Assume that the market demand shifts to the right due to an increase in consumers’ income (or to a change in the other determinants of market demand, e.g. increase in total population, etc.).
In the short run the supply curve is given. Price will rise (to P’ in figure 5.18) and the quantity supplied will increase (from Q to Q’ in figure 5.18) by an expansion of the production of the existing firms (from X to X’ in figure 5.19), which will be realizing excess profits at the higher market price (equal to the area ABCP’).
In the long run the excess profits made by the established firms will attract new firms into the industry. This influx of firms will shift the market supply to the right and will cause price to fall below the short-run equilibrium level (P). The new equilibrium price may remain above the original level, or it may return to the original level, depending on the size of the shift in the market supply, which reflects the cost conditions of the industry (the change in factor prices as the industry expands).
An industry is a constant-cost industry if the prices of factors of production employed by it remain constant as industry output expands. An industry is an increasing-cost industry if the prices of factors of production increase as the market expands. An industry is a decreasing-cost industry if the prices of factors of production decline as the market expands.
In figure 5.20 we show the case of long-run equilibrium of an industry which grows with constant costs. We start from an initial long-run equilibrium situation where the demand-curve price line of the firm is tangent to the long-run and the short-run average- total-cost curves at their minimum points. Assume that the market demand shifts from DD’ to D1D’1. In the short run price increases to P and the existing firms increase their output, operating their plant above full capacity.
The increased quantity is shown by a movement along the market supply SS’. This situation, however, cannot persist in the long run because the excess profits attract entry. The resulting increase in the demand of factors of production is assumed not to raise their price, so that the LAC curve does not shift upwards. The new firms will produce under the same LAC conditions as the already established firms.
Entry will continue until the new supply curve S1S1 intersects the shifted-demand curve at the initial price P. If the market continues to grow, the industry-demand curve will shift further to the right (D2D’2) and the whole process will repeat itself. New firms will enter in the industry and the supply curve will shift to the right until it cuts the new demand curve at the initial price. The long-run industry supply is a straight line (abc in figure 5.20) parallel to the quantity-axis at the initial price level.
An industry is said to be an increasing-cost industry if its long-run supply curve has a positive slope, indicating that the prices of factors increase as the industry output expands. The process of adjustment of the industry supply to the growing market demand under conditions of increasing costs is shown in figure 5.22. As the market demand shifts from its initial equilibrium DD’ to the new level D1D1 price will increase in the short run (to P1): an increase in the quantity supplied is forthcoming by existing firms working their plant beyond its optimal capacity. Excess profits will attract new firms in the industry. Now, however, we assume that the prices of factors increase as their demand expands.
The LAC of all firms (existing as well as new) shifts upwards, while the LMC shifts to the left with the increasing factor prices. This will tend to shift the industry supply to the left. However, at the same time, the quantity supplied increases as new firms enter the industry and thus the market supply will tend to shift to the right. The latter shift more than offsets the first, so that on balance the supply curve shifts outwards as price increases (otherwise the new firms would work by bidding away resources from the established firms, and industry output would be impossible to expand as required by the increase in the market price).
The shift of the supply curve will lead to a fall in price (as compared with the short-run level P1) if the increase in factor prices permits it. If, however, the increase in factor costs is substantial the new equilibrium price might stay at the short-run level despite the shift in supply. In any case the new market price will be higher than the original level and the long-run supply curve (e.g in figure 5.22) will be upwards-sloping. In an increasing-cost industry output can expand in the long run only at an increasing supply price.
An industry is said to be a decreasing-cost industry if its long-run supply curve has a negative slope, indicating that the prices of factors fall as the industry output expands. The process of adjustment of the industry supply to the expanding market demand is shown in figure 5.24. As the market demand shifts to the right (from D to D1) price increases in the short run and entry is attracted. The ensuing increased demand for factors encourages their suppliers to innovate or improve their skills, so that factor costs become in fact lower per unit of output.
In these circumstances we speak of external (to the industry and to the firm) economies (figure 5.24). The decline in factor prices shifts the cost curves of individual firms downward (figure 5.25). The industry supply shifts so far to the right that price in the long run falls below the initial level. The long-run supply curve is the line him in figure 5.24, which has a negative slope. This implies that if there are strong external economies the industry supply can expand in the long run at a decreasing price.