Microeconomics Monday-Long Run Industry Supply

Long run industry supply is different than short run industry supply because of the differences in trade offs.  In the long run, firms can do just about anything.  In the long run, they might even be able to innovate substitutes to replace pieces of the supply chain that don’t exist today.

But most long run supply issues hinge on whether or not each firm’s costs are affected by the total size of the industry.

When industries grow larger, many input prices fall, or rise.  If there is competition for scarce inputs, prices will rise.  Examples of this might be land, people with specialized skills, Conversely, sometimes economies of scale cause prices to fall.  Examples of this might be computer chips, or machinery.  Robots once were enormously expensive but the cost of producing one has dropped over the years.  Technology costs drop according to Moore’s Law.  The cost for DNA research is dropping at a faster rate than technology costs.

If there are such effects, a firm’s cost curves rise and fall with contraction or expansion of the industry.  That means the minimum average cost curve is a function of industry size.   This is important to note when analyzing competing firms in an industry.  Competing firms will only be able to get their costs so low if the costs of the industry depend on scale.

In a constant cost industry, costs, including minimum average costs are not affected by overall industry size.  Their long run supply curves are horizontal at Price equaling minimum average costs (P=min AC).  The elasticity of supply is infinity.  This can be a reasonable base case for most industries, but note the implication for the long run price in such an industry.

In an increasing cost industry, costs including the min AC rise as the industry gets larger.  The long run supply  curve has a positive slope.  There is resource extraction.  Industries using high fraction of rare inputs.  Examples of this might be mining industries.

It is very difficult to come up with an example of decreasing cost industries.  Sometimes, industries start that way, but as the resource they use for decreasing costs gets used up, supply becomes constrained.  Even solar power, with the sun as a supply input doesn’t have decreasing costs.

Think about each of these different ideas and what outcome would occur.  What happens to quantity (Q) and Price (P) if fixed costs rise? (In the short run, nothing.  The firm loses profit.  In the long run, the cost is passed on to consumers in the form of higher prices, P goes up and Q goes down) If marginal costs rise?  (In the short run, nothing.  In the long run the firm will look for substitutes, innovate around the MC, or pass along the increase to consumers.  P might go up, and Q might go down)  What if the government imposes a $1 tax per unit sold on the firm?  (The tax gets passed along to the end consumer, and quantity used goes down)  What happens if government imposes a $1 tax per unit bought on the customer?  (The consumer purchases less, and Q goes down with increased P)

What if consumer income rises?  (Consumers will spend more, driving up price)  What if the price of a close substitute rises?  (Prices should go up)

Understanding long run industry supply and its effects is critical when analyzing any company.  Knowing how industry supply curves will change with growth or contraction in the industry will allow you to predict stock price action given your prediction.

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