Now that we have examined the supply decision of a single firm, we can discuss the supply curve for a market. There arc two cases to consider. First, we examine a market with a fixed number of firms. Second, we examine a market in which the number of firms can change as old firms exit the market and new firms enter. Both cases are important, for each applies over a specific time horizon. Over short periods of time, it is often difficult for firms to enter <ind exit, so the assumption of a fixed number of firms is appropriate. But over long periods of time, the number of firms can adjust to changing market conditions.
The Short Run: Market Supply with a Fixed Number or Firms
Consider first a market with l.llflfl identical firm». For any given price, each firm supplies a quantity of output so that its marginal cost equals the price, as shown in panel (a) of Figure 6. That is, as long as price is above average variable cost, each firm's marginal-cost curve is its supply curve. The quantity of output supplied to the market equals the sum of the quantities supplied by each of the 1J.HX) individual Firms. Thus, to derive the market supply curve, we add the quantity-supplied by each firm in the market. As panel lb) of Figure 6 shows, because the firms are identical, the quantity supplied to the market is 1,000 times the quantity supplied by each firm.
The Long Run: Market Supply with Entry and Exit
Now consider what happens if firms are able to enter or exit the market. Let's suppose that everyone has access to the same technology for producing the good and access to the same market» to buy the inputs into production. Therefore, all firms and all potential firms have the same cost curves-
Decisions about entry and exit in a market of this type depend on the incentives facing the owners of existing firms and the entrepreneurs who could start new firms. If firms already in the market are profitable, then new firms will have an incentive to enter the market. This entry will expand the number of firms, increase the quantity of the good supplied, and drive down prices and profits Conversely, if firms in the market are making losses, then some existing firms will exit the market. Their exit will reduce the number of firms, decrease the quantity of the good supplies!, and drive up prices and profits. At the cnJtf this process of entry ami exit, firms that remain in the market mut: be making zero economic profit.
Recall that we can write a firm's profit as
This equation shows that an operating firm has zero profit if and only if the price of the good equals the average total cost of producing that good. If price is above-average total cost, profit is positive, which encourages new firms to enter. If price is less than average total cost, profit is negative, which encourages some firms to exit. The praorss of entry ami exit ends only when price and average total cost are driven to equality.
This analysis has a surprising implication. We noted earlier in the chapter that competitive firms maximize profits by choosing a quantity at whkh price equals marginal cost. We just noted that free entry and exit force price to equal average total cost. But if price b to equal both marginal cost and average total cost, these two measures of cost must equal each other. Marginal cost and average total cost are equal, however, only when the firm is operating at the minimum of average total cost. Recall from the preceding chapter that the level of production with lowest average total cost is called the firm's efficient scale. Therefore, in the long-run equilibrium oj'n tvmpetitàr market with free entry and exit, firms mus) he operating a I their efficient scale
Panel (a) of Figure 7 shows a firm in such a long-run equilibrium. In this figure, price P equals marginal cost >V1C, SO the firm is profit-maximizing. Price also equals average total cost ATC, so profits are zero. New firms have no incentive to enter the market, and existing firms have no incentive to leave the market.
From this analysis of firm behavior, we can determine the long-run supply curve for the market. In a market with free entry and exit, there is only one price consistent with zero profit—the minimum of average total cost. As a result, the long-run market supply curve must be horizontal at this price, as illustrated by the perfectly elaslic supply curve in panel (b) of Figure 7. Any price above this level would generate profit, leading to entry and an increase in the total quantity supplied. Any price below this level would generate losses, tending to exit and a decrease in the total quantity supplied. Eventually, the number of firms in the market adjusts so that price equals the minimum of average total cost, ami there are enough firms to satisfy all the demand at this price.
Why Do Competitive Firms Stay in Business If They Make Zero Profit?
At first, it might seem odd that competitive firms earn zero profit in the long run. After all, people start businesses to make a profit. If entry eventually drives profit to zero, there might seem to be little reason to stay in business.
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