Illustrate, diagrammatically, the effects on the individual firm and industry of an increase in the level of productivity of that industry. (Assume a perfectly competitive industry and that the industry and firms were initially in long run equilibrium and that all the firms in the industry have similar cost curves).
There are several assumptions in a perfectly competitive market. First is the existence of many suppliers having an insignificant share in the market because each firm is small relative to the market that it cannot significantly affect price by changing its supply. In this case, all firms are price takers. Second is the production of homogenous or standardized products, which are perfect substitutes. Third is the existence of perfect information on price of all firms so that in case a firm increases its market price there will be a huge substitution effect away from the firm. Fourth is equal access to resources and technology. Fifth is the lack of barriers to entry and exit of firms in the long run making the market open to competition from new firms. Sixth is the lack of externalities in relation to consumption and production such as social cost and benefits. (2002)
In a perfectly competitive industry long run equilibrium exists when there is no longer an incentive for firms to enter or exit the industry because the existing firms are receiving normal profit. Price is equivalent to the long run average cost.
In a given industry, if the firms are receiving abnormal profits then there will be an output expansion. The situation provides an incentive for new firms to enter the industry. As new suppliers come in, there is a shift in the supply curve from Ms to MS2 shown in Figure 1 below. Assuming that the demand curve is unchanged, the increase in market supply would lower the price from P1 to P2. If this happens, then a decrease in equilibrium market price would happen until such time that the price equals the long run average cost of the firm. (1999)
Figure 1: Shift in Supply Curve caused by the Entry of New Firms
Figure 2: Achievement of Long Run Equilibrium
During the stage when equilibrium supply is at MS, equilibrium price is at Pe then the profit maximizing level is at Qe as seen in Figure 2 above. In this case, individual firms are only receiving normal profit or the profit level sufficient for a firm in a given industry not to shift its resources for the production of other goods and services and into another industry. This is the reason why there is no longer any incentive for new firms to enter the market. The result is long run equilibrium. Long run equilibrium in a perfectly competitive industry is a situation where economic profit is at the zero level so that entry and exit ceases. In this situation, the long run average cost is consequently at its minimum so that firms do not have the incentive to change the size of their plants. (L1999)
Assuming that an industry and firms within the industry are experiencing long run equilibrium, the decision to expand production depends upon its effect on the performance of the individual firm and the industry in terms of efficiency scale. Again, long run equilibrium means productive efficiency because the firms in the industry are operating at the minimum point in their long run average total cost curve, which means that they are utilizing the most efficient scale of efficiency as shown in Figure 3 below. Moreover, firms experiencing long run equilibrium are also at their allocation efficiency because price is equal to marginal cost for the last unit of output produced. Due to this, the value of the resources used in producing the last unit of output is also equal to the value of the output produced. It would then be economical to shift production in a manner that would improve the scale of efficiency. (1999)
Figure 3: Efficient Scale of Production in Long Run Equilibrium
Apart from the profit consideration in deciding on increasing productivity in long run equilibrium, other factors have to regarded, such as the nature of the industry. If the firm belongs to a constant cost industry, any change in the equilibrium level of output does not have an effect on the long run equilibrium price. If the firm belongs to an increasing or decreasing cost industry, any changes in the equilibrium level of output will have an effect on average cost. This is because in an increasing cost industry, the increase in output increases the cost of producing the additional output. The change in long run equilibrium price depends upon the corresponding changes in demand. These considerations imply that any changes in the industry output may have an effect on the cost function of the individual firms.
In an increasing cost industry, increase in productivity is expressed by the shift in the supply curve as seen in the leftmost diagram in figure 4 below. The new supply curve at S’ intersects the new demand curve at D’ corresponding to the new equilibrium price Po and the equilibrium quantity Qo. The leftmost diagram shows that there is an increase in price due to the shift in the supply curve because the increased production resulted to increased cost.
Figure 4: Shifts in the Increasing Cost Industry
The effect of the shifts in the supply and demand curves in an increasing cost industry shifts the long run average cost curve upwards as shown in the rightmost diagram in Figure 4 above. This implies that the minimum efficient scale is now achieved at a higher cost.
In a constant cost industry, an increase in supply results to the corresponding changes in the supply and demand curves as shown in the leftmost diagram of figure 5 below. This results to a change in equilibrium quantity at Qo but equilibrium price remains the same at Pe. Because of these changes, the long run average cost curve does not shift so that the minimum efficient scale does not change.
Figure 6: Shifts in a Decreasing Cost Industry
The effect of increasing production in an industry to a firm and to the industry depends upon the characteristics of the industry as shown above.
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