The Long Run Supply Curve

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What to Read For Can an "industry" be defined by the techniques it uses to make its products? Are railways "an industry"? Which suppliers are in it? What about potential suppliers? What is a normal return? What is an entrepreneur? What is an entry price? If an entrepreneur is getting a price higher than his entry price, what is the excess called? What is economic rent? The margin of cultivation?

The analysis of the industry given so far starts to unravel if you ask insistently, "What is the industry?" For example, what is the industry in which a railway competes? The answer seems obvious: track and wheel, locomotives and cars, stations and tunnels, executives and porters. For purposes of a book on railway engineering or of a discussion of make-work rules by railway unions or of agitation in Congress for taxes on trucks this technological definition makes sense. In these cases it is the technology that gives the feature in common. But for purposes of analyzing the market for the services of railways, the technological definition misses the point entirely. The Norfolk and Western Railroad and the Santa Fe Railroad do not supply substitutes: They are 2000 miles apart, supplying completely different customers. No single customer faces a mutually exclusive choice between shipping cattle from Norfolk to Roanoke by one railroad or from Santa Fe to Albuquerque by another. And looking at the matter from the railways' point of view, within a technologically defined "industry" the parts in different locations will have different interests.

Q: Like the airlines today, railways in the late nineteenth at Chicago. There were a half-dozen companies from century divided into eastern and western companies the East Coast to Chicago and about ten from Chicago

The Mere Definition of an Industry Can Affect One's Argument westward. The Interstate Commerce Commission (ICC) was formed in 1887 to regulate this commerce, which it continues to do. The ICC says that it acts on behalf of the general public, but most economists and historians believe that it was in fact captured by the railways soon after its formation, if not actually created by them, and has been used since then to raise rather than lower rates. The simplest version of the "capture theory" ignores the geographical divisions within railways, arguing that the ICC is a simple conspiracy of all railways against the public.

1. Were the eastern and western companies in the same "industry"? How would a ton of wheat get from Iowa City to New York?

2. A ton of wheat cost $6 in 1890 to transport from Iowa City through Chicago to New York. All railways would clearly like to have seen the rate be higher than $6. But given a $6 cost in total, why was it in the interest of eastern railroads to get the ICC to reduce western rates?

3. Not all goods transported to or from Iowa City came from or went to New York: Some came from or went to Chicago. Why would this fact have made western (for instance, Iowan) customers of railways also enthusiastic about reducing western rates?

How to Choose the Definition of an Industry Wisely: First,


TorF: Since the U.S. Postal Service has a legal monopoly of first-class mail, people wishing to communicate be-

4. Restate the capture theory in a form that takes account of the two different industries making up "the" railroad industry.

A: 1. No. The two groups did not compete in the same market. They carried the same ton of wheat, but at different stages of its travels. A ton of wheat would travel on one of the western railroads (on the Rock Island as it happens) to Chicago and then to New York on one of the eastern railroads, say, the Pennsylvania Railroad.

2. If the Pennsylvania could get the ICC to reduce rates on the Rock Island, the Pennsylvania would receive a larger share of the $6 total.

3. Since some of their business was not through to New York, the customers of the Rock Island would join the Pennsylvania in appealing for lower western rates. In fact they did, arguing that the high rates for the Iowa City to Chicago leg of a journey constituted unfair discrimination.

4. The ICC can be viewed in 1890 as a conspiracy of eastern railways allied with western customers against the western railways and eastern customers. It was not "the" railway industry against customers, but a blend.1

tween San Francisco and Los Angeles are at the mercy of the Service.

The trivial-looking task of defining the industry, then, is difficult and important. One wants a workable definition of the industry in which railroads compete that means "all suppliers in the same market." Therefore one must pick a market such as "the transport industry from Norfolk to Roanoke," including in it not only the Virginia Railroad and Norfolk and Western Railroad, but also the buses, trucks, autos, airplanes, barges, ships, and mule trains competing with the railroads over the route. If one defines the people transport industry as "automobile-assembling companies, most of whose stockholders are Americans," then the automobile industry will appear to be nearly a monopoly, with four major companies, one much larger than the other three (General Motors, Ford, Chrysler, and American). But if one recognizes that Toyota, Volkswagen, Honda, Mazda, Subaru, Fiat, Peugeot, Mercedes-Benz, Renault, and others compete with the Big Four in some markets and that public transport, motorcycles, bicycles, and shoe leather compete with them in others, it becomes less obvious. It is not so obvious that the people transport industry is a case of competition among the few, by which the few can rob their customers at will.

