Chapter Nine The Rise and Fall of Industries

9 | 2 Copyright © Houghton Mifflin Company. All rights reserved. Markets and Industries Industry – A group of firms producing a similar product. Market – Sometimes used interchangeably with the term “industry”; also used to refer to the consumers who buy goods; also used to refer to the interaction of producers and consumers.

9 | 3 Copyright © Houghton Mifflin Company. All rights reserved. Long Run Competitive Equilibrium Model Long-run competitive equilibrium model – A model of firms in an industry in which free entry and exit produce an equilibrium such that price equals the minimum average total cost.

9 | 4 Copyright © Houghton Mifflin Company. All rights reserved. The difference between the demand curve faced by a competitive firm and the market demand curve is that the competitive firm cannot affect the price in the market and the demand curve is horizontal. The competitive firm’s demand curve is illustrated with the graph on the left side in the following figure. The graph on the right is the market demand curve. Firm and Market Demand

9 | 5 Copyright © Houghton Mifflin Company. All rights reserved. Firm and Market Demand (cont’d) Figure 9.2

9 | 6 Copyright © Houghton Mifflin Company. All rights reserved. Entry and Exit Free entry and exit – A movement of firms in and out of an industry that is not blocked by regulation, other firms, or by any other barriers. When the firms enter or exit, the market or industry supply curve is affected. More firms in the industry shifts the supply curve to the right and less firms shift the supply curve to the left.

9 | 7 Copyright © Houghton Mifflin Company. All rights reserved. Long-Run Equilibrium Long-run equilibrium – A situation in which entry into and exit from an industry are complete and economic profits are zero, with price (P) equal to the average total cost (ATC).

9 | 8 Copyright © Houghton Mifflin Company. All rights reserved. This figure illustrates a market that is in a long-run equilibrium. Long-Run Equilibrium (cont’d) Figure 9.3

9 | 9 Copyright © Houghton Mifflin Company. All rights reserved. In the previous figure, the intersection of the supply and demand curve in the market determines the market equilibrium price. This is the price that the competitive firm takes. The price intersects the marginal cost (remember, P = MC is the profit maximizing rule for a competitive firm) at the minimum of the ATC, and the firm makes zero profits. Long-Run Equilibrium (cont’d)

9 | 10 Copyright © Houghton Mifflin Company. All rights reserved. An Increase in Demand Figure 9.4 illustrates the effects on the equilibrium of an increase in the market demand. The top two graphs illustrate the effects in the short run while the graphs on the bottom illustrate the effects in the long run.

9 | 11 Copyright © Houghton Mifflin Company. All rights reserved. From Figure 9.4, an increase in the demand of a good will result in the following: 1)It will cause the equilibrium price to increase in the short run. 2)In response to the higher price, the firm will sell a higher quantity and generate positive profits. Profits in the short run are illustrated by the shaded rectangle on the top left graph. An Increase in Demand (cont’d)

9 | 12 Copyright © Houghton Mifflin Company. All rights reserved. 3)Because of free entry and exit, more firms will try and enter the industry once it is evident that positive profits are being generated in this industry. 4)The increase in the number of firms will result in an increase in supply (supply shifts right) and a decrease in price. 5)The decrease in price reduces firms’ profits; profits are eventually driven back to zero because P=ATC. An Increase in Demand (cont’d)

9 | 13 Copyright © Houghton Mifflin Company. All rights reserved. In the long run, the end result of an increase in demand is that the increase in demand is met with a corresponding increase in supply. The price, which starts at P = ATC, will end up at P=ATC again in the long run. An Increase in Demand (cont’d)

9 | 14 Copyright © Houghton Mifflin Company. All rights reserved. Economic Profits vs. Accounting Profits It is important to remember that when we say that profits are zero in the long run, we refer to zero economic profits, not zero accounting profits. Accounting profits – Total revenue minus total costs, where total costs exclude the implicit opportunity costs; profits usually reported by firms.

9 | 15 Copyright © Houghton Mifflin Company. All rights reserved. Economic Profits – Total revenue minus total costs, where total costs include opportunity costs, whether implicit or explicit. Normal Profits – The amount of accounting profits when the economic profits are equal to zero. Economic Profits vs. Accounting Profits (cont’d)

9 | 16 Copyright © Houghton Mifflin Company. All rights reserved. Entry or Firm Expansion? In reality, when an industry grows, the growth does not only result in an increase in the number of firms. In the long run, a firm can increase its capital stock and be able to expand. Economic Profits vs. Accounting Profits (cont’d)

9 | 17 Copyright © Houghton Mifflin Company. All rights reserved. Entry or Firm Expansion? Expansion of a firm, instead of increasing the number of firms, usually occurs when the firm size is below the minimum efficient scale (i.e., the firm can still lower the ATC by increasing output) or if a change in the price of inputs pushes the minimum efficient scale into a higher quantity. Economic Profits vs. Accounting Profits (cont’d)

9 | 18 Copyright © Houghton Mifflin Company. All rights reserved. A Decrease in Demand Figure 9.5 illustrates the effects on the equilibrium of an decrease in the market demand. The top two graphs illustrate the effects in the short run while the bottom graphs illustrate the effects in the long run.

