximizing output satisfies the condition p =
MC(q), i.e.:

(1) p = 2 + 2q.

Solving equation (1) in terms of q yields:

q = (p - 2)/2.

Summarizing, the supply curve of the firm, qs is:

(2) qs = (p - 2)/2, for p > 10,

qs = 0, for p < 10.

The thick line in the graph below represents the supply of the firm:

14
 60

50

40

30

20

10

0
0 5 10 15 20 25 30 35

v) Industry supply:
In this industry there are 100 identical firms. Each firm's supply is expressed by equation (2). In
order to construct the industry supply curve, Qs, it suffices to multiply the individual firm supply
curve by the number of firms, i.e., by 100:
QS = 100 * (p - 2)/2 = 50p -100, for p > 10,
Q S = 0, for p < 10.

II) Short-run equilibrium:

A short-run equilibrium for a competitive industry is a price level, pe, at which demand is equal
to supply. Hence, in order to find it, we just set QD = QS, or

10,000 - 50p = 50p -100

or pe = 10,100/100 = 101

Since pe = 101 is greater than the min AC = 10, each firm in the industry is producing a positive
amount of output. In order to obtain the industry equilibrium output, Qe, we substitute pe in the
demand and get:

Qe = 10,000 -50*(101) = 4,950.

III) Profits of the firm: Since there are 100 identical firms and the industry equilibrium output is
Qe = 4,950, each firm is producing qe = Qe/100 = 49.5. Therefore, each firm is realizing short-run
profits equal to

 = peqe-C(qe) = 101*(49,5) - (16 +2*(49,5)+(49.5)2) = 2,434.25.

Example 2: Identical Costs II.

Problem: An industry is composed 100 identical firms. Each firm has a very simple cost
structure: it can produce at most 100 units of output per year at a constant marginal cost of $10.
There is no fixed cost involved in the production process. The industry demand curve is given by

15
QD = 20,000 -100p.

You are asked to find the short-run equilibrium and the profit of each firm in the industry.

Answer: We proceed by finding I) the industry supply through the supply curve of each firm, ii)
the industry short-run equilibrium price and quantity, and iii) the profits of each firm.

I) Industry supply:

i) Firm’s supply curve:

Since there are not fixed costs and since the marginal cost is constant and equal to $10, the
average cost is equal to the marginal cost. Therefore, the firm will not produce for any price
below $10. If the price exceeds the marginal cost, i.e., it is greater than $10, each firm will find
profitable to produce up to capacity. While if p = $10, the firm realizes zero profits
independently of the quantity produced and it is therefore indifferent to produce any quantity
between zero and 100. Therefore, the thick line in the graph below represents the supply curve of
the firm.

MC=AC=10
$10

100 Q

ii) Industry supply:

Since there are 100 identical firms, the industry supply is obtained by multiplying by 100 the
firm’s supply curve. The thick line in the graph below represents the industry supply curve.

16
 P

MC=AC=10
$10

10,000 Q

II) Short-run equilibrium:

Start by observing that at a price of $10, the demand is equal to

Q(10) = 20,000 - 100*(10) = 19,000.

Since at p = 10, the demand exceeds the island capacity, it must be the case that in the short-run
equilibrium all firms are operating at capacity and the equilibrium price is above $10. Hence, in
order to find the short-run equilibrium price, pe ,we set demand equal to the island capacity, i.e.:

20,000 - 100p = 10,000,

or pe = 100.

III) Firm’s profit:

Each firm is producing at capacity, the price is p =100, while the per unit cost of production is
$10. Hence the profits are:

 = pq - 10q = 100*100 - 10*100 = 9,000.

