CHAPTER 9 Long-Run Costs and Output Decisions © 2009 Prentice Hall Business Publishing Principles...

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© 2009 Prentice Hall Business Publishing Principles of Economics 9e by Case, Fair and Oster

PowerPoint Lectures for

Principles of Microeconomics, 9e

By

Karl E. Case, Ray C. Fair & Sharon M. Oster

; ;

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9PART II THE MARKET SYSTEM

Long-Run Costs and Output Decisions

Fernando & Yvonn Quijano

Prepared by:

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9PART II THE MARKET SYSTEM

CHAPTER OUTLINEShort-Run Conditions and Long-

Run Directions

Maximizing ProfitsMinimizing LossesThe Short-Run Industry Supply CurveLong-Run Directions: A Review

Long-Run Costs: Economies and Diseconomies of Scale

Increasing Returns to ScaleConstant Returns to ScaleDecreasing Returns to Scale

Long-Run Adjustmentsto Short-Run Conditions

Short-Run Profits: Expansion to EquilibriumShort-Run Losses: Contraction to EquilibriumThe 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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We begin our discussion of the long run by looking at firms in three short-run circumstances:

(1) firms earning economic profits,

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

(3) firms that decide to shut down and bear losses just equal to fixed costs.

breaking even The situation in which a firm is earning exactly a normal rate of return.

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Short-Run Conditions and Long-Run Directions

Example: The Blue Velvet Car Wash

Maximizing Profits

TABLE 9.1 Blue 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.

LaborMaterials

$ 1,000600

Total revenue (TR) at P = $5 (800 x $5) $ 4,000

2. Other fixed costs (maintenance contract, insurance, etc.) 1,000

$ 1,600 Profit (TR TC) $ 400

$ 2,000

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Refer to the figure. Given the market price and cost conditions described in the graphs, which of the four firms earns a normal rate of return?

a. A

b. B

c. C

d. D

e. All of the firms above earn a normal rate of return because they produce the level of output for which MR = MC.

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Refer to the figure. Given the market price and cost conditions described in the graphs, which of the four firms earns a normal rate of return?

a. A

b. B

c. C

d.d. DD

e. All of the firms above earn a normal rate of return because they produce the level of output for which MR = MC.

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FIGURE 9.1 Firm Earning Positive Profits in the Short Run

A profit-maximizing perfectly competitive firm will produce up to the point where P* = MC. Profits are the difference between total revenue and total costs. At q* = 300, total revenue is $5 × 300 = $1,500, total cost is $4.20 × 300 = $1,260, and total profit = $1,500 $1,260 = $240.

Maximizing Profits

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Use the graph in the upper-left corner as a reference. When the firm produces 600 units of output, which area, A, B, or C, corresponds to the firm’s profit?

a. A

b. B

c. C

d. None of above. Profit is not anarea but a distance.

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Use the graph in the upper-left corner as a reference. When the firm produces 600 units of output, which area, A, B, or C, corresponds to the firm’s profit?

a. A

b. B

c.c. CC

d. None of above. Profit is not anarea but a distance.

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operating profit (or loss) or net operating revenue Total revenue minus total variable cost (TR TVC).

■ 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 firm to 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.

Minimizing Losses

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Producing at a Loss to Offset Fixed Costs: The Blue Velvet Revisited

TABLE 9.2 A 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 costsVariable costsTotal costs

+$

$

2,0000

2,000


+$

$

2,0001,6003,600

Profit/loss (TR TC)

$ 2,000 Operating profit/loss (TR TVC) $ 800

Total profit/loss (TR TC) $ 1,200

Minimizing Losses

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FIGURE 9.1 Firm Suffering Losses but Showing an Operating Profit in the Short Run

When price is sufficient to cover average variable costs, firms suffering short-run losses will continue operating instead of shutting down. Total revenues (P* × q*) cover variable costs, leaving an operating profit of $90 to cover part of fixed costs and reduce losses to $135.

Minimizing Losses

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Whether or not a firm decides to produce or shut down in the short run depends solely on whether revenues from operating are sufficient to cover:

a. Fixed costs.

b. Variable costs.

c. Total costs.

d. Normal profit.

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Whether or not a firm decides to produce or shut down in the short run depends solely on whether revenues from operating are sufficient to cover:

a. Fixed costs.

b.b. Variable costs.Variable costs.

c. Total costs.

d. Normal profit.

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Shutting Down to Minimize Loss

TABLE 9.3 A 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


+$

$

2,0000

2,000


+$

$

2,0001,6003,600

Profit/loss (TR TC): $ 2,000 Operating profit/loss (TR TVC) $ 400

Total profit/loss (TR TC) $ 2,400

Minimizing Losses

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FIGURE 9.1 Firm Suffering Losses but Showing an Operating Profit in the Short Run

At prices below average variable cost, it pays a firm to shut down rather than continue operating.Thus, the short-run supply curve of a competitive firm is the part of its marginal cost curve that lies above its average variable cost curve.

shut-down point The lowest point on the average variable cost curve. When price falls below the minimum point on AVC, total revenue is insufficient to cover variable costs and the firm will shut down and bear losses equal to fixed costs.

