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- Now that we understand a firm's cost[br]curves, and its entry and exit decisions,

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we're able to show how supply curves are[br]actually derived from these more

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fundamental considerations.[br]Let's take a closer look.

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- The supply curve[br]is built upon firm

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entry and exit decisions and the[br]effect of these decisions on industry

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costs. And the key question is this, as[br]industry output increases, what happens to

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costs? There are three possibilities.[br]First, an increase in cost industry. That

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is industry costs increase with greater[br]output. Second, constant cost industry.

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Industry costs are flat, they don't change[br]with greater or lesser output. And

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finally a decreasing cost industry,[br]industry cost falls with greater output.

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As we'll see, the first and second are[br]quite common, the third is quite uncommon,

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but is nevertheless important and[br]interesting in order to understand

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economic geography, which we'll come to a[br]bit later. Let's show how the industry

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supply curve is derived from the entry and[br]exit and cost curves of individual firms.

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We can do this for an increase in cost[br]industry very easily with just a two firm

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example. Suppose that Firm 1 is a[br]producer of oil, where its oil is very

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close to the surface, so it has a quite low[br]average cost curve. It's pretty cheap for

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this firm to produce oil. On the other[br]hand, Firm 2 has a much higher average

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cost curve because for Firm 2 it's[br]located in a part of the world where it

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has to drill much deeper in order to get[br]the oil. Now, given these figures what's

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the industry supply curve of oil if the[br]price of oil is below $17? Well, if the

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price of oil is below $17, neither of[br]these firms can make a profit.

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That's below the minimum point of the[br]average cost curve for both of these

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firms. So neither of these firms is going[br]to want to be in the industry. So if the

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price of oil is below $17, the industry[br]supply is just going to be zero, right

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here, zero. Now what happens at $17? Well,[br]at $17, Firm 1 just breaks even. So

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we'll say Firm 1 will just enter the[br]industry. So at $17, the industry output

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is the same as the output of Firm 1,[br]namely four units. Notice that at $17,

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Firm 2 doesn't enter the industry[br]because the price is still too low. Firm

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2 is not going to make a profit, will[br]take a loss at that price. Indeed as the

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price of oil increases, the output from[br]Firm 2 will increase as it moves along

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its marginal cost curve. That will[br]continue to happen so industry output will

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increase along with the output of Firm 1[br]until we reach a price of $29. At the

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price of $29, Firm 2 just breaks even[br]and it enters the industry. So at $29,

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total industry output is 6 units from[br]Firm 1 and five units from Firm 2 for

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a total of 11 units from, uh, the industry. As[br]the price goes above $29 both Firm 1

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and Firm 2 expand along their marginal[br]cost curves so the industry output is then

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the sum of the output from both firms. So[br]what we see here is that the industry

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supply curve is upward sloping because the[br]cost curves of these firms are different.

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Because in order to attract more firms[br]into this industry, the only way we can do

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that is by attracting higher cost firms.[br]So the industry supply curve is upward

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sloping. Any industry where it's difficult[br]to exactly duplicate the productive inputs

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is going to be an increase in cost[br]industry. I've already mentioned oil, but

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copper, gold, silver, all the mining[br]industries, are very similar. We can't just

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duplicate another gold mine. If we want[br]another gold mine we're going to have to

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dig deeper, we're going to have to look[br]elsewhere, it's going to be more expensive

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to produce it than it is now. Coffee is[br]another example, because there's really

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only a limited number of places in the[br]world where we could produce great coffee.

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If we want coffee from other places than[br]Brazil or Guatemala, it's going to be

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lower quality. We're going to have to go[br]down further on the mountain. It's going

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to require more inputs. Nuclear engineers -[br]very hard to expand the supply of nuclear

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engineers. There's a limited number of[br]people who can be a nuclear engineer. If

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we want more nuclear engineers, we're[br]really going to have to pull them from

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other industries where they have very high[br]opportunity cost. So it's hard to expand

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the supply of nuclear engineers without[br]pushing up the wages of nuclear engineers.

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That's an increasing cost industry.[br]Moreover, any industry that buys a large

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fraction of the output of an increasing[br]cost industry will also be an increasing

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cost industry. So pretty obviously[br]gasoline is an increasing cost industry

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because if we want more gasoline that[br]requires more oil, and oil is an increasing

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cost industry. Electricity will primarily[br]be an increasing cost industry to the

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extent that we generate our electricity[br]from coal. So if we want a lot more

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electricity we're going to require more[br]coal and that's going to push the price of

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coal up, which is going to push[br]the cost of producing electricity up.

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- So what we just showed is that for an[br]increasing cost industry, you can derive a

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upward sloped supply curve.[br]We're now going to do a constant cost

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industry for which we'll show you actually[br]get a flat supply curve, and then a

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decreasing cost industry, which as you[br]might expect, will give you now a

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downward-sloped supply curve. We'll[br]do these in separate lectures. Thanks.

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