b. Heterogeneous Technologies.
In some industries, firms have different technologies. For instance, in the exploitation of natural
resources (see the Phelps Dodge case), the cost structure of a firm depends very much on how
productive its mines are and those are, typically, heterogeneous both across and within firms.
From a pure logical point of view the construction of the aggregate supply curve is identical to
the previous case (i.e., identical technologies), but the mechanics is a bit different. To illustrate
the point, we will use again a simple example with only two firms (or, equivalently, an industry
with two types of technologies). The supply curve of firm #1 below represents one technology
and the supply curve of firm #2 represents another technology.
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 How do we know that the two supply curves represent different technologies? Remember that
the supply curve coincides with the firm’s MC curve (above the minimum AC), thus reflecting
the technology of production.
How do we aggregate the two individual supply curves? We start from price zero, increasing the
price slowly, slowly. Nothing happens until the price hits the $10 level. At this point only firm
#1 enters the market and will stay the only firm until the price hits the $20 level. Therefore, up to
the price of $20 the industry supply curve is identical to firm 1 supply curve. However, above
$20, the industry supply is equal to the sum of the two individual supplies. For example, when
the price is $30, one firm will supply 200 units while the second will supply 50 units. The
aggregate industry supply is, therefore, 350, as is shown in the third panel.

P
P
$45 S2
P

S1

$30 S1+2
$30
$30

$20
$20 $20

$10 $10 $10

200 300 Q 50 200 Q 200 350 Q

The examples below illustrate the construction of the industry supply curve and the
characterization of the short-run equilibrium.

Example 3: Heterogeneous firms: short run.

Problem: An industry is composed of two types of firms, type A and type B. There are 100 firms
of Type A and can produce at most 100 units of output per year at a constant marginal cost of
$10. The fixed cost is $1,000 per month.
There are 300 firms of Type B and each can produce at most 200 units of output per year at a
constant marginal cost of $10. The fixed cost is $6,000 per month. The industry demand curve is
given by:

QD = 20,000 -100p.

You are asked to find the short-run equilibrium and the profit of the firms of both types.

Answer: We proceed by finding i) the supply curve of each firm, ii) the industry supply, iii) the
industry short-run equilibrium price and quantity, and iv) the profits of each firm.

i) Firm’s supply curve:

Let’s start by considering type A firms. Since the marginal cost is constant, the average cost is
18
AC(q) = MC+AFC = 10 +(1,000/q)
Since the average cost curve is decreasing, it reaches its minimum at capacity.
Hence, the minimum average cost of type A firm is
MinAC = 10 + (1,000/100) = 20.
The supply curve of a firm of type A is therefore:
qs = 100 if p > 20,
qs = 0 if p < 20 .

Since type A firms are identical their aggregate supply is just 100 times their individual supply.
When p = 20, all firms are indifferent between not supplying any output and producing at
capacity. As usual, rather then drawing points, we simplify by assuming that at p=20, the
aggregate supply is the continuous line joining 0 with 100*capacity = 10,000
Thus,
SA = 10,000 if p > 20,
SA = any multiple of 100 from 0 to 10,000 if p = 20,
SA = 0 if p < 20,
The supply curve of a type A firm and the aggregate supply of all type A firms are depicted in
the two graphs below.

P
Supply Curve of a Type A firm P
Supply Curve of ALL Type A firms

S
S

$20
$20

100 Q
10,000 Q

A similar analysis applies to type B firms. Since the marginal cost is constant, the average cost is
AC(q) = MC + AFC = 10 + (6,000/q).

Since the average cost curve is decreasing, it reaches its minimum at capacity.
Hence, the minimum average cost of type B firm is
MinAC = 10 + (6,000/200) = 40.
The supply curve of a firm of type B is therefore:
qs = 200 if p > 40 ,
qs = 0 if p < 40 .
Since type B firms are identical, their aggregate supply is just 300 times their individual supply.
Thus,
SB = 60,000 if p > 40,
SB = any number from 0 to 60,000, if p = 40,
SB = 0 for p < 40.

ii) Industry supply:

The market supply is the sum of type A and B aggregate supplies. The market supply is zero if
p<20. It coincides with the supply curve of type A if 20< p<40, and it is equal to their sum if
19
p>40. Thus:
S = 0 if p<20,
S = any number (multiples of 100) between 0 and 10,000 if p = 20,
S = 10,000 if 20<p<40,
S = any number (multiples of 200) between 10,000 and 70,000 if p = 40,
S = 70,000 if p>40,
The aggregate supply curve is the thick line in the graph below.

