*- 'nll-' uni-I'v- 'p---uI--'II Reread pp. 247253 in the Browning and Zupan reading on long run supply and m Consider a highly competitive market where the firms all face the same costs. They start in long run equilibrium with 1000 firms, a price of $10 for the good, and each firm production 100 units. Using graphs and sentences, trace the effects of an unanticipated reduction in demand for a constantcost industry in both the short and long run. Describe the effects for the market price, output produced by each firm, market quantity, profits, and the number of firms in the short run, and then describe the effects in the long run. Feel free to make up additional numbers you may need to illustrate the example (Just make sure the numbers move in the right direction). Make sure that you write complete sentences in describing the changes. The assignment is worth 20 points as part of your homework assignments grade. There are 10 outcomes and each one is worth two points, of which 1 is based on the correct direction of change and 1 is based on the quality of your graphs and written descriptions. Draw 2 graphs here side by side with individual firm's graph on the left and the market graph on the right: Write your answers about the outcomes in full sentences. Example, output rises from X to Y using the numbers you put on the graph. Describe the effects for the market price, output produced by each firm, market quantity, profits, and the number of firms in the short run, and then describe the effects in the long run. 1. Market price in the short run. 2. Output produced by each firm in the short run. 3. Prot earned by each rm in the short run. 4. Market Quantity in the short run. 5. Number of firms in the short run. 6. Market price in the long run. 7. Output produced by each firm in the long run. 8. Profit earned by each firm in the long run. 9. Market Quantity in the long run. 10. Number of firms in the long run.t, _-. 247 that Mensa has some especially productive input that Densa does not have. For example, suppose that Mensa and Densa both purchase ofce space to begin their operations. Through foresight or chance, Mensa's selected ofce site proves to be more favorable. Sup pose that government policymakers unexpectedly encourage businesses to set up shop in Mensa's vicinity while locating a nuclear waste dump adjacent to Densa, thereby scaring off potential corporate neighbors. Because of the government actions, Mensa's location is more productive, even though both rms originally may have paid the same price for the ofce space. The better location accounts for Mensa's lower production cost. Due to the unexpectedly productive location, Mensa's income statement will indicate a positive accounting prot. The original price Mensa paid for the space understates its real economic value; that is, the cost of using the space is greater than its purchase price. Re member, however, that cost reects forgone opportunities, and once it is known that Mensa's location is highly productive, its market valuewhat other rms would pay for the spacewill rise. Provided that input markets are perfectly competitive, the opportunity cost to Mensa of its ofce space will be hid up to reect its full economic value. Once Mensa's of ce space is valued at its true opportunity cost, Mensa's economic prot falls to zero. In this analysis it makes no difference whether Mensa rents or owns the ofce space. If Mensa rents the space, and it becomes apparent that the space is unusually productive, the rental cost will go up because other rms will be willing to pay more for highly productive of, ce space. If Mensa owns the ofce space, the same principle applies; the original purchase price is irrelevant. What counts is how much the ofce space is worth to other potential usersthat is, its opportunity cost. In this case the cost of using the ofce space is an implicit cost. and, as explained in an earlier chapter, we include implicit costs in the cost curves. The process by which unusually productive inputs receive higher compensation is not re- stricted to ofce space. Suppose that you go to work for a business as a manager and are promised a salary of $40,000. When the rm hires you, it doesn't know whether you'll be any good at your job. Fortunately, you turn out to be brilliant, and even after paying your salary, the rm's net revenue rises by $25,000 due to your extraordinary managerial skills. The rm's owner is delighted, and the rm's hooks show a $25,000 prot increase. Once your managerial skills are recognized, however, you are in a position to command and re' ceive a $25,000 raise, which will effectively eliminate the rm's accounting prot. You will be in such a position so long as your managerial skills are transferable across rms and there is a competitive market for your managerial talents. Provided these conditions hold, if you don't get a raise, you can resign and accept a position with another rm that will pay you a salary closer to what you're worthyour best alternativeand your former employer's prot will decline to