Declining Industries
What happens when a competitive industry in long-run equilibrium
experiences a continual decrease in the demand for its product? One
example of this might be a long-term reduction in demand for in-store
video rentals driven by the availability of online movies. Another example
is the ongoing substitution away from glass soft-drink bottles to plastic
ones. As market demand for these products declines, market price falls,
and firms that were previously covering average total costs are no longer
able to do so. They find themselves suffering losses instead of breaking
even; the signal for the exit of capital is given, but exit takes time.
The Response of Firms
The profit-maximizing response to a steadily declining demand is to
continue to operate with existing equipment as long as revenues can
cover the variable costs of production. As equipment becomes obsolete
because the firm cannot cover even its variable cost, it will not be
replaced unless the new equipment can cover its total cost. As a result,
the capacity of the industry will shrink. If demand keeps declining,
capacity will continue shrinking.
Declining industries typically present a sorry sight to the observer.
Revenues are below long-run total costs and, as a result, new equipment
is not brought in to replace old equipment as it wears out. The average