P
Industry Supply of type A and type B Firms

$40

$20

10,000 70,000 Q

iii) Short-run equilibrium:

Start by observing that at a price of $20, the demand is equal to

D(20) = 20,000 - 100*(20) = 18,000.

Since at p = 20, the demand exceeds type A aggregate capacity, in the short-run equilibrium all
firms of type A are operating at capacity and the equilibrium price is above $20.
Similarly, at p = 40, the aggregate demand is equal to
D(40) = 20,000 - 100*(40) = 16,000.
An output level of 16,000 is above type A aggregate capacity, but it is below the aggregate
capacity of the industry. Thus, the short-run equilibrium price is 40. Type A firms produce at
capacity, thereby providing 10,000 units of output. At p = 40, type B firms are indifferent
whether to produce at capacity or not produce at all. Since an additional 6,000 units of output are
needed to service the aggregate demand, a number equal to (6,000/200) = 30 of firms of type A
will produce at capacity. The picture below describes the equilibrium.

20
 P
Market Equilibrium

$40

$20
D

10,000 16,000 70,000 Q

iv) Firm’s profit:

Each type A firms produce at capacity and the price is p =40. Hence the profits are:

 = (p – AC(q))q = (40-20)100 = 2,000.

30 type B firms produce at capacity, while the remaining 270 do not produce at all. The price is
40, which coincides with their minimum average cost. Hence, all B firms make zero economic
profits.

VII. Changes in Market Supply Curves

Similar to the analysis of changes in the demand curve, we want to examine the different
determinants of changes in the aggregate supply curve. Remember that the firm’s supply curve
was derived from the cost structure of the firm. Therefore, when analyzing changes in the supply
curve it will be useful to distinguish between two different types of changes: changes in marginal
costs and changes in (avoidable) fixed costs.

Suppose for instance, that the price of a variable input (e.g., oil) has increased. As a result, all
per-unit costs (marginal and average) have also increased. Thus, the marginal cost curve of each
firm shifts upward, creating an identical shift in the aggregate supply curve. Suppose, for
example, as a result of an oil shock the marginal cost of production has increased by $1 at each
conceivable level of output. Thus, the supply curve of each firm in the market will also shift up
by $1, and, pay attention, the industry supply curve will shift up vertically also by $1!!!

The figure below illustrates the shift in a supply curve when there is an increase in marginal
costs of $1 per unit. The new supply curve is $1 “higher” than the original curve. For example,
the MC at an output level of 24,000 per period has increased from $60 to $61.

21
 P

S2

S1

61

60

24,000 Q

VIII. Changes in Supply & Demand, and Equilibrium.

1. Changes in Supply.
What will be the effect of a change in supply on the equilibrium prices and quantities? In order
to analyze this problem, we have to consider both the demand and supply curves.

We use the previous example of a dollar increase in the MC. We will pay particular attention to
the change in equilibrium price. If the price increase is equal to the change in the marginal cost
(zero) we will say that the consumers (firms) suffer the entire burden of the cost increase. If the
increase in the market price is positive, but below the cost increase, consumers and firms share
the burden of the cost increase.

To make the analysis clear we start analyzing two extreme cases.

First, suppose that the market demand is vertical. A vertical demand curve represents a situation
where the good/service under consideration does not have substitutes, and the quantity that
buyers will want to buy is fixed over a large range of prices. A typical, contrived example is
water in the desert. In the Phelps Dodge case, you will see a real industry facing a vertical
demand curve.
Let’s use the previous example, of a dollar increase in the MC and see what happens to the
equilibrium price and quantity.
Assume, for example, that before the cost increase the equilibrium price and quantity are $60 and
24,000 respectively. As can be seen in the graph below, following the shift in the supply curve,
the new equilibrium price is $1 higher than the old price, but the equilibrium quantity remains
the same. Buyers suffer the entire burden of the cost increase.

