Welcome back. In the last session, we looked at how long run competitive equilibrium gets established in a perfectly competitive industry. Now, we're going to turn to dealing with a subtlety, an important one at that, as an overall competitive industry expands or shrinks. What happens if input prices change along the way? So far, we've assumed that input prices don't change along the way, and we've dealt with what is known as a Constant cost competitive industry. That input prices, no matter how small the industry is or how large, stay the same at different at different levels of operation. The more common case is an industry that's Increasing cost, that certain inputs get bit up in price as an industry seeks to expand. take the case of land in a place like Hong Kong or in a place like Los Angeles where there's certain limits imposed by mountainous terrain. As the industry expands for producing real estate, the input particularly land, gets more and more expensive and that has to be reflected in the cost of doing business in the LA Basin or in the Hong Kong area. There are other spots, let's say in the Midwest of the United States, where there are no similar geographic constraints imposed by mountains, that we won't see that increase in real estate costs, should a city, expand, that have to be dealt with. And then there's also potential, although very rare, where certain input costs may decrease as an industry expands. Now let's take a closer look at what this means, so far we've looked at a Constant Cost Industry, and let's run through what that means say initially and panel B shows what's going on In the market for MBA education overall, the United States, for example, produces 120,000 MBAs each year through over 500 accredited different schools. And say the initial demand is D, and the initial short-run supply curve, the summation of the existing business schools is SS and we look at the individual business school, in particular the NYU Stern School of Business, the price this firm faces for the tuition it can charge is at a level of P. In long-run competitive equilibrium, assuming that's where we start, the price where it intersects with the firm's short-run marginal cost curve NYU's business school isn't making any money. It's operating at Q1, small Q1, charging P in tuition, and just covering long-run average cost. What happens if the industry expands? There's an increase in demand for MBA education so the overall demand curve shifts to D'. Initially, if there's no entry, that D', we look at panel B, the short run effect on price is a rise in tuition to P'. We look at where that new D prime curve hits the short-run supply curve, SS, higher price of P prime. And what that provides is an incentive for each business school like NYU to expand output from Q1 to Q2 in panel a. And each representative business school makes money, average revenue prime is above long-run average cost. Is that a long run equilibrium? No. Why? Because profits are greater than zero and that positive signal will track more entry into this business. More marginal cost curves mean the short run supply curve shifts over to SS prime and that shift will keep occurring so long as there's positive profit signal. And in a case where input costs don't change, where the long-run average cost doesn't change as the industry expands, as does the, nor does the short-run marginal cost curve, price will end up being driven down to its original level, entry will keep occurring until it wipes out the profit signal. So we started with the change in demand short run going from point A to point B in the overall industry panel, panel B, a representative firm changed output to point E in panel A. But long-run, the long-run equilibrium that gets established after entry occurs brings us back down to point C where the SS prime curve hits the D prime curve. What the long-run supply curve does is it connects all points of long-run equilibrium and the points in panel B where the industry is no longer in equilibrium. One of the points is point A, another point is point C, note why point B isn't on the long run supply curve, that's because there's still positive profits and there's still that signal to handle the business that prevails at point b. If input cost stay the same as an industry expands, the long-run supply curve is flat, as we see in panel B, when we connect points A and C. And what that flatness indicates is that, the average cost of production in the long run hasn't changed, as this industry's expanded from Q1 to Q3. Maybe the case, but it doesn't need to be and let's turn now to another possibility. We're going to take the same MBA education market and that same initial shift from D to D prime, let's see what happens in both the short-run and the long-run Initially, NYU's business school, still producing small Q1, where the SMC curve hits the price curve. With the increase in price, as demand increases for MBA education, price goes to P' just like before, this firm this particular business school expands output in the short-run to Q2 and makes money because average revenue prime is above average long-run average cost. But in an increasing cost business what will happen differently along the way as entry occurs, certain inputs get bid up in price and what we've seen in the business education process, in the marketplace in business education. Faculty have been one particular input that's been bid up in price, and nowadays for example, a Rookie Finance professor can cost a business school 200,000 dollars, a more senior finance professor can cost $350,000. Salaries as the industry's expanded over the last 40 years have been going up but at quicker than inflation rate, if inputs costs go up, like Finance professors, what'll happen to the cost curves? The cost curves themselves, the long-run average cost curve will rise to reflect those higher input costs for any individual firm producing output in this business, so will the short-run marginal cost curve as I've seen prime. And note here we've been focused on just the cost towards the matter driving home this point. Long-Run average cost of production and the short-run marginal cost to determine what particular output level the firm would produce at an in any short-run setting, entry by itself will serve to lower price, just like we saw before. As the SS curve starts shifting to the right driving down price, that lower and lower price will work to extinguish the profit signal, will shave some profits off the top and yet in an increasing cost industry as costs rise, they also serve to eliminate profits from the bottom. There's less opportunity, there's less of a wedge between the prevailing price and the height of costs. Where do we end up in an increasing cost case? Price will fall to the point where profits are wiped out, at the new higher long-run average cost curve so, we'll end up at the bottom of an LAC prime curve, higher input costs for any representative firm. Each firm will still be producing at a price now P double prime, where P double prime equals the SMC prime, the higher marginal cost of production but no profits, and so instead of price falling to its initial level, it doesn't fall as much, why? Because costs, have been rising along the way and squeezing out profits from the bottom. In an increasing costs case, the long run supply curve will be upward sloping, it's height will get larger, higher, as the industry expands. We still made that same initial move from point A to point B in the short run but now we've ended up at point C, at a higher level of unit cost than prevailed before as this industry expanded. And connecting the long-run equilibrium points A and C, we end up with that long-run supply curve. Now, to emphasize the, that MBA education is an increasing cost business just to share with you some facts. So USC's Marshall school, a representative school that I used to be a part of, in 1970, believe it or not, actually charged $1950 a year nowadays, the school charges $55,000 a year for MBA tuition, in real terms, that's the equivalent of about $10,000. So prices have gone up as the MBA education market has expanded and a key reason those prices have gone up, haven't returned to their initial real levels is because input costs, like faculty costs have been driven up along the way. Now, let me just cover, is it possible for a cost to actually go down as an industry expands? There's certain costs like GMAT tests potentially or how business schools take applications that may become cheaper to do as the industry gets larger but it, it's, still rare to think of the situation where an overall industry is able to access a certain technology of lower input cost as the industry expands. It is true that we observe certain industries with price declining over time, but more then likely it's not due to being a Decreasing Cost case as an industry, more than likely it's due to technology improving over time. Let's look at figure 9.12 where we look at the price and equilibrium quantities over time of pocket calculators in the seventies, where the long run supply curve met demand was at a pretty high unit price calculators at that time, were going for 300 dollars a unit. Over time sales have expanded but the cost have come down significantly and isn't because necessarily the long-run supply curve's downward sloping, it's much more likely that it's been due to the long-run supply curve rightward shifting over time as technology has improved. So along long-run supply curve we assume technology remains the same, when technology changes, the long-run supply curve shifts. We'll now turn in the next session to emphasizing a few other key points, about the long-run supply curve.