Minimizing Losses

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Refer to the figure below. Which of the firms below chooses to produce output at a loss?

a. A

b. C

c. Both A and C.

d. A, C, and D.

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Refer to the figure below. Which of the firms below chooses to produce output at a loss?

a.a. AA

b. C

c. Both A and C.

d. A, C, and D.

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short-run industry supply curve The sum of the marginal cost curves (above AVC) of all the firms in an industry.

The Short-Run Industry Supply Curve

FIGURE 9.4 The 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

A profit-maximizing perfectly competitive firm will produce up to the point where P* = If there are only three firms in the industry, the industry supply curve is simply the sum of all the products supplied by the three firms at each price. For example, at $6, firm 1 supplies 100 units, firm 2 supplies 200 units, and firm 3 supplies 150 units, for a total industry supply of 450.

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Long-Run Directions: A Review

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

Short-Run Condition Short-Run Decision Long-Run Decision

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

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

(TR TVC) (losses < fixed costs)

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

(TR < TVC) losses = fixed costs

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increasing returns to scale, or economies of scale An increase in a firm’s scale of production leads to lower costs per unit produced.

constant returns to scale An increase in a firm’s scale of production has no effect on costs per unit produced.

decreasing returns to scale, or diseconomies of scale An increase in a firm’s scale of production leads to higher costs per unit produced.

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Example: Economies of Scale in Egg Production

TABLE 9.5 Weekly 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 25Transport costs 15Land and capital costs attributable to egg production

17

$177Total output 2,400 eggsAverage cost $0.074 per egg

Chicken Little Egg Farms Inc. Total Weekly Costs

Labor $ 5,128Feed, other variable costs 4,115Transport costs 2,431Land and capital costs 19,230

$30,904Total output 1,600,000 eggsAverage cost $0.019 per egg

Increasing Returns to Scale

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long-run average cost curve (LRAC) A graph that shows the different scales on which a firm can choose to operate in the long run.

FIGURE 9.5 A Firm Exhibiting Economies of Scale

The long-run average cost curve of a firm shows the different scales on which the firm can choose to operate in the long run. Each scale of operation defines a different short run. Here we see a firm exhibiting economies of scale; moving from scale 1 to scale 3 reduces average cost.

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Constant Returns to Scale

Technically, the term constant returns means that the quantitative relationship between input and output stays constant, or the same, when output is increased.

Constant returns to scale mean that the firm’s long-run average cost curve remains flat.

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Refer to the figure below. The firm in question exhibits economies of scale:

a. Along the decreasing portion of the long-run average cost curve (LRAC), up until Q0.

b. Along the increasing portion of the long-run average cost curve (LRAC), after Q0.

c. At Q0, where LRAC is minimum.

d. Anywhere along the LRAC, as long as increasing the scale of operations does not affect cost per unit.

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Refer to the figure below. The firm in question exhibits economies of scale:

a.a. Along the decreasing portion of the long-run average cost curve Along the decreasing portion of the long-run average cost curve ((LRACLRAC), up until ), up until QQ00..

b. Along the increasing portion of the long-run average cost curve (LRAC), after Q0.

c. At Q0, where LRAC is minimum.

d. Anywhere along the LRAC, as long as increasing the scale of operations does not affect cost per unit.

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Decreasing Returns to Scale

FIGURE 9.6 A Firm Exhibiting Economies and Diseconomies of Scale

Economies of scale push this firm’s average costs down to q*. Beyond q*, the firm experiences diseconomies of scale; q* is the level of production at lowest average cost, using optimal scale.

optimal scale of plant The scale of plant that minimizes average cost.

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Blood bank merger ‘good’ for Manatee

Bradenton Herald.com

“Northwest needed to be aligned with a larger organization to achieve economy of scale,” said J.B. Gaskins, Florida Blood Services vice president. “That economy of scale is good for the whole network, including Manatee County.”

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Long-Run Adjustments to Short-Run Conditions

Short-Run Profits: Expansion to Equilibrium

FIGURE 9.7 Firms Expand in the Long Run When Increasing Returns to Scale Are Available

When economies of scale can be realized, firms have an incentive to expand. Thus, firms will be pushed by competition to produce at their optimal scales. Price will be driven to the minimum point on the LRAC curve.

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In the long run, equilibrium price (P*) is equal to long-run average cost, short-run marginal cost, and short-run average cost. Profits are driven to zero:

P* = SRMC = SRAC = LRAC

Any price above P* means that there are profits 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. Only at P* will profits be just equal to zero, and only at P* will the industry be in equilibrium.

Short-Run Profits: Expansion to Equilibrium

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Short-Run Losses: Contraction to Equilibrium

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

When firms in an industry suffer losses, there is an incentive for them to exit. As firms exit, the supply curve shifts from S0 to S1, driving price up to P*. As price rises,

losses are gradually eliminated and the industry returns to equilibrium.

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Whether we begin with an industry in which firms are earning profits or suffering losses, the final long-run competitive equilibrium 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 LRAC curve.

