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2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

Prepared by:

Fernando & YvonnQuijano

9

Chapter

Long-Run Costsand Output Decisions

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Chapter Outline9Long-Run Costs

and Output Decisions

Short-Run Conditions and Long-

Run Directions

Maximizing Profits

Minimizing LossesThe Short-Run Industry Supply Curve

Long-Run Directions: A Review

Long-Run Costs: Economies and

Diseconomies of Scale

Increasing Returns to Scale

Constant Returns to Scale

Decreasing Returns to Scale

Long-Run Adjustments

to Short-Run ConditionsShort-Run Profits: Expansion to Equilibrium

Short-Run Losses: Contraction to Equilibrium

The Long-Run Adjustment Mechanism:

Investment Flows toward Profit Opportunities

Output Markets: A Final Word

Appendix: External Economies and

Diseconomies and the Long-Run Industry

Supply Curve

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LONG-RUN COSTS AND OUTPUT DECISIONS

We begin our discussion of the long run by looking at firmsin three short-run circumstances:

(1) firms earning economic profits,

(2) firms suffering economic losses but continuing tooperate to reduce or minimize those losses, and

(3) firms that decide to shut down and bear losses just

equal to fixed costs.

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SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

breaking evenThe situation in which a firmis earning exactly a normal rate of return.

Example: The Blue Velvet Car Wash

MAXIMIZING PROFITS

TABLE 9.1Blue Velvet Car Wash Weekly Costs

TOTAL FIXED COSTS (TFC)

TOTAL VARIABLE COSTS

(TVC) (800 WASHES)

TOTAL COSTS

(TC=TFC+TVC) $3,600

1.Normal return to investors $1,000 1.

2.

Labor

Materials

$1,000

600

Total revenue (TR)

atP= $5 (800 x $5) $4,000

2.Other fixed costs

(maintenance contract,

insurance, etc.) 1,000

$1,600 Profit (TRTC) $ 400

$2,000

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Graphic Presentation

FIGURE 9.1Firm Earning Positive Profits in the Short Run

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MINIMIZING LOSSES

operating profit (or loss) or net operatingrevenueTotal revenue minustotal variable cost (TRTVC).

In general,

If revenues exceed variable costs, operating

profit is positive and can be used to offset fixed

costs and reduce losses, and it will pay the firmto keep operating.

If revenues are smaller than variable costs, the

firm suffers operating losses that push total

losses above fixed costs. In this case, the firm

can minimize its losses by shutting down.

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Producing at a Loss to Offset Fixed Costs: TheBlue Velvet Revisited

TABLE 9.2A Firm Will Operate If Total Revenue Covers Total Variable Cost

CASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $3

Total Revenue (q= 0) $ 0 Total Revenue ($3 x 800) $2,400

Fixed costs

Variable costs

Total costs

+

$

$

2,000

0

2,000

Fixed costs

Variable costs

Total costs

+

$

$

2,000

1,600

3,600

Profit/loss (TRTC) $2,000 Operating profit/loss (TRTVC) $ 800

Total profit/loss (TRTC) $1,200

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FIGURE 9.2Firm Suffering Losses but Showing an Operating Profit in the Short Run

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ATCAFC!AVCor

AFC = ATC AVC = "#$%0 "&$%0 "%$00

Remember that average total cost is equal to averagefixed cost plus average variable cost. This means that atevery level of output, average fixed cost is the differencebetween average total and average variable cost:

As long as price (which is eual to average revenue per unit! is sufficient to cover average

variable costs, the firm stands to gain by operating instead of shutting down.

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Shutting Down to Minimize Loss

TABLE 9.3A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost

CASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $1.50

Total Revenue (q= 0) $ 0 Total revenue ($1.50 x 800) $1,200

Fixed costsVariable costs

Total costs

+$

$

2,0000

2,000

Fixed costsVariable costs

Total costs

+$

$

2,0001,600

3,600

Profit/loss (TRTC): $2,000 Operating profit/loss (TRTVC) $ 400

Total profit/loss (TRTC) $2,400

Any time that price (average revenue! is below the minimum point on the average variable

cost curve, total revenue will be less than total variable cost, and operating profit will be

negative"that is, there will be a loss on operation. In other words, when price is below all

points on the average variable cost curve, the firm will suffer operating losses at any

possible output level the firm could choose. #hen this is the case, the firm will stop

producing and bear losses eual to fixed costs. $his is why the bottom of the average

variable cost curve is called the shut%down point. At all prices above it, the marginal cost

curve shows the profit%maximizing level of output. At all prices below it, optimal short%run

output is zero.