22
 P

D
S2

S1

61

60

24,000 Q

At the opposite extreme, consider a market where the demand for the product is horizontal. A
typical example of such a case is a small country exporting to the world a product that is
produced by many other countries as well, providing, therefore, perfect substitutes to the product
sold by the small country. There is a world market for the product, and the small country is
facing, therefore, a horizontal demand for the product at the world market price. Buyers are
willing to buy any quantity of the good at the world market price. For higher prices, the demand
vanishes, all buyers would switch to the perfect substitute, i.e., the same product sold by other
countries. For lower prices, all the buyers of the substitute enter our tiny country market and the
demand explodes (goes to infinity).
When the demand is horizontal, the effect of a shift in the aggregate supply is only on quantities.
As can be seen in the graph below, the equilibrium quantity changes from Q1* to Q2*, while the
pricey remains constant. The firms suffer the entire burden of the cost increase.

23
 P

S2

S1

P*
D

Q2* Q1* Q

Now that we have seen the two extreme cases, we can examine the more common, intermediate
case shown in the graph below. Following the cost increase, the market equilibrium shifts from
point A to point B. The new price is higher and the new level of output is lower. However, since
the market demand is negatively sloped, the difference between the new and old equilibrium
prices is less than the cost increase, i.e. P2*-P1*<1. Thus, in general, under normal
circumstances, firms and buyers will share the burden of the cost increase. Furthermore, the
steeper the demand curve the higher the price change and the lower the quantity change (and the
higher the share of the burden suffered by the consumers).

S2

S1

B
P2*
A
P1*

Q2* Q1* Q

24
The effect of a change in fixed costs on the supply curve.
Our analysis of this issue will be relatively brief You are welcome to think about it by yourself..
The problem boils down to the following observation: A change in fixed cost does not affect the
marginal cost, but it does change the minimum average cost. If the industry price is above the
new altered minimum average cost, the change in fixed cost does not affect the short-run
equilibrium. (Thus every time the fixed cost decreases nothing will happen to the short-run
equilibrium.) However, suppose that the increase in the fixed cost produces yields, for some
firms, a new minAC above the market price. Those firms will cease any productive activity.
Typically, the industry supply contracts and the equilibrium price increases.

2. Changes in Demand
We have already seen how changes in the prices of substitutes and complements, as well as
changes in income affect the market demand curve. What we want to examine now is the effects
of such changes on market prices quantities. The discussion will be relatively short because it is
very similar to our previous analysis of changes in the supply curve. Let’s assume, that for some
reason (e.g., change in income, preferences, price of substitutes and so on) the market demand
increases as shown in the graph below. The new equilibrium B will to the “north-east” of the old
equilibrium. The price has increased and the demand has increased.

B
P2*
A
P1*

D2

D1

Q1* Q2* Q

Consider, for example, a different situation, where the industry is operating at capacity, in the
vertical region of the supply curve (as is shown in the left panel below). As you can see, all the
change will be in price. If the marginal cost, however, is constant and capacity is not fully
utilized, the intersections of demand and supply curves will take place along the horizontal
region of the supply curve. As a result the only effect of a change in demand will be on the
quantity (as is shown in the right panel below).

25
P P
S

P2*

P1*
D2
P* S

D1
D2
D1
Q* Q Q1* Q2* Q

In general, the steeper the demand curve, the greater the price effect and the smaller the quantity
effect.

26
 Industry Analysis:
Perfect Competition in the Long Run

In this class we conduct an analysis of perfect competition in the long run. Before turning to the
analysis we summarize the determinants of profitability in perfect competition in the short run.
This summary should be contrasted, later on, with the conclusion of our long-run analysis.

I. Profits Opportunities in the Short Run

1. Profits are ultimately determined by the price.

2. Price is determined by the interaction of demand and supply.
3. Look for the "Marginal Producer"
If demand is high, the marginal producer could be relatively inefficient, and competing could be
easy.

II. Long-Run Analysis.

In the long run the number of firms in the industry is an endogenous variable. In other words,
depending on expected profitability and expected losses firms can either enter or exit the
industry. Firms that lose money will have enough time to exit the industry, while potential
entrants will join the industry if this decision generates (expected) positive economic profits.

