CFA® Program Curriculum, Volume 2, page 129 We have described the determination of the profit-maximizing output in the short run for both price-taker and price-searcher firms. For a given plant size, producing up to the quantity where marginal revenue equals marginal cost will maximize profits as long as price at that output quantity is greater than average variable cost.
In the long run, when plant size is variable, firms under perfect competition will all choose to operate at the minimum average cost, considering all possible plant sizes (scales of operation). In Figure 14, we have reproduced the long-run average total cost curve derived previously, with short-run average cost for two firm sizes. Consider first firm-size 1 with short-run average total cost curve SRATCj when the market price is Py A firm at this scale can increase its size to firm-size 2, decreasing its SRATC to the level of P2 at the minimum point of SRATC2- If the market price remains at Py the firm will now earn economic profits. But all firms have the option of increasing scale to the minimum efficient scale and will increase to this scale in search of profits.
In equilibrium, they will be back to zero economic profit, however, as the increase in market supply (as firms increase size to Q2) causes the market price to decline to P2.
Figure 14: Long-Run Average Total Cost
Price
scale = Q2
For a price below P2 under perfect competition, firms will have economic losses, and some will exit the industry. This exit of firms from the industry reduces market supply and increases market price. Firms will exit the industry until market price increases to P2 and firms are again earning economic profits of zero. In sum, entry of firms into the industry or increases in firm size in response to positive economic profit opportunities put downward pressure on market price. The exit of firms from the industry when economic profit is negative decreases industry supply, and the equilibrium market price increases. From this analysis, we can conclude that the long-run industry supply curve is perfectly elastic at the ATC for the minimum efficient scale, P2 in our example. In practice, this result will hold only if the cost of the firms’ inputs is constant as the industry expands output. Next, we consider industries for which input costs (or input quality) change as an industry expands output.
LOS 15-i: Distinguish among decreasing-cost, constant-cost, and increasing- cost industries and describe the long-run supply of each.
CFA® Program Curriculum, Volume 2, page 131 What we did not consider in describing the effects of firms that increase output or scale in response to positive economic profits is that resource prices may increase as industry output increases. While the output decision of a single firm does not affect market price, increases in output by many or all firms can drive up the price of resources.
Consider an increase in demand that results in an increase in the market price. In the short run, all firms earn positive economic profits when the market price rises. As firms enter the industry in pursuit of profits, the demand for the productive inputs specific to the industry increases, and their market prices increase as well. This results in an increasing-cost industry. This can also result from a reduction in the quality of inputs as production expands. The long-run supply curve for the industry is upward-sloping as a result. Higher output is associated with more firms but also higher ATC as input prices rise or input quality deteriorates. Oil is an example of an increasing cost industry because as demand for oil increases over time, the costs of finding and producing a barrel of oil increase as more and more is produced.
For some industries, resource prices fall as the industry expands. In this case, the industry is said to be a decreasing-cost industry, and the long-run industry supply curve is downward sloping. A recent example is the flat-panel television industry. As the industry grew and demand for the electronic components for flat-panel televisions grew, the manufacturing cost of these inputs fell significantly. Economies of scale in the production of components reduced prices and the ATC for flat-panel television manufacturers, and prices fell each year as the industry grew to replace conventional televisions.
For ranges of industry output in which input prices do not increase or decrease, the industry supply curve is perfectly elastic at minimum average cost. We refer to this as a constant-cost industry.
Figure 15 illustrates the long-run industry supply (SLR) curve for increasing-, decreasing- and constant-cost industries. In each panel, from an initial equilibrium at Point 1, an increase in market demand to D1 increases both price and output in the short run (Point 2). Over time, the increase in market price produces economic profits for firms. The resulting entry of firms to the industry and expansion of scale by existing firms increases supply to Sj (Point 3). Whether the new long-run equilibrium price is above or below the initial equilibrium price as the industry expands depends on the effect of industry expansion on input prices. For decreasing-cost industries, the equilibrium price falls with industry growth; for increasing-cost industries, price rises; and for constant-cost
Study Session 4
^ Figure 15: Long-Run Industry Supply Curves
Price (a) Increasing-cost industry Price (b) Decreasing-cost industry
Price (c) Constant-cost industry
Example: Long-run industry supply
Minifone, Ltd. produces personal electronics, currently a decreasing-cost industry.
Demand for the products has increased recently. What is most likely to happen in the long run to selling prices and per-unit production costs?
Answer:
Because Minifone operates in a decreasing-cost industry, the most likely equilibrium response to an increase in demand is for prices and per-unit production costs to decrease.
LOS 15-j: Calculate and interpret total, marginal, and average product of labor. * • CFA® Program Curriculum, Volume 2, page 134 We discussed the marginal product of labor and diminishing returns to a factor of production in connection with our analysis of a firm’s production function. For a production process with a fixed amount of capital, we can define the following terms:
• The total product of labor is the output for a specific amount of labor.
• The average product of labor per worker (or other unit of labor input) is the total product of labor divided by the number of workers (or units of labor employed).
• The marginal product of labor is the addition to the total product of labor from employing one more unit of labor.
We illustrate these calculations for Sam’s Shirts in Figure 16 based on the production schedule given in terms of output employing different quantities of labor. Note that the marginal product of labor at first increases as more workers are employed, and then it decreases as additional workers are added. This is consistent with an average product of labor that first increases, and then it decreases as more workers are added. Recall that the quantity of labor employed at which the marginal product of labor begins to decrease is the point of diminishing marginal productivity of (or diminishing marginal returns to) labor. Note in the table that total product in measured in shirts, and average and marginal product are measured in shirts per worker.
Figure 16: Short-Run Output as a Function of Labor Employed
Workers Total Product Marginal Product Average Product
1 8 8 8.0
2 20 12 10.0
3 26 6 8.7
4 30 4 7.5
5 32 2 6.4
6 33 1 5.5
For analysis, the usefulness of the total product measure is limited, as it does not measure the efficiency of any one firm. It provides information on the output of the firm relative to industry output. Average product is a measure of overall efficiency, not the efficiency of any one worker. Marginal product is a better measure of the productivity of an individual worker and is preferred over average product or total product. However, average product may be an appropriate measure when it is difficult to determine the productivity of any one worker (e.g., a team that performs tasks collectively).