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Industry Supply summary
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- ECO204
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- University Of Toronto (U Of T )
Industry Supply summary
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ECO204Y-2022/23Industry Supply Summary
Industry supply is the horizontal sum of firm level supply curves (much as market
demand is the horizontal sum of individual level demand curves).
Short run equilibrium: In the short run, there are 3 possible outcomes for firms with
positive output at the equilibrium market price, 𝑝∗ . They are 1) positive economic profits
(𝑝∗ > 𝑆𝐴𝐶(𝑦)), 2) negative economic profits (𝑝∗ < 𝑆𝐴𝐶(𝑦) but 𝑝∗ > 𝑆𝐴𝑉𝐶(𝑦)) and 3)
zero economic profits. There is also the possibility that some firms set output to 0
because 𝑝∗ < 𝑆𝐴𝑉𝐶(𝑦).
Long run equilibrium: In the long run if profits are less than 0 firms can exit since all
inputs are variable. If profits are positive other (potential) firms should notice and there
will be entry. The entry and exit of firms will cause industry supply and thus the market
clearing price to shift around. The entry of firms, all else equal, will cause supply to shift
out, and the exit of firms will, all else equal, cause supply to shift in. This shifting of the
supply curve causes the equilibrium price to change. This process will end when the
price settles at a level where the market is at equilibrium: no firms have an incentive to
leave (profits less than 0) or to enter (profits greater than 0). Therefore we predict
(economic) profits in equilibrium will be 0.
In an industry where firms have identical costs, we expect this process to reach an
equilibrium when price equals the minimum of the average cost curve and thus profits
equal 0. In this case we argue that the long run supply curve is horizontal at the
minimum average cost. This is analogous to the supply curve of a single firm that faced
constant returns to scale. This relationship is not coincidental, as the entry of new firms
can effectively duplicate what firms already in the industry are doing.
Profits equal to 0 in the long run means all factors of production receive their market
return or price. It does not mean accounting profits are equal to 0.
If there are factors that are fixed in the long run (i.e., we are not really in the “long run”)
we can think of any positive profits as the return to the fixed factor. We call this return
an economic rent. Economic rents can accrue to fixed factors such as land or special
talents, or may be the result of public policy.
Economic rents may also arise if there is a barrier to entry to (or exit from) an industry.
The textbook discusses (and you should read) a number of cases where public policy
creates economic rents by restricting the entry of firms to an industry, and describes “rent
seeking behaviour” these policies induce.
The text presents a number of examples of economic rents.
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