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♪ [music] ♪

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

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What we're going to show
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
is one where it's very easy

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to expand output
without pushing up costs.

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So for example, pencils, rutabagas,
domain name registration --

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these are all constant cost
industries.

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Think about pencils.

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We can easily increase
the supply of pencils

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

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

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We need more wood,
we need more graphite,

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we need more rubber.

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

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relative to the total
world supply of wood.

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Just a little bit more graphite
relative to the world supply

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of graphite.

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

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of rubber.

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

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but only increase the demand
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
the price of wood, for example,

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when we produce more pencils.

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The story would be different
if it was housing.

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

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That would require a lot more wood
and could potentially push

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the price of wood up.

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

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

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We can easily increase
the supply of rutabagas by a lot

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without increasing
the price of the input,

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such as land or fertilizer.

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Rutabagas are simply too small
a portion of the market

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for land or the market
for fertilizer

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

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

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Same thing with domain name
registration.

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As the internet has expanded,
tremendously, it still costs

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about six or seven dollars
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
computers.

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A little bit more
computer resources --

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very small portion
of the total number of computers --

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and we can increase the supply
of domain name registrars

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very, very easily.

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The implication of all this
is that long run supply curves

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for these goods, for goods
like pencils, rutabagas,

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and domain name registration,
the long run supply curve

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is going to be flat.

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Let's take a closer look
with a diagram.

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So in this diagram,
we're going to show

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how a constant cost industry
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
why it's a constant cost industry.

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

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the market
and the representative firm.

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So there are lots of firms
in this industry

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and we're going to pick
just one of them

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to represent them all.

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Now we're going to begin
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
is our short run supply curve.

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The quantity demanded is equal
to the quantity supplied --

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that determines our initial
or short run equilibrium.

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

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for reasons
which will become clear.

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Now we also want
the representative firm

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to be in equilibrium.

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So the firm is profit maximizing,
so that means the price

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is going to be equal
to marginal cost.

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And in addition,
price will be equal

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to average cost, because the firm
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
for the market side --

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quantity demanded is equal
to the quantity supplied.

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

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so firms are profit maximizing,
and price is equal

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to average cost, so profits
are normal or zero.

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Okay, now let's look
at what happens

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when we increase demand.

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Two things are going to happen
on the market side --

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of course the demand curve
will shift out pushing up the price

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to a new equilibrium.

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On the firm side,
as the price goes up

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the firm will be expanding
along its marginal cost curve.

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

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are going to happen
simultaneously --

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let's look at what happens
in the market

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

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So here we go --
an increase in demand --

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the price shifts up,
we come to a new equilibrium

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

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along its marginal cost curve
so we have a new equilibrium

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for the representative firm,
also at point B.

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

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For the representative firm,
looking now

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at the representative firm.

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Now looking
at the representative firm,

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here is the increase in demand --
it drives price up

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

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In fact, the reason
why the supply curve

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in the short run is upward sloping
is precisely that each firm

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currently in the industry
is expanding

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as price increases
along its marginal cost curve.

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By the short run,
what we actually mean,

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

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into the industry.

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So the entire increase in supply
in the short run is being driven

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by the increased output
of currently existing firms

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

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Now notice that initially,
the representative firm

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was making zero economic profit,
it was making normal profits.

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With the increase in demand,
they're making positive,

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above normal profits.

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Remember profit is price
minus average cost times quantity.

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

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

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Other firms are going to say,
"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
is above average cost,

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that's when new firms
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,
it's going to shift out

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the short-run supply curve.

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

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

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As price is pushed down,
each firm will contract

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along its marginal cost curve,
profits falling all the way

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until we reach a point

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of normal economic profits
once again.

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

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first of all we can look
at the market side

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and then we'll look
at the representative firm.

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

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As we get new entry,
the supply curve

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in the short run expands,
shifts outward,

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pushing down the price
until we reach

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a new long run equilibrium
which is here

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and until profits
are zero over here.

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

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Okay here's the representative firm
on the right.

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As profits attract entry

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

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let's see what happens.

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As the price goes down,
each firm contracts

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along its marginal cost curve.

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

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Because we begin at point A
at the minimum point

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

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

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of the average cost curve.

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So the long run supply curve
is flat at the minimum point

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of the average cost curve.

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

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It comes in right here.

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Because the idea is that
when the industry expands

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with new entry,
that isn't driving up

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the representative firm's costs.

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And the reason that is,
is that this industry is small

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relative to its input markets.

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

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of its inputs.

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That means that this average
cost curve isn't changing

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as the industry expands
or contracts.

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Because this cost curve
for the representative firm

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isn't changing,
the only equilibrium

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with zero economic profit
is at the minimum point,

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is when price is equal
to average cost.

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

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

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to the point where
there's zero economic profits.

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

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which is flat.

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

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

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We began with an initial
equilibrium at point A,

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an increase in demand
pushed us in the short run

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

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Those profits attracted new firms
into the industry.

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Those new firms shifted
to the right,

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the short-run supply curve,
pushing prices down

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

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That new point
of long-run equilibrium

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is precisely when we're
back to zero

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or normal economic profits
at the minimum point

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of the average cost curve.

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The average cost curve
isn't shifting because input prices

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aren't changing as this industry
expands or contracts,

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

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

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So we've now shown how an increase
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
supply curve.

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

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the unusual case, leads
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
to test yourself,

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click "Practice Questions,"

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

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♪ [music] ♪