Entry, Exit, and Supply Curves: Constant Costs

Some industries have a flat supply curve. These are called constant cost industries. Take domain name registration, to increase the supply of domain names, we must only increase the inputs by a negligible amount. That is why even as the internet expands so rapidly, it still costs only about $6 or $7 dollars to register a new domain name. By showing you how these industries respond to an increase in demand, we can explain why it’s a constant cost industry.

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- Okay this talk is going to be a bit more
involved. What we're going to show is how

a constant cost industry generates a flat
supply curve. Let's begin.

- A constant cost industry is one where
it's very easy to expand output without

pushing up costs. So for example, pencils,
rutabagas, domain name registration. These

are all constant cost industries. Think
about pencils. We can easily increase the

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

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

more graphite, we need more rubber.
However, we'd need just a little bit more

wood relative to the total world supply of
wood. Just a little bit more graphite

relative to the world supply of graphite
and just a little bit more rubber relative

to the total world supply of rubber. In
other words, we can increase the number of

pencils produced but only increase the
demand for the inputs by a small and

non-appreciable amount. We're not going
to be pushing up the price of wood for

example when we produce more pencils. The
story would be different if it was

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

That would require a lot more wood and
could potentially push the price of wood

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

about rutabagas? Again, the idea's the
same. We can easily increase the supply of

rutabagas by a lot without increasing the
price of the input such as land or

fertilizer. Rutabagas are simply too small
a portion of the market for land or the

market for fertilizer to have an
appreciable effect on the price of these

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

Same thing
with domain

name registration. As the internet has
expanded tremendously it still costs

about six or seven dollars to register a
domain name since it's very cheap to do

that with just a few additional computers.
A little bit more computer resources very

small portion of the total number of
computers and we can increase the supply

of domain name registrars very, very
easily. The implication of all this is

that long run supply curves for these
goods for goods like pencils, rutabagas

and domain name registration the long run
supply curve is going to be flat. Let's

take a closer look with a diagram. So in
this diagram we're going to show how a

constant cost industry adjusts to a shift
in increase in demand and in so doing

we'll in fact show why it's a constant
cost industry. We're going to do so by

looking at two things simultaneously. The
market and the representative firm. So

there are lots of firms in this industry
and we're going to pick just one of them

to represent them all. Now we're going to
begin with the market side with which

we're very familiar here is our demand
curve and here is our short run supply

curve. The quantity demanded is equal to
the quantity supplied that determines our

initial or short run equilibrium. In fact,
this is also going to be the long run

equilibrium for reasons which will become
clear. Now we also want the representative

firm to be equilibrium. So the firm is
profits maximizing. So that means the

price is going to be equal to marginal
cost and in addition price will be equal

to average cost because the firm is going
to be earning normal, or zero, economic

profits. Normal profits. So this is our
initial equilibrium for the market side

quantity demanded is equal to the quantity
supplied and on the firm side price is

equal to marginal cost
So firms are profit

maximizing and prices equal to average
cost. So profits are normal or zero.

Okay now let's look at what happens
when we increase demand. Two things

are going to happen on the market side
of course the demand curve will shift out

pushing up the price to a new equilibrium.
On the firm side, as the price

goes up the firm will be expanding along
its marginal cost curve. Let's look at the

market both of these things are going to
happen simultaneously let's look at what

happens in the market and then we'll do
it again to focus on the representative

firm. So here we go an increase in demand
the price shifts up we come to a new

equilibrium at point B on the market side
and as I said each firm expands along its

marginal cost curve so we have a new
equilibrium for the representative firm

also at point B. Now in case you missed
it let's show that again. For the

representative firm looking now at the
representative firm. Now looking at the

representative firm here is the increase
in demand it drives price up as it does so

each firm expands along its marginal cost
curve. In fact, the reason why the supply

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

currently in the industry is expanding as
price increases along it's marginal cost

curve. By the short run what we actually
mean is the time period before new firms

have a chance to enter into the industry.
So the entire increase in supply in the

short run is being driven by the increased
output of currently existing firms as they

expand to take advantage of the increase
in price. Now notice that initially the

representative firm was making zero
economic profit it was making normal

profits. With the increase in demand,
they're making positive above normal

profits.
Remember profit is

price minus average cost times quantity.
So profit here is positive it's above

normal and those above normal profits are
going to attract other firms. Other firms

are going to say, "I want a piece of the
action. I want a piece of the pie."

Remember when price is above average cost
that's when new firms enter into the

industry. So what is that entry going to
do? Well, it's going to do two things. On

the market side, it's going to shift out
the short-run supply curve. It's going to

shift out the short-run supply curve to
the right and as that happens price is

going to be pushed down. As price is
pushed down, each firm will contract along

its marginal cost curve profits falling
all the way until we reach a point of

normal economic profits once again. So
let's show this again we'll show it

twice first of all we can look at the
market side and then we'll look at the

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

As we get new entry, the supply curve in
the short run expands, shifts outward,

pushing down the price until we reach a
new long run equilibrium which is here

and until profits are zero over here.
Again, now let's look at this again for

the representative
firm. Okay here's

the representative firm on the
right as profits attract entry, entry is

going to push price down and here we go
let's see what happens. As the price goes

down, each firm contracts along its
marginal cost curve. In fact, we can now

see why the long run cost curve is flat
because we begin at point A at the minimum

point of the average cost curve and we
end at point C, here's point C, which is

also at the minimum point of the average
cost curve. So the long run supply curve

is flat at the minimum point of the
average cost curve. Now where does our

assumption of constant industry cost
comes in. It comes in right here

because the idea is that when the
industry expands with new entry that

isn't driving up the representative firm's
costs and the reason that is, is that

this industry is small relative to its
input markets. So when this industry

expands it doesn't drive up the price of
its inputs. That means that this average

cost curve isn't changing as the industry
expands or contracts because this cost

curve for the representative firm isn't
changing the only equilibrium with zero

economic profit is at the minimum point.
It's when price is equal to average cost.

So that's always going to, price is going
to be driven down in the long run to the

minimum of this average cost curve to
the point where there's zero economic

profits. So A and C are along a long run
industry supply curve, which is flat.

All right, that's a huge amount to take
in. Let's just go over it briefly using

this diagram. We began with an initial
equilibrium at point A an increase in

demand pushed us in the short run to point
B where each firm was making positive

profits. Those
profits attracted

new firms into the industry.
Those new firms shifted to the right the

short run supply curve. Pushing prices
down until we reach a new point of long

run equilibrium. That new point of
long-run equilibrium is precisely when

we're back to zero or normal economic
profits at the minimum point of the

average cost curve. The average cost curve
isn't shifting because input prices aren't

changing as this industry expands or
contracts and that's why the long run

supply curve is flat. Whoo! All right.
That was a lot. What else?

So we've now
shown how an increase

in cost industry leads to an upward
sloped supply curve. A constant cost

industry leads to a flat or horizontal
supply curve and we're about to show how

a decreasing cost industry, the unusual
case, leads to a downward sloped supply

curve or at least over some
range. Let's do that next.

- 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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