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$he short%run supply curve of a competitive firm is that portion of its marginal cost

curve that lies above its average variable cost curve (&igure '.!.

shut-down pointThe lowest point on theaverage variable cost curve. When pricefalls below the minimum point on AVC, totalrevenue is insufficient to cover variable

costs and the firm will shut down and bearlosses equal to fixed costs.

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FIGURE 9.3Short-Run Supply Curve of a Perfectly Competitive Firm

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FIGURE 9.4The Industry Supply Curve in the Short Run Is the Horizontal Sum of

the Marginal Cost Curves (above AVC) of All the Firms in an Industry

short-run industry supply curveThesum of the marginal cost curves (above

AVC) of all the firms in an industry.

THE SHORT-RUN INDUSTRY SUPPLY CURVE

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LONG-RUN DIRECTIONS: A REVIEW

TABLE 9.4Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and

Short Run

SHORT-RUNCONDITION

SHORT-RUNDECISION

LONG-RUNDECISION

Profits TR > TC P = MC: operate Expand: new firms enter

Losses 1. With operating profit P = MC: operate Contract: firms exit

(TRTVC) (losses < fixed costs)

2. With operating losses Shut down: Contract: firms exit

(TR

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LONG-RUN COSTS: ECONOMIESAND DISECONOMIES OF SCALE

increasing returns to scale,oreconomies ofscaleAn increase in a firms scale of productionleads to lower costs per unit produced.

constant returns to scaleAn increase in afirms scale of production has no effect on costsper unit produced.

decreasing returns to scale,ordiseconomies

of scaleAn increase in a firms scale ofproduction leads to higher costs per unitproduced.

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INCREASING RETURNS TO SCALEThe Sources of Economies of Scale

Most of the economies of scale that immediately

come to mind are technological in nature.

Some economies of scale result not from technologybut from sheer size.

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Example: Economies of Scale in Egg ProductionTABLE 9.5Weekly Costs Showing Economies of Scale in Egg Production

JONES FARM TOTAL WEEKLY COSTS

15 hours of labor (implicit value $8 per hour) $120Feed, other variable costs 25

Transport costs 15Land and capital costs attributable to egg production 17

$177

Total output 2,400 eggs

Average cost $.074 per egg

CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTS

Labor $ 5,128Feed, other variable costs 4,115

Transport costs 2,431

Land and capital costs 19,230

$30,904

Total output 1,600,000 eggs

Average cost $.019 per egg

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long-run average cost curve (LRAC)A graphthat shows the different scales on which a firm

can choose to operate in the long run.

O G COSS CO O S

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FIGURE 9.5A Firm Exhibiting Economies of Scale

LONGRUNCOSTSECONOMIES

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CONSTANT RETURNS TO SCALE

Technically, the termconstant returnsmeans that thequantitative relationship between input and output staysconstant, or the same, when output is increased.

Constant returns to scale mean that the firms long-runaverage cost curve remains flat.


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DECREASING RETURNS TO SCALE

FIGURE 9.6A Firm Exhibiting Economies and Diseconomies of Scale

All short%run average cost curves are )%shaped, because we assume a fixed scale of plant

that constrains production and drives marginal cost upward as a result of diminishing

returns. In the long run, we make no such assumption* instead, we assume that scale of

plant can be changed.


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optimal scale of plantThe scale of plant thatminimizes average cost.

It is important to note that economic efficiency requirestaking advantage of economies of scale (if they exist)and avoiding diseconomies of scale.

LONGRUNADJUSTMENTS

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LONG-RUN ADJUSTMENTSTO SHORT-RUN CONDITIONS

SHORT-RUN PROFITS: EXPANSION TO EQUILIBRIUM

FIGURE 9.7Firms Expand in the Long Run When Increasing Returns

to Scale Are Available

LONGRUNADJUSTMENTS

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&irms will continue to expand as long as there are economies of scaleto be realized, and new firms will continue to enter as long as positive

profits are being earned.

In the long run, euilibrium price (P+! is eual to long%run average

cost, short%run marginal cost, and short%run average cost. rofits are

driven to zero-

P* = SRMC = SRAC = LRAC

where SRMCdenotes short%run marginal cost, SRACdenotes short%

run average cost, and LRACdenotes long%run average cost. o other

price is an euilibrium price. Any price above P*means that there areprofits to be made in the industry, and new firms will continue to

enter. Any price below P*means that firms are suffering losses, and

firms will exit the industry. /nly at P*will profits be 0ust eual to zero,

and only at P* will the industry be in euilibrium.

