Question

In a constant-cost industry each firm's marginal cost curve is upward sloping, though all the firms together (the industry) have a horizontal supply curve. Carefully demonstrate and explain how this can occur.

Answer 1

Let us hypothesise an industry that produces Good X. Consider the following diagram.

   

Price (C) -Me TRI -- - PB in Parit <TRSS as Quantity *DDI DDE dia, aduently fig. B fig. A

Figure A is the firm's supply curve. Figure B is the industry supply curve (driven by supply and demand).

Let E be the equilibrium with quantity Q₁ and price P₁ for the individual firm. Let E^/ be the market equilibrium with market price P₁P₁ and quantity Q₁Q₁. At E, P₁ = MR = AR and the firm is making zero profits (no profit, no loss). This is the point where MC = AC.

Let us assume that demand of the Good X increases because of a rise in income levels. As a consequence, the industry demand curve (fig. B) DD₁ shifts upwards to DD₂. At this demand, the quantity supplied by the firm is Q₂ at price P₂. At this point, the individual firm generates super normal profits worth the shaded region (fig. A). However, the market is in disequilibrium. There is excess demand for good X in the market. As the existing firms display super-normal profits, more and more firms join the industry (free market). Since, it is a constant-cost industry, any number of firms will not influence input prices, hence the CoP remains constant. Consequently,MC and AC curves are long run MC and AC for individual firms. Due to rising no. of firms, the supply of Good X increases in the market and SS₁ shifts to the right to SS₂ till all the super-normal profits is driven out of the market, and all the firms reach zero economic profit levels of production at Q₁. There is a new industrial equilibrium now at E^// at a higher output Q₃Q₃ at price P₁P₁.

As we can see, the increase in price was short lived, till new players drive in and suck out all the super-normal profit to re-settle the price at the original value. The horizontal line depicting the market equilibrium is the Long run industry supply curve (LRSS), where prices remain constant due to free entry and exit of the firms. Therefore, in a constant-cost industry, the long run industry supply can be horizontal with upward sloping individual marginal cost curves.