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- [Alex] Okay -- this talk is going[br]to be a bit more involved.

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What we're going to show[br]is how a constant cost industry

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generates a flat supply curve.

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Let's begin.

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A constant cost industry[br]is one where it's very easy

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to expand output[br]without pushing up costs.

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So for example, pencils, rutabagas,[br]domain name registration --

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these are all constant cost[br]industries.

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Think about pencils.

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We can easily increase[br]the supply of pencils

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by quite a bit without pushing up[br]the cost of producing pencils.

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Why not? Well, what do we need[br]to produce more pencils?

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We need more wood,[br]we need more graphite,

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we need more rubber.

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However, we'd need[br]just a little bit more wood

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relative to the total[br]world supply of wood.

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Just a little bit more graphite[br]relative to the world supply

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of graphite.

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And just a little bit more rubber[br]relative to the world supply

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of rubber.

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In other words, we can increase[br]the number of pencils produced,

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but only increase the demand[br]for the inputs by a small

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and non-appreciable amount.

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We're not going to be pushing up[br]the price of wood, for example,

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when we produce more pencils.

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The story would be different[br]if it was housing.

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If we want to produce more housing,[br]that's a big demander of wood.

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That would require a lot more wood[br]and could potentially push

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the price of wood up.

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As we'll see, that would correspond[br]to an increase in cost industry.

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What about rutabagas?[br]Again, the idea's the same.

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We can easily increase[br]the supply of rutabagas by a lot

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without increasing[br]the price of the input,

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such as land or fertilizer.

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Rutabagas are simply too small[br]a portion of the market

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for land or the market[br]for fertilizer

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to have an appreciable effect[br]on the price of these inputs,

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even if we were to increase[br]the supply of rutabagas by a lot.

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Same thing with domain name[br]registration.

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As the internet has expanded,[br]tremendously, it still costs

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about six or seven dollars[br]to register a domain name,

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since it's very cheap to do that

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with just a few additional[br]computers.

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A little bit more[br]computer resources --

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very small portion[br]of the total number of computers --

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and we can increase the supply[br]of domain name registrars

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very, very easily.

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The implication of all this[br]is that long run supply curves

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for these goods, for goods[br]like pencils, rutabagas,

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and domain name registration,[br]the long run supply curve

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is going to be flat.

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Let's take a closer look[br]with a diagram.

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So in this diagram,[br]we're going to show

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how a constant cost industry[br]adjusts to a shift

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in increase in demand.

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And in so doing, we'll in fact show[br]why it's a constant cost industry.

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We're going to do so by looking[br]at two things simultaneously:

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the market[br]and the representative firm.

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So there are lots of firms[br]in this industry

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and we're going to pick[br]just one of them

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to represent them all.

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Now we're going to begin[br]with the market side,

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with which we're very familiar.

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Here is our demand curve and here[br]is our short run supply curve.

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The quantity demanded is equal[br]to the quantity supplied --

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that determines our initial[br]or short run equilibrium.

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In fact, this is also going[br]to be the long run equilibrium

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for reasons[br]which will become clear.

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Now we also want[br]the representative firm

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to be in equilibrium.

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So the firm is profit maximizing,[br]so that means the price

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is going to be equal[br]to marginal cost.

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And in addition,[br]price will be equal

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to average cost, because the firm[br]is going to be earning normal,

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or zero economic profits.

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Normal profits.

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So this is our initial equilibrium[br]for the market side --

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quantity demanded is equal[br]to the quantity supplied.

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And on the firm side,[br]price is equal to marginal cost,

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so firms are profit maximizing,[br]and price is equal

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to average cost, so profits[br]are normal or zero.

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Okay, now let's look[br]at what happens

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when we increase demand.

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Two things are going to happen[br]on the market side --

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of course the demand curve[br]will shift out pushing up the price

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to a new equilibrium.

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On the firm side,[br]as the price goes up

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the firm will be expanding[br]along its marginal cost curve.

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Let's look at the market --[br]both of these things

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are going to happen[br]simultaneously --

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let's look at what happens[br]in the market

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and then we'll do it again to focus[br]on the representative firm.

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So here we go --[br]an increase in demand --

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the price shifts up,[br]we come to a new equilibrium

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at point B on the market side,[br]and as I said each firm expands

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along its marginal cost curve[br]so we have a new equilibrium

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for the representative firm,[br]also at point B.

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Now in case you missed it,[br]let's show that again.

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For the representative firm,[br]looking now

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at the representative firm.