1 So argues David Haddock in an unpublished doctoral dissertation at the University of Chicago, 1978, entitled "The Regulation of Railroads by Commission."

A: False, if "at the mercy of" means "unable to find any alternative to." The industry is not the mail between the two cities but communication in general,

How to Choose the Definition of an Industry Wisely: Second, Profitable Supply

Q: Tell what is wrong with the following argument used to explain the cheapening of cotton textiles in the early nineteenth century: "The expansion of demand for cotton textiles allowed each firm to expand, to spread fixed costs over a larger output, and therefore to lower prices."

A: Everything is wrong. To take the last point first. If the fixed costs were in fact fixed over such a long period, then they would not determine price, since fixed cost is no part of what does determine price, namely marginal cost. Furthermore, marginal cost for each firm must have been upward sloping, not downward sloping. If it were downward sloping, then each firm could have profited more by expanding at once, which is to say that the firms would not be in equilibrium at the earlier, small output. The argument needs at the least a supplement explaining why firms did not seize an opportunity for profit in front of their noses. Equilibrium and there with all the possibilities available of telephone, parcel post, telex, microwave, telegraph, radio, messenger, and personal travel.

fore an upward slope of marginal cost would imply in fact that expansion of the industry would have raised, not lowered, cost. The most important error, however, is the first, "the expansion of the industry allowed each firm to expand." This would be true only if the firms in the industry were unchangeable, that is, only if the expanded quantity had to be shared among the existing firms. But in the long run it does not have to be shared. At the higher price from expanded demand, additional firms will enter (and at a lower price exit). The size of the whole industry does not fix the size of firms within it, only the number of firms. A permanent rise in the demand for cotton textiles increases the number (not the size) of firms, each of optimal size. So too a permanent rise in the attendance at Busch Stadium increases the number of ice cream vendors (not their daily capacity) and a permanent fall in the number of newspaper readers reduces the number of newspapers (not the circulation of each).

The decision whether or not to include the telephone in the same industry with the mail depends on the size of their cross elasticities of demand and on the demanders one wishes to emphasize. Cross elasticity, you recall, measures how sensitive telephone consumption is to the price of mail. That is, it measures substitutability in consumption. Business may well view a telephone call or a typed letter as close substitutes for many purposes. The courts, however, are required by law to do their official business by letter,- and some lovers prefer the phone to the mail. The magnitude of cross elasticity one chooses will also vary from question to question. The only guide is consistency. If you bundle together the varied products of "the housing industry" for some question, you must admit a similar level of variety, and similar cross elasticities of demand, when asking a similar question about another part of the economy.

The root definition of industry is "all firms that can profitably supply goods some group of consumers view as close substitutes." Close substitutes is a feature of the utility functions of consumers. "Can profitably supply," it will now be shown, is a feature of the cost curves of firms. The industry contains everyone who can make money at the going price. At a higher going price more will enter.

The long-run supply curve, in other words, includes potential entrants. The point is the same as that involved in defining the railroad industry, for in the business of transporting people from Boston to New York the buses, airplanes, and autos are all potential or actual competitors with the New Haven Railroad. The correct supply curve of an industry adds up horizontally the supply curves of everyone who can at the various prices profitably supply the good.

The Meaning of The remaining question is simply who can profitably supply the good—say, Normal Profit rental housing for students. The answer is, anyone who can cover long-run total cost. The answer is straightforward, but it contains one piece of fancy footwork that should be noted. The definition of "cost" of rental housing for students includes of course all the costs of materials such as gas for heating and of labor for janitors. Slightly less obviously, it includes the cost of capital. The cost of capital is the interest cost on the loan taken out to buy the building plus the annual cost of replacing it as it wears out under the constant assault of late-night parties and the weather plus the expected annual capital loss from a fall in price of a building of given quality (or if a rise in price, minus the expected capital gain). Least obviously of all—and this is the fancy footwork— it includes the "normal profit" or "normal return" to taking the bother, knowing the market, seeing the opportunity, assuming the risk. In a word, it includes the normal return to the "entrepreneur."