III. Long-Run Costs.

In our short-run analysis we introduced the notion of avoidable and unavoidable costs. Avoidable
costs are affected by short-run production decision, while unavoidable costs are independent of
any decisions made while in business. The firm has unavoidable costs independently of its
decision to produce or not. For instance, in the TV Listing Magazine situation, national channels,
core staff, and computer costs were all unavoidable in the short run for all the decisions proposed
by the case. However, they all become avoidable costs as we increase the time span under
consideration. TV Listing Magazine can stop subscribing to the national channels, can sell the
computers, fire the core stuff, and so on. In other words, it can go out of business. In the long run
all costs are avoidable. Thus, in our simple story, the long-run production costs exceed their
short-run counterparts. The difference between the long and short-run costs is equal to the (short-
run) unavoidable costs. We will call them, as well, set-up costs to capture the idea that these are
costs generated by resources needed to start the business (e.g., long-term contracts, buildings,
core staff, lawyers, etc.).

The text-book assumption of lack of any entry or exit costs is meant to capture the idea of an
industry without any barrier to entry and exit. Thus, consumers’ loyalty, patents, industry
standards, and switching costs are all out of the picture. This is a world where anybody can
perfectly copy anybody else.

Let’s illustrate the distinction between long-run and short-run costs with an example. Consider
our earlier example of the “apples’ seller”. To refresh your memory, here are the basic numbers:
1. Our entrepreneur sells apples each Saturday in Union Square, in a perfectly competitive
market.
2. She pays 10 dollars per case of apples.
3. She pays 250 dollars for the truck and 150 dollars for labor.
27
 4. The truck capacity is 500 cases.
We now introduce a new cost item. In order to sell apples in Union Square she has to buy a
license from the city of New York. The license fee is 1000 dollars per month (4 Saturdays), non-
refundable and non-transferable. As you can see, as soon as the fee is paid, it becomes an
unavoidable cost for the next four weekends. If you want to consider this month as the life of the
business you could say that this cost item is unavoidable “while in business”. It is avoidable, of
course, as long as you didn’t pay the fee (i.e., didn’t enter the market).
Let’s recall our earlier supply curve:

Price/Case
S
AC

$ 10.80
$ 10

Cases of apples
500

We now want to introduce the new cost item into the analysis. We do that by adding one more
line, Long-run Average Costs (LAC). We construct the new LAC curve by adding the license fee
to the earlier AC curve. This will increase the average costs, at any level of output, by 250/q
(remember that the fee is 1000 dollars for four weekends, which makes it 250 dollars per
weekend). The new cost curve will cut the capacity line at $11.30 ($10.80 + ($250/500)), as
shown in the graph below:

28
 $ /Case S
LAC

AC

$ 11.30

$ 10.80
$ 10

Cases/weekend
500
We now ask the following question: What is the minimum (expected) price under which you will
consider entering this business (i.e., buying the license)?
As can be seen in the above graph, you shouldn’t buy the license unless you expect the market
price to be, on average, above $11.30 per case of apples, over the next four weekends.
However, as soon as you bought the license and it has become a sunk cost, you should ignore it.
Therefore, if you bought the license, having in mind the idea that the market price will be above
$11.30, but later on realize that you were wrong, you will still produce at capacity every
Saturday in which the price is above $10.80. If, following these lower prices, you update your
expectations concerning future prices, you will be out of this business as soon as the current
license expires. This is the sense in which there is a free costless exit from the industry.

To sum: The AC curve includes all costs that are avoidable while in business. The LAC includes
additional costs that become unavoidable (over certain length of time) while in business.
This “certain length of time” will differ dramatically across industries, and could play a major
role in determining the length of time that it will take firms to exit the industry.

IV. Long-Run Equilibrium.

In a long-run equilibrium the size of the industry (i.e., the number of firms in the industry) is
endogenous. This idea has two components. First, any insider (firms already operating in the
industry) can leave the industry at zero cost. Of course, they will do so if they expect negative
(long-run) economic profits. Second, there is a large pool of potential entrants (outsiders).
Outsiders are firms that can join the industry at zero entry cost. Of course, they will do so if this
generates positive (long-run) economic profits.