its original level. Needless to say, this process doesn't work instantaneously or with exact precision. There is a tendency, however, for inputs to receive compensation equal to their opportunity costs, that is, what they are worth to alternative users. This process leads to the zero-prot equilib- rium. One implication of this analysis is that the accounting measure of prot may vary widely among rms in an industry even though economic prot is zero for each rm. This variation arises because a rm's assets are frequently valued on the books at their original purchase prices instead of their opportunity was. In our earlier example, Mensa's account ing prot would be higher than Densa's if they both counted only the purchase price of the ofce space as a cost. 1 THE LONG-RUN INDUSTRY SUPPLY CURVE To derive the competitive industry's shortrun supply curve we horizontally sum individual rms' supply curves. We cannot similarly derive a competitive industry's long'run supply curve. however, because in the long run rms enter or exit the industry in response to the 248 CHM '1 i-' Ni\"\"' { LONG-RUN INDUSTRY SU PPLY CURVE the long'run relationship between price and industry output, which depends on whether input prices are constant, increasing, or decreasing as the industry expands or contracts CONSTANT-COST INDUSTRY an industry in which expansion of output does not bid up input prices, longrun average production cost per unit remains unchanged, and the longrun industry supply curve is horizontal INCREASING-COST INDUSTRY an industry in which expansion of output leads to higher longlrun average production costs and the longrun supply curve slopes upward DECREASING-COST INDUSTRY a highly unusual situation in which the long-run supply curve is downward sloping A r . P writ MMi at '. i ; i, C ,,_\\ economic prots being earned. So we do not know which rms' supply curves to sum hori- zontally. Moreover, as an industry expands or contracts due to rm entry or exit, the priceS that rms pay for their inputs may change. For example. as the movie business expands due to rm entry, the prices of actors and directors may be hid up. As the oil producing indusn-y shrinks due to rm exit, the prices of petroleum engineers and drilling rigs may decline. As we will see, the derivation of a longrun industry supply curve in a competitive mar- ket depends centrally on what happens to input prices as the industry expands or contracts, Based on the three possible effects of industry size on input prices, competitive industries are classied as constantcost, increasingrcost, or decreasingvcost. We address each of these cases in turn, starting with the simplest of the three: when input prices remain constant re- gardless of an industry's overall size. ConstantCost Industry To derive the longrun supply curve for a ConstantICost industry, we start from a position of equilibrium and trace the effects of a demand change until the industry once again returns to a longarun equilibrium. As our example, let's assume that the market for MBA education is perfectly competitive, with business schools being the representative rms. We begin by examining the industry when it is in longrun equilibrium (say in 1970). Figure 9.11b shows the industry's initial longrun equilibrium: when demand is D, outpm is Q], and price is P. Assuming that we start in longrrun equilibrium, point A is then one point on the longvrun supply curve, LS. Figure 9.11a shows the representative rm's posi tionsay that ofNew York University (NYU). It is producing its most protable output, q,, and making zero economic prot at price P. To identify other points on the long~run supply curve, let's imagine that there is an unexr pected increase in demand to D' and work through the consequences for the industry De- mand for MBA education has grown over the past three decades for a number of reasons, including more women joining the work force and seeking a business education, worldwide economic growth and entrepreneurship (while domestic applications to US. MBA pro- grams have increased slightly in recent years, international applications have boomed), and the evervadvancing state of business management knowledge. Reflecting the increased demand, existing business schools have an immediate shortrun responsethey increase output by expanding operations in their existing plants and in- creasing employment of variable inputs such as faculty and staff. The response appears as a movement along the shortrun industry supply curve, 33, from point A to point B. (Note that the initial longrun equilibrium is also a shorttun equilibrium. Every school is operat' ing its existing plant at the appropriate levelwhere SMC equals Pso point A is also a point on the shortrun supply curve.) In the short run, price rises to P', and output increases rm 0. QC flan ihrilncfrv Dvnanr'lc alnnry QC "" "L '1' "" '-""""-l "_l' m--"" \"-"-'D "V In Figure 9.11a, we can see what this adjustment means for NYU, a representative rm in the industry. The higher price induces NYU to increase output along its