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- Now that we understand a firm's cost
curves, and its entry and exit decisions,
we're able to show how supply curves are
actually derived from these more
fundamental considerations.
Let's take a closer look.
- The supply curve
is built upon firm
entry and exit decisions and the
effect of these decisions on industry
costs. And the key question is this, as
industry output increases, what happens to
costs? There are three possibilities.
First, an increase in cost industry. That
is industry costs increase with greater
output. Second, constant cost industry.
Industry costs are flat, they don't change
with greater or lesser output. And
finally a decreasing cost industry,
industry cost falls with greater output.
As we'll see, the first and second are
quite common, the third is quite uncommon,
but is nevertheless important and
interesting in order to understand
economic geography, which we'll come to a
bit later. Let's show how the industry
supply curve is derived from the entry and
exit and cost curves of individual firms.
We can do this for an increase in cost
industry very easily with just a two firm
example. Suppose that Firm 1 is a
producer of oil, where its oil is very
close to the surface, so it has a quite low
average cost curve. It's pretty cheap for
this firm to produce oil. On the other
hand, Firm 2 has a much higher average
cost curve because for Firm 2 it's
located in a part of the world where it
has to drill much deeper in order to get
the oil. Now, given these figures what's
the industry supply curve of oil if the
price of oil is below $17? Well, if the
price of oil is below $17, neither of
these firms can make a profit.
That's below the minimum point of the
average cost curve for both of these
firms. So neither of these firms is going
to want to be in the industry. So if the
price of oil is below $17, the industry
supply is just going to be zero, right
here, zero. Now what happens at $17? Well,
at $17, Firm 1 just breaks even. So
we'll say Firm 1 will just enter the
industry. So at $17, the industry output
is the same as the output of Firm 1,
namely four units. Notice that at $17,
Firm 2 doesn't enter the industry
because the price is still too low. Firm
2 is not going to make a profit, will
take a loss at that price. Indeed as the
price of oil increases, the output from
Firm 2 will increase as it moves along
its marginal cost curve. That will
continue to happen so industry output will
increase along with the output of Firm 1
until we reach a price of $29. At the
price of $29, Firm 2 just breaks even
and it enters the industry. So at $29,
total industry output is 6 units from
Firm 1 and five units from Firm 2 for
a total of 11 units from, uh, the industry. As
the price goes above $29 both Firm 1
and Firm 2 expand along their marginal
cost curves so the industry output is then
the sum of the output from both firms. So
what we see here is that the industry
supply curve is upward sloping because the
cost curves of these firms are different.
Because in order to attract more firms
into this industry, the only way we can do
that is by attracting higher cost firms.
So the industry supply curve is upward
sloping. Any industry where it's difficult
to exactly duplicate the productive inputs
is going to be an increase in cost
industry. I've already mentioned oil, but
copper, gold, silver, all the mining
industries, are very similar. We can't just
duplicate another gold mine. If we want
another gold mine we're going to have to
dig deeper, we're going to have to look
elsewhere, it's going to be more expensive
to produce it than it is now. Coffee is
another example, because there's really
only a limited number of places in the
world where we could produce great coffee.
If we want coffee from other places than
Brazil or Guatemala, it's going to be
lower quality. We're going to have to go
down further on the mountain. It's going
to require more inputs. Nuclear engineers -
very hard to expand the supply of nuclear
engineers. There's a limited number of
people who can be a nuclear engineer. If
we want more nuclear engineers, we're
really going to have to pull them from
other industries where they have very high
opportunity cost. So it's hard to expand
the supply of nuclear engineers without
pushing up the wages of nuclear engineers.
That's an increasing cost industry.
Moreover, any industry that buys a large
fraction of the output of an increasing
cost industry will also be an increasing
cost industry. So pretty obviously
gasoline is an increasing cost industry
because if we want more gasoline that
requires more oil, and oil is an increasing
cost industry. Electricity will primarily
be an increasing cost industry to the
extent that we generate our electricity
from coal. So if we want a lot more
electricity we're going to require more
coal and that's going to push the price of
coal up, which is going to push
the cost of producing electricity up.
- So what we just showed is that for an
increasing cost industry, you can derive a
upward sloped supply curve.
We're now going to do a constant cost
industry for which we'll show you actually
get a flat supply curve, and then a
decreasing cost industry, which as you
might expect, will give you now a
downward-sloped supply curve. We'll
do these in separate lectures. Thanks.
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