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Now looking[br]at the representative firm,

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here is the increase in demand --[br]it drives price up

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as it does so each firm expands[br]along its marginal cost curve.

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In fact, the reason[br]why the supply curve

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in the short run is upward sloping[br]is precisely that each firm

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currently in the industry[br]is expanding

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as price increases[br]along its marginal cost curve.

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By the short run,[br]what we actually mean,

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is the time period before new firms[br]have a chance to enter

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into the industry.

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So the entire increase in supply[br]in the short run is being driven

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by the increased output[br]of currently existing firms

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as they expand to take advantage[br]of the increase in price.

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Now notice that initially,[br]the representative firm

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was making zero economic profit,[br]it was making normal profits.

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With the increase in demand,[br]they're making positive,

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above normal profits.

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Remember profit is price[br]minus average cost times quantity.

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So profit here is positive,[br]it's above normal.

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And those above normal profits[br]are going to attract other firms.

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Other firms are going to say,[br]"I want a piece of the action.

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I want a piece of the pie."

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Remember when price[br]is above average cost,

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that's when new firms[br]enter into the industry.

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So what is that entry going to do?

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Well, it's going to do two things.

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On the market side,[br]it's going to shift out

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the short-run supply curve.

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It's going to shift[br]the short-run supply curve

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to the right, and as that happens,[br]price is going to be pushed down.

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As price is pushed down,[br]each firm will contract

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along its marginal cost curve,[br]profits falling all the way

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until we reach a point

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of normal economic profits[br]once again.

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So let's show this again,[br]we'll show it twice,

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first of all we can look[br]at the market side

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and then we'll look[br]at the representative firm.

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So, profits in the short run[br]are going to attract new entry.

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As we get new entry,[br]the supply curve

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in the short run expands,[br]shifts outward,

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pushing down the price[br]until we reach

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a new long run equilibrium[br]which is here

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and until profits[br]are zero over here.

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Again, now let's look at this again[br]for the representative firm.

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Okay here's the representative firm[br]on the right.

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As profits attract entry

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entry is going to push[br]price down and here we go,

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let's see what happens.

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As the price goes down,[br]each firm contracts

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along its marginal cost curve.

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In fact, we can now see why[br]the long run cost curve is flat.

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Because we begin at point A[br]at the minimum point

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of the average cost curve,[br]and we end at point C,

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here's point C, which is also[br]at the minimum point

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of the average cost curve.

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So the long run supply curve[br]is flat at the minimum point

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of the average cost curve.

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Now where does our assumption[br]of constant industry cost come in?

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It comes in right here.

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Because the idea is that[br]when the industry expands

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with new entry,[br]that isn't driving up

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the representative firm's costs.

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And the reason that is,[br]is that this industry is small

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relative to its input markets.

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So when this industry expands,[br]it doesn't drive up the price

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of its inputs.

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That means that this average[br]cost curve isn't changing

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as the industry expands[br]or contracts.

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Because this cost curve[br]for the representative firm

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isn't changing,[br]the only equilibrium

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with zero economic profit[br]is at the minimum point,

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is when price is equal[br]to average cost.

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So that's always going to --[br]price is going to be driven down

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in the long run to the minimum[br]of this average cost curve,

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to the point where[br]there's zero economic profits.

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So A and C are along a long-run[br]industry supply curve,

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which is flat.

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All right, that's[br]a huge amount to take in.

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Let's just go over it briefly[br]using this diagram.

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We began with an initial[br]equilibrium at point A,

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an increase in demand[br]pushed us in the short run

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to point B, where each firm[br]was making positive profits.

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Those profits attracted new firms[br]into the industry.

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Those new firms shifted[br]to the right,

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the short-run supply curve,[br]pushing prices down

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until we reach a new point[br]of long-run equilibrium.

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That new point[br]of long-run equilibrium

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is precisely when we're[br]back to zero

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or normal economic profits[br]at the minimum point

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of the average cost curve.

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The average cost curve[br]isn't shifting because input prices

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aren't changing as this industry[br]expands or contracts,

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and that's why[br]the long-run supply curve is flat.

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Whew! All right.[br]That was a lot. What else?

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So we've now shown how an increase[br]in cost industry leads

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to an upward sloped supply curve.

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A constant cost industry leads

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to a flat or horizontal[br]supply curve.

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And we're about to show[br]how a decreasing cost industry,

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the unusual case, leads[br]to a downward sloped supply curve,

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at least over some range.

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Let's do that next.

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- [Narrator] If you want[br]to test yourself,

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click "Practice Questions,"

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or if you're ready to move on,[br]just click, "Next Video."

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