short-run marginal cost curve SMC and produce q: where SMC = P'. (Recall that the summation of all the schools' SMC curves yields the SS curve.) At this point every business school is making an economic prot (equal to area P'EFG). The industry, however, has not fully adjusted to the increase in demand; this position is only a shortrun equilibrium. The key to the long'mn adjustment is prot'seeking by rms. In the short'run equilibrium, existing schools are making economic prots. The return on in' vestment in the MBA education market is now greater than in other industries. Whenever economic prots exist in an industry, investors will realize that they can make more money by moving resources into the industry. If entry is costless, as it is assumed to be in the case of perfect competition, resources will be shifted into the MBA education market, thereby in' creasing its productive capacity. Dollars per unit c2 Long-Run Supply in a Constant-Cost Industry The long-run industry supply curve L5 of a constant-cost competitive industry is horizontal. Expansion of industry output does not bid up input prices. Thus, when industry output expands from {.21 to 03, firms' cost curves do not shift and the long-run average production cost per unit remains unchanged. NYU Business School Dollars MBA Market per unit PI 'll q: Output 0 Ql Q: Q; Output Suppose that new schools enter the industry in an attempt to share in the market's prof itability. The entry increases the industry's total output. which, in Figure 9.11b. is shown as a rightward shift in the shortrun supply curve. Recall that a shortrun supply curve repre- sents a fixed number of schools with given plants. When the number of rms increases. the total output at each price is greater (there are more \"member" rms with their corresponding MC curves in the industry "cluh")-implying a shift in the shortrtun supply curve. As out- put expands in response to entry, price falls from its shortlrun level along D' since the higher output can he sold only at a lower price. This process of rms entering. total output increasing, and price falling continues so long as the industry is generating a positive eco- nomic prot signal. In other words. a new long'run equilibrium emerges when schools are once again making only a \"normal profit\"that is. zero economic prot. For a constant-cost industry the increased employment of inputs associated with expand' ing output occurs without an increase in the price of individual inputs. This means business school cost curves do not shift. Thus, price must fall back to its original level before prots return to a normal level: if price is higher than P economic prots will persist. and entry of new schools will continue. Figure 9.1 1b shows the process of entry as a rightward shift in 33; it continues until 33' intersects the demand curve D' at point C and price has returned to its original level P. Point C is a seCond point on the long-run supply curve LS. With demand curve D'. in dustry output expands until it reaches Q; and price is P. Each school once again makes zero economic prot. In Figure 9.1 la, NYU is again confronted with price P and can do no better than cover its average cost by producing ch. The increase in industry output from QI to Q; is the result HF entry by new Schools. 250 . rm. ~ \\1 'rl'1":"|l1[""i': twirl-'5' . a, ,.______.___________________ _ _ ______._____. _ __ _ ______ A constant'cost competitive industry is characterized by a horizontal long-rim supply came. Given time to adjust, the industry can expand with no increase in price along L3. The Cl'u' ciai assumption producing this result is that input prices are not affected by an industry's size, so new schools can enter the market and produce at the same average cost as existing schools. The term constant cost refers to the fact that schools" cost curves do not shift as the industry expands or contracts; it does not mean that each school in the industry has a hori- :ontal LAC curve. increasingiCost Industry We can derive the longrun supply curve for an increasing-cost industry in the same way We derived it for a constant'cost industry. We assume an initial long-run equilibrium; then the demand curve shifts, and we follow the adjustment process through to its conclusion. Figure 9.12 illustrates this case. The initial industry long-run equilibrium price and quantity are P and (2., respectively. The typical rm, NYU, is producing up and just covering its costs, shown by LAC, at the market price. Once again, we assume an unexpected demand increase to D'. The shortrun equilibrium is determined by the intersection of the short-run supply curve 55 and D'. Price rises to P'' and output increases to Q3. The representative school expands output along its SMC curve to q2 and realizes economic prot. In the long run, the prot attracts resources to the industry. Up to this point the analysis is identical to the constantcost case. Moreover, the attain- ment of a new longvrun equilibrium involves further expansion of industry output until eco. nomic prots