The industry is in a long-run equilibrium if no outsiders want to enter and no insiders want to
leave. More precisely:
A long-run equilibrium is a short-run equilibrium where, in addition, insiders are not making
losses and outsiders cannot make positive profits by joining the industry.

29
Thus, in a long-run equilibrium the price cannot be above the minLAC of the least efficient
insider and it cannot be below the minLAC of the most efficient outsider.

As explained above, a short-run equilibrium determines the market price and the aggregate
output. A long-run equilibrium determines one additional variable: the number of firms in the
industry.

In order to explain how to characterize the long-run equilibrium of a perfectly competitive

industry, we analyze two types of industries. In the first example, the industry is populated by
firms (insiders and outsiders) with identical technologies; while in the second example firms
have different costs structures.

a. Identical Firms
The graph below represents the cost structure of all (identical) firms in the industry:

Cost/unit
MC

$400
LAC

$340
$300
AC

$250

Q
650 700 1000
The supply curve of each firm is simply the portion of the MC curve that is above the Min AC,
which is $250 in the example.
Assume that the current, short-rum, equilibrium price in this market is $400 per unit. Each firm
is supplying 1000 units per period and there are 100 firms in the industry. Hence, the aggregate
supply at $400 is equal to 100,000 units. Since we are in a short-run equilibrium, the market
demand at $400 must also equal to 100,000, i.e., the quantity supplied. The graph below
represents this market equilibrium.

30
 P Short Run Equilibrium
S

$400
$300

Q
100,000 140,000

This is the point at which we allow entry and exit of firms, thus conducting a long-run analysis.
First notice that when the price is $400, each firm is producing 1000 units and LAC(1000) = 340.
Thus, each firm realizes long-run profits equal to (400-340)*1000 = $60,000 per period.
Now, what is likely to happen to an industry in which all firms are generating positive economic
profits?
The answer is: ENTRY!!!

As long as expected economic profits in an industry are positive, new firms will enter the
industry. The short-run supply curve will shift to the right, and as a result, the new short-run
equilibrium price will get lower. As new firms enter the industry, the market price keeps falling.
When will this process end?
The answer is simple: When outsiders do not have an incentive to enter the industry and insiders
to leave it. When the price is equal to Min LAC, each firm realizes zero long-run economic
profits and there is no incentive for new firms to enter. Thus, the long-run equilibrium price is
equal to the minLAC ($300, in the example above) and it is, therefore, entirely determined by the
prevailing technology. The long-run equilibrium output must equal the aggregate demand
computed at the minLAC (140,000 units, in the example). The long-run output is, thus, entirely
determined by what consumers are willing to buy at the minLAC. Finally, the number of firms is
determined by dividing the aggregate long-run output (140,000) by the output corresponding to
the minLAC (700). In the example, the number of firms is equal to 200 firms.

Most students are puzzled by the fact that in a long-run equilibrium (with identical technologies)
economic profits are zero. Why should any business operate when its profits are equal to zero?
This is an extremely fundamental point that requires further clarification.
Let’s do it by introducing the following question:
Assume that the industry in our above example is an industry where the typical firm is an
average US corporation, characterized by average risk exposure (in the finance lingo, beta = 1).
If the industry is in a long-run equilibrium, i.e., zero economic profits, what are the average
31
returns on equity (ROE) to investors in such an industry?
The correct answer is “about 11%”, which is the average nominal return on the S&P500 index
over the last 40 years or so. Why 11% and not zero?
Recall that when we calculate economic profits, all resources have to be counted as costs. Capital
is a resource that has an opportunity cost because it could be invested elsewhere. Therefore,
when an industry is in a long-run equilibrium, accounting profits are such that potential investors
are indifferent between entering the industry and investing their capital elsewhere.

It should also be pointed out that since we are talking about long run, the zero profit condition
does not exclude the realization of positive economic profits (and unfortunately, losses as well)
during the short run.

