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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- [Alex Tabarrok] Now that
we understand a firm's cos tcurves,

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 is 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,

will 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 cost 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 six units from Firm one

and five units from Firm two

for a total of 11 units
from the industry.

As the price goes above $29
both Firm one and Firm two

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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