return to zero, just as in a constantcost industry. However, in an increasing- cost industry the expansion of output leads to an increase in some input prices. To produce more output, schools must increase their demand for inputs, and some inputs such as nance Long-Run Supply in an Increasing-Cost Industry For an increasing-cost competitive industry, the long-run supply curve LS slopes upward. Expansion of industry output bids up some input prices. Thus, when industry output expands from Q, to 03, firms' cost curves shift upward from LAC to MC and SMC to SMC', and the output expansion leads to a higher long-run average production cost. Dollars NYU Business School Dollars MBA Market per unit per unit 53 SMC' SMC P' MR = AR P' LAC' LAC P" P" G MR" = AR" P P 0 q] q: Output 0 LD' : 1.. 2- - 25' professors are assumed to be available in larger quantities only at higher prices. This situa- tion contrasts sharply with that of the constant-Cost case, where schools can hire larger quantities of all inputs without affecting their prices. Let's see how this difference affects the iongrun adjustment process. At the shortrun equilibrium, positive economic prots liad to entry by new schools and an expansion in in dustry outputa rightward shift in the short-run supply curve. Increased industry output now tends to reduce prots in two ways. First. as we saw earlier. the higher output causes price to fall. which reduces prots. Second. the increased demand for inputs that accompa nies the expansion in industry output leads to higher input prices. Higher input prices mean higher production costs. which also reduce prots. Profits are thus caught in a two'way squeeze as the industry expands. The two-way squeeze continues until economic prots equal zero and a new longorun equilibrium is attained. Figure 9.12 shows the two-way squeeze on economic profits. Starting with the short- run equilibrium at point B (panel b). as new schools enter the market, SS shifts to the right and price falls. Each school's horizontal demand curve shifts downward as price de clines from i" to P", and this decline reduces profits. At the same time. higher input prices shift the firms' cost curves upward, from LAC to LAC' and LMC to LMC'. ln Figure 9.1221. NYU's profit (area P'EFG) is squeezed from above by the decline in the product price and from below by the rising unit cost of production. A rising cost and falling price eventually eliminate NYU's economic profit. This occurs at price P". when NYU can just cover its average cost by producing at the minimum point on LAC'. Once profit is elimi nated. there is no longer an incentive for industry output to increase further. and a new longarun equilibrium is reached. In Figure 9.12b, SS has shifted rightward to SS'. produc ing a price of P\" and an output of OJ. No further shift in the short-run supply curve will occur, because economic profits have fallen to zero. Thus, point C is another point on the long-run industry supply curve. Ari increasingcost competitive industry is characterized by an upward-sloping long-run supply curve. This industry can produce an increased output only if it receives a higher price. be cause the cost of production rises (cost curves shift upward) as the industry expands. The term increasing cost indicates that the cost curves of all schools shift upward as the industry expands and input prices are bid up. Decreasing-Cost Industry A decreasingcost competitive industry is one that has a downwardvsloping longrun supply curve. You might think that such a situation is impossible, and, in fact, some economists be lieve that it is. Others claim that a decreasing-cost industry is theoretically conceivable but admit that it is a remote possibility. Because all agree that it is, at best, highly unusual, we will deal with it only briefly here. A decreasingcost industry adjusts to an increase in demand by expanding output, just as industries in the other two cases. In this instance, though, the expansion of output by the industry in some way lowers the cost curves of the individual schools, leading to a new long run equilibrium with a higher output but a lower price. The tricky part is to try to explain why the Cost curves shift downward. A downward shift in cost curves usually reflects a de crease in input prices, but for that to happen we have to explain how an increase in demand for some input leads to an increased quantity supplied at a lower pricenot an easy task. Although economists are in agreement about how rare decreasingcost industries must be, many noneconomists nd the concept appealing. The reason for its appeal stems from the observation that prices have declined sharply as output has expanded in some industries. For example, color televisions, VCRs, and pocket calculators have all fallen in price in real terms by 80 to 90 percent since they were rst introduced. More recently. there have been dramatic reductions in personal computer prices. 