LONGRUNADJUSTMENTS

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SHORT-RUN LOSSES: CONTRACTION TOEQUILIBRIUM

FIGURE 9.8Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses

LONGRUNADJUSTMENTS

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As long as losses are being sustained in an industry, firms will shutdown and leave the industry, thus reducing supply"shifting the

supply curve to the left. As this happens, price rises. $his gradual

price rise reduces losses for firms remaining in the industry until

those losses are ultimately eliminated.

#hether we begin with an industry in which firms are earning profits

or suffering losses, the final long%run competitive euilibrium

condition is the same-

P* = SRMC = SRAC = LRAC

and profits are zero. At this point, individual firms are operating at the

most efficient scale of plant"that is, at the minimum point on their

LRACcurve.

LONGRUNADJUSTMENTS

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THE LONG-RUN ADJUSTMENT MECHANISM:

INVESTMENT FLOWS TOWARD PROFITOPPORTUNITIES

In efficient markets, investment capital flows toward profit opportunities.

$he actual process is complex and varies from industry to industry.

When firms in an industry are making positive

profits, capital is likely to flow into that

industry. Entrepreneurs start new firms, and

firms producing entirely different productsmay join the competition. The success of Ben

and Jerrys has inspired a slew of imitators

to compete in the ice cream industry.

LONGRUNADJUSTMENTS

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Investment"in the form of new firms and expanding old firms"will over time tend

to favor those industries in which profits are being made, and over time industries in

which firms are suffering losses will gradually contract from disinvestment.

long-run competitive equilibrium WhenP=SRMC=SRAC=LRACand profits arezero.

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OUTPUT MARKETS: A FINAL WORD

In the last four chapters, we have been building a modelof a simple market system under the assumption ofperfect competition.

You have now seen what lies behind the demandcurves and supply curves in competitive outputmarkets. The next two chapters take up competitiveinput markets and complete the picture.

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breaking even

constant returns to scale

decreasing returns to scale,or diseconomies of scale

increasing returns to scale,

or economies of scale

long-run average cost curve

(LRAC)

REVIEW TERMS AND CONCEPTS

long-run competitive equilibrium

operating profit (or loss) or net

operating revenueoptimal scale of plant

short-run industry supply curve

shut-down point

long-run competitive equilibrium,

P=SRMC=SRAC=LRAC

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EXTERNAL ECONOMIES AND DISECONOMIESAND THE LONG-RUN INDUSTRY SUPPLY CURVE

Appendix

When long-run average costs decrease

as a result of industry growth, we say thatthere areexternal economies.

When average costs increase as a resultof industry growth, we say that there areexternal diseconomies.

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Appendix

TABLE 9A.1Construction of New Housing and Construction Materials Costs, 20002005

YEAR

HOUSE PRICES

%OVER

THE PREVIOUS

YEAR

HOUSING

STARTS

HOUSING

STARTS

% CHANGE

OVER THE

PREVIOUS

YEAR

CONSTRUCTION

MATERALS

PRICES

% CHANGE

OVER THE

PREVIOUS

YEAR

CONSUMER

PRICES

% CHANGE

OVER THE

PREVIOUS

YEAR2000 1573

2001 7.5 8.2 1661 5.6% 0% 2.8%

2002 7.5 6.6 1710 2.9% 1.5% 1.5%

2003 7.9 6.4 1853 8.4% 1.6% 2.3%

2004 12.0 1949 5.2% 8.3% 2.7%

2005 13.4 2053 5.3% 5.4% 2.5%

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Appendix

THE LONG-RUN INDUSTRY SUPPLY CURVE

FIGURE 9A.1A Decreasing-Cost Industry: External Economies

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Appendix

long-run industry supply curve (LRIS)A graph that traces out price and total

output over time as an industry expands.

decreasing-cost industryAn industrythat realizes external economiesthat is,average costs decrease as the industrygrows. The long-run supply curve for suchan industry has a negative slope.

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Appendix

FIGURE 9A.2An Increasing-Cost Industry: External Diseconomies

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increasing-cost industryAn industrythat encounters external diseconomiesthat is, average costs increase as theindustry grows. The long-run supply

curve for such an industry has a positiveslope.

constant-cost industryAn industry thatshows no economies or diseconomies ofscale as the industry grows. Suchindustries have flat, or horizontal, long-runsupply curves.

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