The word entrepreneur is French, meaning "contractor" in the American sense of "building contractor," that is, someone who takes the considerable trouble of bringing together the carpenters, lumber, painters, and paint to remodel your house. The entrepreneur (or, if female, entrepreneuse) coordinates the other factors of production. Since she could hire a manager as one hires a janitor, it is not routine management that is her skill. Indeed, entrepreneurship could be defined as all inputs that cannot be hired. If she can buy insurance against some hazard in the business, for example, she is hiring "security," and only uninsurable risks remain with her. The buck stops with her.

It is easy to point to entrepreneurs in this sense, for they are the heroes of our economic mythology: Eli Whitney, Thomas Edison, John D. Rockefeller, Andrew Carnegie, Henry Ford, Edwin (Polaroid) Land. It is much less easy to point to a line in the actual income statement of a real firm, or in the tax returns of the leaders of the firm, and say, "Ah, I see that the price of entrepreneurship has gone up this year." The income of an Edwin Land will include income as a normal research scientist and as a living advertisement for Polaroid, but mixed into it will be his income for the qualities of brains and energy that make him one of the company's entrepreneurs. The reason one needs a line for "entrepreneurship" in the hypothetical accounts of a firm is precisely because the brains and energy are scarce and have alternative employment. If entrepreneurship is not rewarded at Polaroid, it will leave to join Kodak, or to join another industry entirely. The normal amount of entrepreneurship is rewarded at the normal rate and is included in normal costs. Building contractors are not earning "profits," really, when their price is above the costs of hired factors. Given the free entry to and exit from the industry, it is reasonable to suppose that they are earning merely normal profit, that is, the return to entrepreneurship necessary to keep it in the industry. The supply curve, in short, includes normal profit.

The final step in allowing for entry is to add up the output supplied at each price. When the expected, long-run price goes up, more firms find that price exceeds their long-run average costs (including normal profit). They enter, and output jumps up. If all the potential entrants are clustered around one entry price (as they might well be if the skills required to enter the industry are widespread), the resulting supply curve at that price is elastic (see Figure 14.1).

The Distribution of Entry Price Determines the Shape of the Supply Curve

Figure 14.1

An Industry That Anyone Can Enter Easily at the Same Price (a) Has a Flat Supply Curve (b)

At the Most Common entry price, the quantity supplied will Entry increase the most. If all the entry prices are clustered tightly

Figure 14.1

An Industry That Anyone Can Enter Easily at the Same Price (a) Has a Flat Supply Curve (b)

At the Most Common entry price, the quantity supplied will Entry increase the most. If all the entry prices are clustered tightly

A case in point would be the restaurant industry. Because the skills of purchasing, cooking, and serving food are widespread (that is, themselves elastically supplied), an increase in demand for ordinary restaurants will attract an increase in their number at roughly constant cost. Almost all restaurants at the equilibrium of supply and demand would be earning virtually zero economic profits (that is, they would be earning nothing over normal profits), because almost all would have entered (thus revealing their own point of zero profit) at or very slightly below the prevailing price. The supply curve for such an industry, with identical cost curves for all firms and no interdependence in the curves, is flat. It is a common case.

Producers' Surplus Is Economic Rent Is Quasi-rent Is Supernormal Profit

Notice in the diagram, however, the little shaded area. It is the sum of all the excess of the actual price over the minimum price necessary to bring forth various different supplies. In other words, some of the firms are earning profit above normal profit. The profit is called in this context rent (or economic rent to distinguish it from a "rent" payment to a landlord, which may or may not be a true economic rent). If the profits are temporary, it is called quasi-rent.

It is larger when the entry prices are more varied.

Q: Suppose that there are only two kinds of oil land, Persian Gulf with a very low marginal cost curve and entry price and North Sea with a very high marginal cost curve and entry price. View the two as two firms, each of which (however) takes world price as given.

1. If world demand for oil is such that the price is exactly at the Persian Gulf Entry Price, what is the amount supplied? If the price fell 1 cent below the Entry Price in the long run, what would happen?

2. If the price is above the Persian Gulf Entry Price but below the North Sea Entry Price, how is the amount of supply determined? Draw the diagram and show the rent earned at some price.

3. If the price is slightly above the North Sea Entry Price, what happens? If it is still higher, what are the areas of rent?