The Industry Long-run Supply Curve

Consider the graph below. We started with a short-run equilibrium at a price that is higher that
min LAC ($400 per unit in the example). Then entry shifted the supply curve to the right, until
the price reached the Min LAC level, as represented by point A. Now the industry is in long-run
equilibrium.
Now, let’s assume that there is a demand shock in the industry, causing a shift in the demand
curve to the right from D1 to D2. The new equilibrium shifts to point B, where the short-run
equilibrium price is, again, above minLAC. The same process described above will, therefore,
repeat itself. Entry will eventually restore a long-run equilibrium at the same price (point C),
equal to minLAC ($300 in the example), but this time with a larger number of firms in the
industry.
The aggregate demand determines the size of the industry (number of firms), but not the long-run
equilibrium price.

P Long Run Equilibrium

S1

S2

S3

B
$400
A C
$300 D2

D1

Q
Q1

As the analysis above shows, the long-run equilibrium price will take place along a horizontal
32
line (see points A and C above). Therefore, the industry long-run supply curve will look like the
graph below:

Long Run Supply, Identical Firms

SLR
$300

A Numerical Example of a Long-run Industry Analysis.

The following example presents a numerical analysis of the long-run equilibrium.
Imagine a market for oranges on the remote island “Y”. It is a perfectly competitive market with
numerous growers. For sake of simplicity, we do not distinguish between long-run and short-run
costs. In other words, the unavoidable (short-run) costs are zero.
All the quantity information below is expressed in tons per day. The available data are the cost
information (identical for all inside and outside firms in the industry) and the market demand.
The cost of production for each farmer is:
1) C(q) = 100 + q + q2.
The market demand is:
2) D = 12,100 - 100p

I) Long-Run Supply
First we wish to compute the long-run supply curve. Thus we just need to compute the minimum
average cost. The MC-curve for each farmer on the island is:
3) MC = 1 + 2q,
While the AC-curve is
4) AC = (100/q) +1 + q
At the minimum MC = AC, Thus
1+2q = (100/q) + 1 + q
Hence, by solving the last equations for q, we get the output level at which the average costs is
minimum, i.e.,
q2 = 100 or, equivalently, q* = 10
By substituting q* into the AC-curve (or, equivalently, the MC-curve), we get the minimum
average cost for the farmers in the island:
33
MinAC = (100/10) + 1 + 10 = 21.
Thus the long-run supply is just a horizontal line at the price p = 21.

II) Long-Run Quantity and Number of Firms.

While the technology determines the price, the market demand is going to determine the long-
run output.
Substituting 21 for p in the demand curve, we find that consumers wish to buy 10,000 tons of
oranges.
Since each firm produces 10 units, the total number of firms, N, is equal to:
N = 10,000/10 = 1000.

b. Heterogeneous Technologies.
So far we assumed that all firms in the industry are identical.
This is somewhat in contrast with real industry situations, like the Phelps Dodge case. In the
mining industry, for example, cost structures are determined by the quality of mines and those
cannot be reproduced. Similarly, in agriculture, the cost structure depends on the quality of the
land and that cannot be copied either. In such cases, even in the long run some firms may
experience positive economic profits. The superior quality of the land/mine acts as a barrier,
protecting long-run profitability.
To make the analysis as simple as possible we illustrate the problem by using a numerical
example.
The example is identical to the last one, but we introduce a twist. We look again at the market for
oranges in the imaginary island of Y. The supply of oranges this time comes from two sources:
farmers operating on the island and farmers operating outside the island. As before, for sake of
simplicity, we do not distinguish between long-run and short-run costs i.e., unavoidable (short-
run) costs are zero.
The cost of production, net of transportation expenses, is identical for the two types of farmers
(identical to the previous example) and it is equal to C(q) = 100 + q + q2.

Farmers outside the island incur an additional transportation cost equal to $1 per ton. The
number of potential farmers outside the island is unlimited. Within the island however, there is
no room for more than 50 farmers.

I) Long-Run Supply
First we have to compute the minAC for both types of firms.
The MC-curve and the AC-curve for the farmers in the island are given, respectively, by
equations (3) and (4) in the previous example. The minimum average cost for the farmers in the
island is, as in the previous example, MinAC = 21, and it is achieved in correspondence of an
output of q* = 10.

