Long run supply when industry costs are increasing or decreasing | Microeconomics | Khan Academy

What we have here we can view as the long run equilibrium or long run steady state for a perfectly competitive market. Let's say this is the market for apples and it was this idealized perfectly competitive situation where we have many firms producing. They are non-differentiated; they have the same cost structure. There's no barriers to entry or exit.

On the left, you can see that this equilibrium price, which is set by the intersection of the supply and demand curves, that’s just going to be the price that the firms have to take. We've talked about that at length in other videos. That's going to define the firm's marginal revenue, not just this firm, but all of the participants in the market.

In other videos, we've talked about the fact that the rational quantity for this firm to produce would be where marginal revenue intersects marginal cost. It's also going to be the point where you have zero economic profit. At that quantity, let's say the quantity for the firm, your average total cost is equal to your marginal revenue.

If marginal revenue were higher than average total cost at this quantity, well, then you would have other entrants into the market because you're having positive economic profit. If marginal revenue is below average total cost at that quantity, well, then firms are running economic losses, and you will have people exiting the industry.

Either of those situations would get us back to an equilibrium state that looks something like this. But now let's imagine a shock to the market. Somehow, let's say a new research study comes out that says that the apples that this market produces, that it's incredibly good for you; it’ll make you live longer, it’ll make you happier, it’ll make you have more friends.

Well, then the demand for apples goes up, and so you have a new demand curve that looks something like this: D prime. Well, in that situation, what's going to happen? Well, now you have a new equilibrium price. You also have a new equilibrium quantity over here. Let's call that P prime. This is going to define a new marginal revenue curve for the participants in the industry, so M marginal revenue prime.

Now, all of a sudden, the rational quantity for them to produce would be out here, at least for this firm, to produce. So Q prime for this firm is out here, and you notice at that quantity it is making economic profit.

For every unit, it gets that much; it costs that much on average for every unit. So it's making that much per unit, and then you multiply that times the number of units of the quantity. This whole area is going to be the economic profit that this firm is getting, and it's likely that all of the firms or most of the firms in this perfectly competitive market are going to be getting it because they all have the same cost structure.

But as we've said before, when you have this positive economic profit, and there's no barriers to entry in the long run, more firms will enter because there's economic profit to be had. In previous videos, we talked about a situation where, as firms enter into a market or exit the market, it doesn't change the cost structures of the individual firms.

But let's imagine for a second that because of everyone entering into this market that seems to have economic profit for the firms that are participating in it, some of the inputs of say growing apples, which is what these firms do, start to go up in cost. So we're not talking about a constant cost perfectly competitive market now; we're not talking about an increasing cost perfectly competitive market.

Well, then firm A and every firm's cost structure is going to change. Because as more firms come in, you're going to have to pay more for maybe apple seeds, pay more for maybe pesticides or wax, or maybe pay more for land on which to grow them. So you would have a different marginal cost curve. Maybe the marginal cost curve now looks like this: marginal cost curve prime.

You would also have a new average total cost curve. Maybe it looks something like this: average total cost prime. So you can imagine that firms will jump into the market in order to capture or think that they might be able to get some economic profit, but they will only do so until the economic profit for all the firms goes to zero.

So what point will the economic profit go to zero? Well, that’s when the marginal revenue for the firms is equal to our marginal cost, which is equal to our average total cost. So it’s that point right over there.

So we would get to this point right over here; let’s call that marginal revenue prime. More and more firms would enter into the market up until the point that the equilibrium price gets us to P prime. The supply would increase, those folks want to get that economic profit, but it would increase until this point.

So it’d shift a little bit to the right, and we would get to S prime. As you can see based on this, we can now start to imagine a long-run supply curve in this increasing cost perfectly competitive market. We were over here; that was our equilibrium point before. Now we are over here, and so our long-run supply curve in this increasing cost environment, even though it's perfectly competitive, might look something like this.

So in a constant cost world, this was a flat line. Now in an increasing cost world, as more and more people enter the market, the cost structure, the inputs into producing an apple, go up. Now, long-run supply is that. Remember, the long run is enough time to go by for people to enter and exit the market, or enough time to go by so fixed costs aren't fixed anymore; that they can be shed or that they could be increased.

Now, you could do another thought exercise. Let’s say we’re dealing with a market where the more people that enter the market the inputs actually get cheaper. If that seems hard to believe, you can imagine, well, now people are able to produce seeds or wax at a new scale, so the inputs actually get cheaper.

Well, then you would see the opposite thing. Then you would see that as more entrants enter the market, this cost structure goes down, and so the supply can increase more and more and more to the point that the equilibrium price is now lower than it was before. Then you would have a downward-sloping long-run supply curve.