Short-Run Losses: Contraction to Equilibrium

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Refer to the figure below. Which level of output does the firm produce under long-run, perfectly competitive conditions?

a. q1.

b. Either q* or q1.

c. q*.

d. In the long run, the firm may produce any level of output, so both q* and q1 are possible.

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Refer to the figure below. Which level of output does the firm produce under long-run, perfectly competitive conditions?

a. q1.

b. Either q* or q1.

c.c. qq*.*.

d. In the long run, the firm may produce any level of output, so both q* and q1 are possible.

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The Long-Run Average Cost Curve:Flat or U-Shaped?

The structure of the industry in the long run will depend on whether existing firms expand faster than new firms enter.

There is an element of randomness in the way industries expand. Most industries contain some large firms and some small firms,

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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 When P = SRMC = SRAC = LRAC and profits are zero.

The Long-Run Adjustment Mechanism: Investment Flows Toward Profit Opportunities

The entry and exit of firms in response to profit opportunities usually involve the financial capital market. In capital markets, people are constantly looking for profits.When firms in an industry do well, capital is likely to flow into that industry in a variety of forms.

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Why Are Hot Dogs So Expensive in Central Park?In New York, you need alicense to operate a hot dogcart, and a license to operatein the park costs more. Sincehot dogs are $.50 more in thepark, the added cost of alicense each year must be roughly $.50 per hot dog sold. In fact, in New York City, licenses to sell hot dogs in the park are auctioned off for many thousands of dollars, while licenses to operate outside the park cost only about $1,000.


The Long-Run Adjustment Mechanism: Investment Flows Toward Profit Opportunities

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Output Markets: A Final Word

In the last four chapters, we have been building a model of a simple market system under the assumption of perfect competition.

You have now seen what lies behind the demand curves and supply curves in competitive output markets. The next two chapters take up competitive input markets and complete the picture.

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REVIEW TERMS AND CONCEPTS

breaking evenconstant returns to scaledecreasing returns to scale,

or diseconomies of scaleincreasing returns to scale, or

economies of scalelong-run average cost curve

(LRAC)

long-run competitive equilibrium

operating profit (or loss) or net operating revenue

optimal 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 DISECONOMIES AND THE LONG-RUN INDUSTRY SUPPLY CURVE

When long-run average costs decrease as a result of industry growth, we say that there are external economies.

When average costs increase as a result of industry growth, we say that there are external diseconomies.

A P P E N D I X

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TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 2000–2005

Year

House Prices % Change Over the

Previous YearHousing Starts(Thousands)

Housing Starts% Change Over

The Previous Year

Construction Materials Prices % Change Over The

Previous Year

Consumer Prices% Change Over

The Previous Year

2000 1,573

2001 7.5 1,661 5.6% 0% 2.8%

2002 7.5 1,710 2.9% 1.5% 1.5%

2003 7.9 1,853 8.4% 1.6% 2.3%

2004 12.0 1,949 5.2% 8.3% 2.7%

2005 13.0 2,053 5.3% 5.4% 2.5%

A P P E N D I X

Example of an expanding industry facing external diseconomies of scale

EXTERNAL ECONOMIES AND DISECONOMIES AND THE LONG-RUN INDUSTRY SUPPLY CURVE

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long-run industry supply curve (LRIS) A graph that traces out price and total output over time as an industry expands.

decreasing-cost industry An industry that realizes external economies—that is, average costs decrease as the industry grows. The long-run supply curve for such an industry has a negative slope.

A P P E N D I X

increasing-cost industry An industry that encounters external diseconomies—that is, average costs increase as the industry grows. The long-run supply curve for such an industry has a positive slope.

constant-cost industry An industry thatshows no economies or diseconomies ofscale as the industry grows. Such industries have flat, or horizontal, long-run supply curves.

THE LONG-RUN INDUSTRY SUPPLY CURVE

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AppendixTHE LONG-RUN INDUSTRY SUPPLY CURVE

A P P E N D I X

FIGURE 9A.1 A Decreasing-Cost Industry: External EconomiesIn a decreasing-cost industry, average cost declines as the industry expands. As demand expands from D0 to D1, price rises from P0 to P1.

As new firms enter and existing firms expand, supply shifts from S0 to S1, driving price

down. If costs decline as a result of the expansion to LRAC2, the final price will be below

P0 at P2.

The long-run industry supply curve (LRIS) slopes downward in a decreasing-cost industry.

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Appendix

A P P E N D I X

THE LONG-RUN INDUSTRY SUPPLY CURVE

FIGURE 9A.2 An Increasing-Cost Industry: External DiseconomiesIn an increasing-cost industry, average cost increases as the industry expands. As demand shifts from D0 to D1, price rises from P0 to P1.

As new firms enter and existing firms expand output, supply shifts from S0 to S1, driving

price down. If long-run average costs rise, as a result, to LRAC2, the final price will be P2.

The long-run industry supply curve (LRIS) slopes up in an increasing-cost industry.

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constant-cost industrydecreasing-cost industryexternal economies and diseconomiesincreasing-cost industrylong-run industry supply curve (LRIS)

REVIEW TERMS AND CONCEPTS

CHAPTER 9 Long-Run Costs and Output Decisions © 2009 Prentice Hall Business Publishing Principles...

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