252 - - FIGURE 9.13l Technological Advances Shift the Long-Run Supply Curve A price reduction and output increase over time need not imply that the long~run supply curve has a negative slope. Technological advances can occur $300 over time, which shift the entire long-run supply curve downward, producing lower prices and higher outputs. Before concluding that such evidence reects decreasingcost industries, we should Ex- plore some other possibilities. One common feature in these examples is that the price Was high when the product was rst marketed but later fell dramatically. This suggests two possi ble explanations. First, the rm initially marketing the product is a monopoly and thus has some pricing power. The price that the monopoly rm sets may be fairly high. As other firms enter the market and begin to compete, price falls and output increases. This process sug. gests that what we may be seeing is the rise of competition from an initial monopoly posi. tion and not a movement along an industry's longvrun supply curve. Second, the passage of time after a product's introduction makes technological imprOVe. ments in production possible. Particularly in the case of new and complex products, techno. logical know-how is frequently rudimentary when rms first market a product. With experience in production over time, technological improvements may occur quickly. We emphasize that technological knowhow is assumed to be unchanged along a supply curve. An improvement in technology shifts the entire supply curve to the right. Consider Figure 9.13. In conjunction with demand, the long-run supply curve fer pocket calculators in 1970, L570, determined a price of $300. This price was, in fact, the approximate price of a calculator that performed only the basic functionswhen ex pressed in constant 1990 dollars. After 10 years firms developed methods that lowered production cost, and the 1980 longtun supply curve was 1.330. We assume that demand is unchanged, although it was probably increasing over the period. This shift in supply led to a price of $100 in 1980. Further technological improvements shifted the supply curve once again, and price fell to $10 in 1990. The combination of lower prices and higher out puts over time resulted here from shifts in an upwardsloping longrun supply curve, not from a slide down the negativelysloped supply curve of a decreasingcost industry. This explanation of the phenomenon is especially appealing because new high-technology items are known to show rapid improvements in technical knowledge in the first years of their production. Dollars per unit $100 0 Q. Q; Q; Quantity of pocket CillClllilltWh 253 These remarks do not rule out the possibility of decreasingcost industries, but if they exist, like the Giffen good case in demand theory, they are extremely rare. For all practical purposes the increasing and constant'cost cases are the relevant possibilities. APPLICATION 9,6 ach year, the country's 700'plus business schools pro, duce a total of 80,000 MBA5.7 The number of busi ness schools has more than doubled and the number of MBA graduates per year has increased 15fold since 1970. As the industry has expanded, certain inputs have been bid up in price. Among the inputs that have been bid up most in price are faculty in disciplines such as manage ment information systems (M18) and nance, in which student enrollments have witnessed the largest increases. For example, top new nance assistant professors garnered starting salaries of more than $145,000 in 200252 per; cent higher than in [997. Leading rookie MIS faculty members were eaming $130,000 in 200253 percent more than in 1997. Annual salaries for the most respected senior faculty members in both elds rose from roughly $120,000 in the mid-1980s to well over $300,000 by 2002. Of course, as the business school market has ex- panded, not all inputs have risen in price. Some have remained constant or perhaps even decreased. For lThis application is based on AACSB Newsline, Vol. 30 No. 3 (2000), pp. 15. THE BIDDING WAR FOR MIS AND FINANCE PROFESSORS example, schools' applicant screening costs have been reduced due to widespread reliance on the Graduate Management Admissions Test (GMAT) as a candidate screening mechanism. On average, however, real input prices have in creased since the 1960s. This suggests that the long-run supply curve in the MBA education market is upward- sloping and provides at least a partial explanation for the rise in annual tuition at private business schools.8 For example, annual MBA tuition at USC, a representa tive private business school, rose from $1,950 in 1970 to $35,000 in 2002. The 2002 annual USC MBA tuition equals roughly $7,550 in constant 1970 dollars. Al though other factors (such as increased reliance by uni- versities on their business schools to generate an operating surplus) have certainly affected MBA tuition, the growth of the MBA industry and the attendant in creases in demand for industry inputs and the (real) prices of those inputs surely also played a role. aTuition at public business schools is generally controlled and subsi- dized by the state. Comments on the LongeRun Supply Curve An industry's long-run supply curve summarizes the results of a complex and subtle process of adjustment. Once the underlying determinants of the supply curve are understood, it he comes a powerful tool of analysis. To use the supply curve correctly, however, we must have a rm understanding of its underpinnings. To that end, we discuss several frequently misun derstood points. 