demand. The nature of the adjustment depends on the cost conditions under
which the industry is operating. In this context the cost conditions refer to the
existence of external economies and diseconomies of scale, which were
defined in Chapter 6. Under constant cost conditions the firm experiences
no external economies or diseconomies when the industry grows in size. Under
increasing cost conditions the firm experiences external diseconomies of
scale; these can be caused by the prices of inputs being driven up by the
increased demand for them. Thus firms may have to pay higher raw material
costs and wages as the industry expands, particularly if the industry has
already reached a mature phase. This means that the firms will find both
short- and long-run unit cost functions shifting upwards. Under decreasing
cost conditions the firm experiences external economies of scale; in this case
input prices are falling as the industry expands. This is most likely to happen in
the initial growth phase of the industry, as the presence of other firms,
particularly in the same locality, helps to provide an infrastructure of complementary
firms, services and skilled labour. This has the effect of shifting the
unit costs downwards. These different cost conditions are now examined
graphically.
a. Constant costs
The effects of an increase in demand are shown in Figure 8.3. In the short run
the increase in demand causes an increase in price (from P1 to P2), since firms
face increasing marginal costs in producing more output (q2 instead of q1) and
no new firms can enter the industry in this time frame. In the long run the
supply curve shifts to S2 as more firms enter the industry, the price falls back to
P1 at the minimum point of LAC, and the firms’ demand curve falls from D2
back to D1. Each firm in the industry ends up selling the same amount as
originally (q1), but with more firms the total industry output increases from Q1
to Q 2. The long-run supply curve in the industry is therefore horizontal, as
shown by SL.