Entry, Exit, and Supply Curves: Increasing Costs

We understand cost curves and entry and entry/exit decisions. Now we are going to explore how each firm’s decisions influence the supply curve. Here’s the key question: As industry output increases, what happens to costs? We look at three options: an increasing cost industry, a constant cost industry, and a decreasing cost industry.
First up, we look at oil as an example of an increasing cost industry. One oil company drills for oil that is close to the surface, and the second company drills for oil deep underground. Other examples of increasing cost industries include copper, gold, and silver, coffee, and even the profession of nuclear engineers.
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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 one 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 two has a much higher average

cost curve because for firm two 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 one just breaks even. So

we'll say firm one will just enter the
industry. So at $17 the industry output

is the same as the output of firm one
namely four units. Notice that at $17

firm two doesn't enter the industry
because the price is still too low. Firm

two is not going to make a profit. We'll
take a loss at that price. Indeed as the

price of oil increases the output from
firm two will increase as it moves along

its marginal costs curve. That will
continue to happen so industry output will

increase along with the output of firm one
until we reach a price of $29. At the

price of $29 firm two just breaks even
and it enters the industry. So at $29

total industry output is 6 units from
firm 1 and 5 units from firm 2 for

a total of 11 units from 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 its 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.

- If you want to test yourself,
click, "Practice Questions," or if you're

ready to move on,
just click, "Next Video."

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