'I. We do not derive the long-run supply curve by summing the long-run marginal cost curves of an industry's rms. Admittedly, every rm is producing where LMC = P at each point on L3, but as the industry adjusts along LS, rms are entering or leaving the market. Therefore. we cannot sum rms' LMC curves as we did in the short run. In addition, for an increasingcost industry the LMC curves themselves shift because of changes in input prices. 2. Just as we did with a demand curve. we assume certain things remain unchanged at all points on the longrun supply curve. For one we assume technology is constant. An industry expanding along its LS curve is using the same technical know-how but employing more inputs to increase output. A change in technology causes the entire supply curve to shift, as we saw in the example about pocket calculators discussed earlier. We also assume that at all points on the long'run supply curve the supply curves of inputs to the industry remain unchanged. Note that we are not assuming that the prices of inputs are unchanged but rather that the conditions of supply remain constant. in a constantcost industry, input prices remain constant not because we assume them to he xed but because the input supply curves facing the industry are horizontal. In contrast, in an increasing'cost industry input prices change because the input supply curves facing the industry are upward'sloping, a condition that gives rise to an upward-sloping, long-run industry supply curve. When relevant, other factors like government regulations or the weather must also be assumed constant along the supply curve. 3. In reality, an industry is not likely to fully attain a position of Iong'run equilibrium. Realworld industries are continually buffeted by changes. For instance, input supplies, demand, technology, and government regulations frequently change. A longrun adjustment takes time, and if underlying conditions change often, an industry will nd itself moving toward a longrun equilibrium that is continually shifting. Recognizing the reality of frequent change, however, does not undermine the usefulness of the long'run equilibrium concept. Although the industry may never attain a long-run equilibrium, the tendency for the industry to move in the indicated direction is what is important. and the outcome is correctly predicted by the theory. 4. Economic prot is zero all along a competitive industry's longrun supply curve. This point is often misunderstood. For example, someone may say that when industry output expands due to an increase in demand. the industry's rms benet. We have seen, however, that after an increase in demand, all rms will make zero economic prots in the long run. There may be temporary economic prots in the short run, but the benet is not permanent. Who does benet as we move along the long-run supply curve? Owners of inputs whose prices are bid up by the industrvaide expansion. With a constanttcost industry no input prices rise. and no input owners receive a permanent gain. if rms own some of the inputs and thus gain as input prices increase, the gain accrues to them on account of their input ownership and not because they are rms in an increasingcost industry. It is also possible that rms own none of the inputs whose prices rise. It may be, for example, that nance professors whose wages go up as the MBA industry expands are the sole beneciaries on this market's supply side. The tendency toward zero economic prot means that the rate of return on invested resources will tend to equalize across industries. If invested resources yield an annual return of 10 percent in the restaurant industry, which is comparable to earnings elsewhere, then the restaurant industry is earning zero economic prot. Accountants, of course, generally call the 10 percent return a \"prot,\" but economists regard the 10 percent return as a cost necessary to attract resources to the restaurant industry. 5. In deriving the longrun supply curve, we assumed that a short-run equilibrium was rst established and then long-run forces came into play. Price rst went up to a short-run high and then came down to a longrun equilibrium level. The actual process of adjustment to demand Changes may not follow this pattern exactly. ldentifying a shortrun equilibrium and then tracing out long'run effects is merely an expedient way of explaining the determination of the nal equilibrium. In fact, following a demand increase, price may never reach its short-run level and may never go above the ultimate longvrun level. This can happen if, for example, rms anticipate the demand increase and make adjustments before demand actually rises