4. What, therefore, is the area above a supply curve, the area called producer's surplus in earlier chapters?

A: 1. Consider Figure 14.2. If the price is at the Persian Gulf Entry Price, the amount supplied is the amount on the Persian Gulf's marginal cost curve at the entry

Figure 14.2

An Industry That Few Can Enter at a Low Price Has a Steep Supply Curve and Much Rent

Because firms will enter only if it is profitable to do so, they will earn more than the minimum price at which they would enter. That is, they will be profitable. The profits— also called rents or quasi-rents or producers' surplus—are the area between the price they get (the market price) and the price they would accept (their marginal cost curves).


North Sea Entry Price

Persian Gulf Entry Price

North Sea Entry Price

Supply Curve of Persian Gulf

Supply Curve of North Sea plus Supply Curve of Persian Gulf

-Oil Demanded and Supplied (quantity)

price, that is, at the zero-profit (zero-economic-rent) point. Evidently, then, rent is zero. If the price fell 1 cent below the entry price, the Persian Gulf would exit the oil industry, at least in the long run. World output of oil would go to zero.

2. Since the North Sea is still out of the picture, the supply curve when the price is between the two entry prices is simply the Persian Gulf's marginal cost curve. In Figure 14.2 it is the marginal cost curve between the Persian Gulf Entry Price and the North Sea Entry Price. The rent is the area behind the marginal cost curve, being all the profit in excess of zero profit. If the price were 1 cent below the North Sea Entry Price, the Persian Gulf would supply out to that point and the rent would be the area Old Rent. The North Sea would be beyond the "margin of cultivation" (margin in this phrase means "edge" or "outer limit"). At some lower price the quantity supplied and the rent would be the lightly shaded area.

3. If the price is slightly above the North Sea Entry Price, the North Sea enters and quantity supplied jumps out. If it is still higher, the area of rent is the area New Rent plus Old Rent.

4. The area above a supply curve is the sum of economic rents earned in the industry, justifying the notion of producers' surplus used in earlier chapters. The supply curve in the right-hand panel is a scalloped curve because there are only two types of cost curves. If one generalized the argument to many types, ranging from Saudi Arabian through Venezuelan to North Sea oil, the scallops would look smoother and the supply curve more conventional. In any event the producers' surplus is the supernormal profit which is the economic rent.2

2 By defining the rent as costs paid to the owners of the scarce resources earning them (such as very fertile oil land), one could eliminate the rent and declare all cost curves flat. Competition among owners of firms would result in their paying over to landlords all their "profits." This maneuver, which protects the zero-profit condition of equilibrium from any conceivable criticism, is sometimes performed in theoretical works. It lacks point, for the rent is only known as what is left over from revenues when the other (opportunity) costs have been paid. Rent is a residual. To define it as a cost would merely encourage one to think that all cost curves are in fact flat when •they have been made "flat" merely by definition.

The argument returns in the end to its beginning. The supply curve is the sum of each firm's marginal cost, with the condition that price be above the point of zero long-run profit. It is this condition that forces one's gaze outward, from the existing firms toward all potential entrants. What one sees when one gazes outward, as the next section will show, are the most typically economic pieces of reasoning.

Summary The industry cannot for many purposes be defined as the existing firms or as the firms sharing a certain technology of supply. It must be defined as all potentially profitable firms sharing a set of consumers who view the products as substitutes. An industry such as American railroads or rental housing violates the definition by including too much in geography and too little in variety of product. The Boston and Maine Railroad does not share customers with the Chicago and Northwestern Railroad, but it does share customers with Eastern Airlines and the Maine Turnpike. Furthermore, an industry must include all firms that can share the customers profitably, whether presently in existence or not. The existing firms grow and shrink in number (not necessarily in size) as the demand grows and shrinks. As the price rises above and falls below the point of minimum average total cost including normal profit, the firms enter or exit. When all firms happen to have the same entry price the resulting supply curve is flat. When they do not have the same entry price the supply curve slopes upward, and the firms inside the margin (the edge) of cultivation earn economic rents.

1. Decide whether the following are industries. Name the sorts of firms who compete for the same customers (remembering that the only guide is consistency with other uses of "industry," such as the "people transport industry"):

a. Movie theaters, TV, Betamax.

b. Universities.

c. Grocery stores in the United States.

d. American producers of bicycles.

2. Is the manager of a store in a grocery chain an entrepreneur? Is the banker who provides loans to run the business? Is the food technologist hired to invent new ways of packaging meat?

3. Draw the supply curve of typists in Madison, Wisconsin, that corresponds to the following distribution of "entry prices" into the "industry" of typing:

At a Price (Wage) This Many Enter per Hour of: the Industry:

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