THE LONE-RUN INDUSTWV SUPPLVCLIHVE 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 govemment 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 bid 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 mrs will be willing to pay more for highly productive of ce space. If Mema 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 325.000 due to your extraordinary managerial skills. The rm's owner is delighted. and the rrn's books show 3 325.000 prot increase. Once your managerial skills are recognized. however, you are in a position to command and re ceive a 325.000 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 altemativeand 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 terovprofrt 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 costs. 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. THE LONG-RUN INDUSTRV SUPPLY CURVE To derive the competitive industry's shortrun supply curve we horizontally sum individual rrns' supply curves. We cannot similarly derive a competitive industry's longrun supply curve. however. because in the long run rms enter or exit the industry in response to the 248 CHAPTER NiNE . PROFIT Maxxmzariow iN PERFECILV COMPETITWE MARKETS . $ Lona-nun INDUSTRY suvav email: the longntn relationship between price and industry output. which depends on whether input prices are Constant. increasing. or decreasing as the industry expands or Conch CONSTANT-COST runusrnv an industry in which expansion of output does not bid up input prices. longrun average production cost per unit remains unchanged. and the lungmn industry supply curve is horizontal INCREASING-COST m nus'rnv an industry in which expansion of output leads to higher long-run average production costs and the longrun supply curve slopes upward DEREASING-COST m nusrnv a highly unusual situation in which the longrun supply curve is downward- sloping economic prots being earned. So we do not know which rms' supply curves to sum hop], zontally. Moreover. as an industry expands or contracts due to rm entry or exit. the pric\" that rms pay for their inpuLs may change. For example, as the movie business expands due to rm entry. the prices of actors and directors may be bid up. As the oil producing indusrw 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 m. ket depends centrally on what happens to input prices as the industry expands or contracu' Based on the three possible effects of industry size on input prices. competitive industries are classied as constantvcost. increasingecost. 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. Constant-Cost Industry To derive the longrun supply curve for a constantcost industry. we start from a position of equilibrium and trace the effects of a demand change until the industry once again return; to a long-run 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 9.1 lb shows the industry's initial longrun equilibrium: when demand is D. output is Q,. and price is P. Assuming that we start in longrun equilibrium. point A is then one point on the longrun supply curve. LS. Figure 9.11a shows the representative nn's posi- tionsay that of New York University (NYU). It is producing its most protable output. r- and making zero economic prot at price I'. To identify other points on the longmn supply curve. let's imagine that there is an unex- 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 U.S. MBA pro grams have increased slightly in recent years. international applications have boomed). and the everadvancing state of business management knowledge. Reecting the increased demand. existing business schools have an immediate shottvmn 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 short'run industry supply curve. $3. from point A to point B. (Note that the initial long-mn equilibrium is also a shortrun equilibrium. Every school is operat- ing its existing plant at the appropriate levelwhere SMC equals Pso point A is also a point on the short-run supply curve.) ln the short run. price rises to P'. and output increases to Q; as the industry expands along SS. In Figure 9.11a, we can see what this adj ustmenr means for NYU. a representative firm in the industry. The higher price induces NYU to increase output along its shortrun 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 rhe bngaun adjustment is protseeking by firms. In the shortmo equilibrium. existing schools are making economic prots. The retum on in' vestment in the MBA education market is now greater than in other industries. Whenever economic pros exist in an industry. investors will realize that they can make more moneyY by moving resources into the industry. If entry is costless. as it is assumed to be in the case 0' perfect competition. resources will be shifted into the MBA education market, thereby in' creasing its productive capacity. . THF LONGRUN INDUSTRY SUPPLY Cums 249 FIGURE 9 11 Dollars per Ilml lung-Run Supply in a (sustain-Oust Industry The long-run industry supply curve LS of a constant-cost competitive indury is horizontal. Expansion of indumy output does not bid up input prices. Thus, when industry output expands from Q. to 0;. finns' cost curves do not shilt and the long-run average production cost per unit remains unchanged. MBA Market NYU Business School Dollars per unit q. q, Outrul o 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 short'run supply curve repre' sents a xed 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 \"club\")implying a shift in the shortrun supply curve. As out put expands in response to entry, price falls from its short'run level along D' since the higher output can be 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 longrun equilibrium emerges when schools are once again making only a \"normal prot\"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 9.11!) shows the process of entry as a rightward shift in 35; it continues until 88' 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 longrun supply curve LS. With demand curve D'. int dustry output expands until it reaches Q, and price is P. Each school once again makes zero economic prot. In Figure 91 la, NYU is again confronted with price P and can do no better than cover its average cost by producing 4,. The increase in industry output from Q. to Q, is the result of entry by new schools 250 CHAl'er Nth, . Przor'rr MAleliA'HON w Pr'm'rcnv Cum-virirwr MAIrKLl': . A constant'wst competitive industry is characterized by a horizontal longrun supply time. Given time to adjust, the industry can expand with no increase in price along LS. The cru. cial 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 existi 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. zontal LAC curve. Increasing-Cost Industry We can derive the longmn 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 11' and just covering its costs, shown by LAC, at the market price. Once again, we assume an unexpected demand increase to D'. The short-run equilibrium is determined by the intersection of the shortrun supply curve SS and D'. Price rises to P', and output increases to Q2. The representative school expands output along its SMC curve to qz 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 attainr ment of a new longrun equilibrium involves further expansion of industry output until eco nomic prots return to zero, just as in a constant-cost 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 FIG U R; 9 I 2 ' Long-lull Supply in In Increasing-Co! Industry For an increasing-cost competitive industry. the longrun supply curve LS slopes upward. Expansion of industry output bids up some input prices. Thus. when industry output expands