The short supply curve of each inside farmer coincides with the MC-cost curve for prices above
the minAC, i.e.,
p = 1+2q, for p > 21, or q = (p-1)/2
Thus, the aggregate supply of the inside farmers is obtained by just multiplying the last equation
by their number, i.e.,
S(insiders) = 50* (p-1)/2 = 25(p-1)

The farmers outside the island have identical technologies, but they incur an additional
34
transportation cost of $1 per ton. Thus, their minimum average cost is, for those selling to the
island, also at an output level of 10 tons, but at value that is $1 higher than the local farmers, i.e.,
MinAC’ = 22.

The shape of the long-run supply reflects the mix of the firms with different technologies. For
prices below 21, the supply is zero. As the price reaches the level of $21 (minAC), the local
farmers (those with the better technology) enter the market, while the marginal firms (the
farmers outside the island) are outside the market. Each local farmer is indifferent between
producing q* = 10 and not producing at all. Thus the long-run supply is, at p = 21, any number
between 0 and 50*q* = 500. (Once again, we should draw 51 points, but as already explained we
draw a line for the sake of simplicity).
Consider prices in the range 21< p < 22. In this price range, the price is below the minimum
average cost of the marginal firms, and therefore they are still out of the market. However, the
price is above the minimum average cost of the farmers on the island. Thus, they profit maximize
by staying on their short-run supply curve. Since there are 50 farmers in the island, the long-run
industry supply in the price range 21<p<22 is
S = 25(p-1)
Finally, when the price is equal to the minimum average cost of the marginal firms, i.e., 22, these
firms are indifferent between producing 10 tons and not producing at all.
By substituting 22 into the previous equation we know that the farmers in the island produce 525
tons. Thus the long-run supply curve at 22 is any number greater than or equal to 525.

Given the above information you should be able to draw the industry long-run supply curve.

II) Long-Run Equilibrium and Number of Farmers

As usual, the long-run position of the market is going to be determined by the intersection of the
demand curve with the long-run supply curve. If the demand curve is
D = 12,205 – 100p, then at p = 22 the island’s consumers wish to buy 10,005 tons of oranges.
This number exceeds the domestic production which is equal, at p = 22, to 525. The farmers
outside the island supply, therefore, 9,480 tons, serving this excess demand. Since each outside
farmer is operating at its minimum average cost and is producing 10 tons, there are 948 outside
farmers.
Each inside farmer is producing 10.5 tons of oranges. Although it’s a long-run equilibrium they
make economic profits:
The insider’s profits = (22*10.5) - C(10.5) = 231-100-10.5-10.52 = 231-220.75 = 10.25.

The transportation costs act as an “entry” barrier protecting (generating) the profits of the
insiders.
If the demand curve is:
D = 10,900 - 500p,
at p = 21, the island’s consumers wish to buy 400 tons of oranges. This number is below the
maximum number of oranges supplied by the island farmers at their minAC. Thus, there will be
room for just a fraction of them. Since each inside farmer produces 10 tons, 400/10 = 40 of them
will be present in the market, while the remaining 10 are out of it.

V. Long-run effects of cost changes. (Time permitting)

The study of the long-run effects of cost changes is virtually identical to its short-run counterpart.
Therefore, we can be very short. There is an important difference in the long-run transmission
35
mechanism that it is simple, but worth mentioning. Any change that affects the minLAC is going
to be entirely translated into long-run equilibrium price. It is irrelevant whether the change
affects marginal or fixed cost as far as it changes the minLAC. However, while the difference is
immaterial as far as the long-run equilibrium price is concerned, it may produce very different
adjustment processes. This point is left out.

In the picture below we look at an example of a cost shock and its effect on long-run
equilibrium. For some reason, the marginal cost of production is increased by $1 at each
conceivable output level, thereby creating an increase of $1 in the minLAC or, equivalently, a
parallel upward shift of $1 in long-run supply curve. At the new long-run equilibrium, aggregate
output has decreased. Since the minLAC is achieved at the same level of individual output, the
number of firms in the industry has declined. Quite obviously, the burden of the cost increase is
suffered in the long-run entirely by the industry buyers.

P
Long Run Supply, increased MC

S2LR

S1LR

Q
Q2 Q1

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