9 | 19 Copyright © Houghton Mifflin Company. All rights reserved. From Figure 9.5, a decrease in the demand of a good will result in the following: 1)It will cause the equilibrium price to decrease in the short run. 2)A reduction in demand lowers the price and causes losses. Losses in the short run are illustrated by the unshaded, hash-marked rectangle on the top left graph. A Decrease in Demand (cont’d)

9 | 20 Copyright © Houghton Mifflin Company. All rights reserved. 3)Because of free entry and exit, more firms will try to exit the industry once it is evident that losses are being generated in this industry. 4)The decrease in the number of firms will result in a decrease in supply (supply shifts left) and an increase in price. 5)The higher price raises the profits of the firms until prices return to P = ATC. A Decrease in Demand (cont’d)

9 | 21 Copyright © Houghton Mifflin Company. All rights reserved. Shifts in Cost Curves The following figure illustrates the effects on the equilibrium of a decrease in the marginal cost faced by the firms. The decrease in cost shifts the MC and ATC downward and to the right. The top two graphs illustrate the effects in the short run while the bottom graphs illustrate the effect in the long run.

9 | 22 Copyright © Houghton Mifflin Company. All rights reserved. Shifts in Cost Curves (cont’d) Figure 9.6

9 | 23 Copyright © Houghton Mifflin Company. All rights reserved. Shifts in Cost Curves (cont’d) From Figure 9.6, the decrease in the marginal cost of providing a good will result in the following: 1)It will cause the supply curve to shift to the right, causing the equilibrium price to decrease in the short run. 2)At the lower price, firms are making economic profits, thereby enticing new firms to enter the industry. Short run profits are illustrated by the shaded rectangle in the top left graph.

9 | 24 Copyright © Houghton Mifflin Company. All rights reserved. Shifts in Cost Curves (cont’d) 3)Because of free entry and exit, more firms will try and enter the industry once it is evident that positive profits are being generated. 4)The increase in the number of firms will further increase supply (supply shifts further right) and decrease the price even more. 5)The decrease in price reduces firms’ profits until prices get back to P=ATC.

9 | 25 Copyright © Houghton Mifflin Company. All rights reserved. Case Study: Zinfandel Grapes An example of entry and exit in an industry is the experience of growers of Zinfandel grapes, an input in the production of Zinfandel Wine.

9 | 26 Copyright © Houghton Mifflin Company. All rights reserved. This figure shows the rise and fall of the price of grapes from Case Study: Zinfandel Grapes (cont’d) Figure 9.7

9 | 27 Copyright © Houghton Mifflin Company. All rights reserved. From Figure 9.7, we can see that the price of Zinfandel grapes more than tripled between 1985 and 1988, going from around $200 per ton to around $700 per ton. The increase in the price brought in profits for the Zinfandel farmers, but also brought in new entrants. Case Study: Zinfandel Grapes (cont’d)

9 | 28 Copyright © Houghton Mifflin Company. All rights reserved. Increased profits attracted new entrants to the industry, which increased the number of vineyards growing Zinfandel. Figure 9.8 shows the growth of vineyards in the grape market from Case Study: Zinfandel Grapes (cont’d)

9 | 29 Copyright © Houghton Mifflin Company. All rights reserved. Case Study: Zinfandel Grapes (cont’d) Figure 9.8

9 | 30 Copyright © Houghton Mifflin Company. All rights reserved. From Figure 9.8, the number of new acres planted with Zinfandel grew from less than 1000 in 1985 to nearly 4000 in As expected, this increase in the number of acres resulted in a drop in the price of Zinfandel grapes after Industry profits declined and the number of new entrants sharply dropped in 1989 – Case Study: Zinfandel Grapes (cont’d)

9 | 31 Copyright © Houghton Mifflin Company. All rights reserved. Additional Features of the Long Run Competitive Model 1)Average Total Cost is Minimized – In a competitive market, the lowest average total cost is reached. This is clearly shown in Figures 9.3, 9.4, 9.5, and )Efficient Allocation of Resources – As firms freely enter and exit an industry, capital is efficiently allocated because capital is allocated to the industry that is in demand, and not to another industry.

9 | 32 Copyright © Houghton Mifflin Company. All rights reserved. External Diseconomies and Economies of Scale Long-run industry supply curve – A curve traced out by the intersections of the demand curves shifting to the right and the corresponding short- run supply curves. The long run industry supply curve may slope up or down, depending on whether the industry exhibits external diseconomies or external economies of scale.

9 | 33 Copyright © Houghton Mifflin Company. All rights reserved. External diseconomies of scale – A situation in which growth in an industry causes average total cost for the individual firm to rise because of some factor external to the firm; it results in an upward-sloping, long-run industry supply curve. Figure 9.9 illustrates an industry exhibiting external diseconomies of scale. External Diseconomies and Economies of Scale (cont’d)

9 | 34 Copyright © Houghton Mifflin Company. All rights reserved. External Diseconomies and Economies of Scale (cont’d) Figure 9.9

9 | 35 Copyright © Houghton Mifflin Company. All rights reserved. External Diseconomies and Economies of Scale (cont’d) External economies of scale – A situation in which growth in an industry causes average total cost for the individual firm to drop because of some factor external to the firm; it results in a downward-sloping, long-run industry supply curve. Figure 9.10 illustrates an industry exhibiting external economies of scale.

9 | 36 Copyright © Houghton Mifflin Company. All rights reserved. External Diseconomies and Economies of Scale (cont’d) Figure 9.10

9 | 37 Copyright © Houghton Mifflin Company. All rights reserved. If a firm exhibits neither external diseconomies nor of economies of scale, then the long-run supply curve will be perfectly horizontal. In this case, the intersections of the shifting demand and supply curves trace out a line that is neither upward sloping nor downward sloping. External Diseconomies and Economies of Scale (cont’d)

9 | 38 Copyright © Houghton Mifflin Company. All rights reserved. Key Terms Industry Long-run competitive equilibrium model Free entry and exit Long-run equilibrium Accounting profits and economic profits Normal profits Long-run industry supply curve External diseconomies and economies of scale