from Q. to 0,, firms' cost curves shift upward from LAC to LAC' and SMCto SMC', and the output expansion leads to a higher long-mu average production cost. Dollars NYU Business School per unit smc' smc p. E MR' - AR' LAC' LAC Po MR\" _ AR" p o q. q, Output (211 Dollars MBA Market per unit 33 l _ w er l\\.i:i~\\H-'v SUl'l'lVC'iirtl 251 professors are assumed to be available in larger quantities only at higher prices. This situa tion contrasts sharply with that of the constantcost case. where schools can hire larger quantities of all inputs without affecting their prices. Let's see how this difference affects the longrrun adjustment process. At the shortvrun equilibrium, positive economic prots lead to entry by new schools and an expansion in inr dustry outputa rightward shift in the short-run supply curve. Increased industry output now tends to reduce profits 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. Prots are thus caught in a twovway squeete as the industry expands. The two-way squeeze continues until economic prots equal zero and a new Iongvrun equilibrium is attained. Figure 9.12 shows the twoway 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 P' 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'. In Figure 9,12a, 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 I\". when NYU can just cover its average cost by producing at the mi mum point on LAC'. Once prot is elimi nated. there is no longer an incentive for industry output to increase further. and a new longrun equilibrium is reached. In Figure 9.12b, 33 has shifted rightward to SS', produc' ing a price of P" and an output of Q, 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. An increasingvcosl competitive industry is characterized by an upwardsloping longrim 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 decreasingcast competitive industry is one that has a downward-sloping long-run 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 decreasingcost 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 decreasing-cost 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 reects 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 decreasing-cost industries must be, many noneconomists find 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 first introduced. More recently, there have been dramatic reductions in personal computer prices. 252 CHAUVLP NW: . PRGHY MAXHMZATION m PFPFECYLV CUMFE'UTP.F MawkErj . FIGURE 9 i3 331:3, 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 dowmnard, producing lower prices and higher outputs. Before concluding th t such evidence reflecrs decreasingcost industries, we should ex- plore some other possib es. 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 firm sets may be fairly high. As other rms 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 long-run 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 knowhow is frequently rudimentary when firms 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 for 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 longrun supply curve was L530. 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 upward-sloping longrun supply curve, not from a slide down the negatively-sloped supply curve of a decreasingvcost industry. This explanation of the phenomenon is especially appealing because new hightechnology items are known to show rapid improvements in technical knowledge in the first years of their production. $100 Quantity of pocket calculators , Tm Lam. RUN leisva SUPPLY Curt! 253 These remarks do not rule out the possibility of decreasing-cost industries. but if they exist. like the Gien good case in demand theory. they are extremely rare. For all practical purposes the increasing and constantcost cases are the relevant possibilities. ach year. the country's 700-plus busine schools pro- duce a total of 80.000 MBAs.7 The number of busi schools has more than doubled and the number of A graduates per year has increased 15fold since 1970. 'As the industry has expanded. certain inputs have been hid up in price. Among the inputs that have been bid up laws! in price are faculty in disciplines such as manage- ment information systems (M15) and nance. in which student enrollments have witnessed the largest increases For example. top new nance assistant profesors garnered starting salaries of more than $145,000 in 200252 per- cent higher than in 1997. Leading rookie M15 faculty members were earning $130000 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-19805 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 'ms application is based on MCSB Newslt'ne. Vol. 30 No. 3 (2000). pp. |_s. THE BIDDING WAR FOR "IS 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 19605. 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 crors (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. 'Tuirion at public business Khmls is generally controlled and subti- dized by the sale. Comments on the Long-Run Supply Curve An industry's longmn supply curve summarizes the results of a complex and subtle process of adjustment. Once the underlying determinants of the supply curve are understood. it be 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 misunv derstood points. I. We do not derive the long-run supply curve by summing the longnrun marginal cost curves of an industry's rms. Admittedly. every rm is producing where LMC = P at each point on LS. 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 254 CHAPYFP Nixr e PROFH' MAxl'.t:ZAYlUN IN Pctwnmw Ctmvrrit .i: MARVEV'S . 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 longrun 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 be 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 upwardsloping. 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 longvrun equilibrium. Real-world industries are continually buffeted by changes. For instance. input supplies. demand. technology. and government regulations frequently change. A long'run 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 longrun supply curve? Owners of inputs whose prices are bid up by the industry-wide expansion. With a constant-cost industry no input prices rise. and no input owners receive a permanent gain. 1f 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 profesors 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. 1f 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 necesary to attract resources to the restaurant industry. 5. in deriving the longrun supply curve. we assumed that a shortrun equilibrium was rst established and then longrun forces came into play. Price rst went up to a shortrun high and then came down to a long-run equilibrium level. The actual process of adjustment to demand changes may not follow this pattern exactly. identifying 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 shortrun level and may never go above the ultimate long-run level. This can happen if. for example. rms anticipate the demand increase and make adjustments before demand actually rises. increasing-cost industry the LMC curves themselves shift because of changes in input prices. 1. 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 knowhow but employing more These remarks also suggest that care must be taken in using the short-run supply curve- The short-mn supply curve can be used to identify the initial effects of a change in de' Read pp. 247-253 in the Browning and Zupan reading on long run supply and demand attached. 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 constant-cost 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. Profit 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