Case Econ08 Ab - Az.ppt 09

Chapter
9
Long-Run Costs
and Output Decisions
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
Long-Run Costs
and Output Decisions
9
Chapter Outline
Short-Run Conditions and Long-

Run Directions
Maximizing Profits
Minimizing Losses
The Short-Run Industry Supply Curve
Long-Run Directions: A Review
Long-Run Costs: Economies and
s noi si ce Dt upt u O
Diseconomies of Scale
Increasing Returns to Scale
Constant Returns to Scale
Decreasing Returns to Scale
Long-Run Adjustments
to Short-Run Conditions
Short-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
ETP A HC
Appendix: External Economies and

Diseconomies and the Long-Run Industry
Supply Curve
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 36
LONG-RUN COSTS AND OUTPUT DECISIONS
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.
ETP A HC
SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
breaking even The situation in which a firm

is earning exactly a normal rate of return.
MAXIMIZING PROFITS
Example: The Blue Velvet Car Wash

TABLE 9.1 Blue Velvet Car Wash Weekly Costs

TOTAL VARIABLE COSTS TOTAL COSTS
TOTAL FIXED COSTS (TFC) (TVC) (800 WASHES) (TC = TFC + TVC) $ 3,600
1.Normal return to investors $ 1,000 1.Labor $ 1,000 Total revenue (TR)

2.Materials 600 at P = $5 (800 x $5) $ 4,000
2.Other fixed costs $ 1,600 Profit (TR − TC) $ 400

(maintenance contract,
ETP A HC
insurance, etc.) 1,000

$ 2,000
Graphic Presentation
ETP A HC
FIGURE 9.1 Firm Earning Positive Profits in the Short Run
MINIMIZING LOSSES
operating profit (or loss) or net operating
revenue Total revenue minus
total variable cost (TR − TVC).
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 firm
to keep operating.
■ If revenues are smaller than variable costs, the
firm suffers operating losses that push total
ETP A HC
losses above fixed costs. In this case, the firm

can minimize its losses by shutting down.
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 costs $ 2,000 Fixed costs $ 2,000
Variable costs + 0 Variable costs + 1,600

Total costs $ 2,000 Total costs $ 3,600
Profit/loss (TR − TC) − $ 2,000 Operating profit/loss (TR − TVC) $ 800

Total profit/loss (TR − TC) −$ 1,200
ETP A HC
ETP A HC
FIGURE 9.2 Firm Suffering Losses but Showing an Operating Profit in the Short Run
Remember that average total cost is equal to average

fixed cost plus average variable cost. This means that at
every level of output, average fixed cost is the difference
between average total and average variable cost:
ATC = AFC + AVC

or
AFC = ATC − AVC = $4.10 − $3.10 = $1.00

ETP A HC
As long as price (which is equal to average revenue per unit) is sufficient to cover average
variable costs, the firm stands to gain by operating instead of shutting down.
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

Fixed costs $ 2,000 Fixed costs $ 2,000
Variable costs + 0 Variable costs + 1,600
Total costs $ 2,000 Total costs $ 3,600
Profit/loss (TR − TC): − $ 2,000 Operating profit/loss (TR − TVC) −$ 400

Total profit/loss (TR − TC) −$ 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
ETP A HC
possible output level the firm could choose. When this is the case, the firm will stop
producing and bear losses equal to fixed costs. This 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.
2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 36
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.
ETP A HC
The short-run supply curve of a competitive firm is that portion of its marginal cost
curve that lies above its average variable cost curve (Figure 9.3).
ETP A HC
FIGURE 9.3 Short-Run Supply Curve of a Perfectly Competitive Firm
THE SHORT-RUN INDUSTRY SUPPLY CURVE

short-run industry supply curve The
sum of the marginal cost curves (above
AVC) of all the firms in an industry.
ETP A HC
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
LONG-RUN DIRECTIONS: A REVIEW
TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and
Short Run
SHORT-RUN SHORT-RUN LONG-RUN
CONDITION DECISION 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
ETP A HC
LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
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.
ETP A HC
INCREASING RETURNS TO SCALE

The 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 technology

but from sheer size.

ETP A HC
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) $120
Feed, other variable costs 25
Transport costs 15
Land 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 $ 5,128
Feed, other variable costs 4,115
Transport costs 2,431
Land and capital costs 19,230
$30,904
ETP A HC
Total output 1,600,000 eggs

Average cost $.019 per egg
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.
ETP A HC
ETP A HC
FIGURE 9.5 A Firm Exhibiting Economies of Scale
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.
ETP A HC
DECREASING RETURNS TO SCALE
FIGURE 9.6 A Firm Exhibiting Economies and Diseconomies of Scale

ETP A HC
All short-run average cost curves are U-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.
It is important to note that economic efficiency requires

taking advantage of economies of scale (if they exist)
and avoiding diseconomies of scale.
optimal scale of plant The scale of plant that

minimizes average cost.
ETP A HC
LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS
SHORT-RUN PROFITS: EXPANSION TO EQUILIBRIUM

ETP A HC
FIGURE 9.7 Firms Expand in the Long Run When Increasing Returns
to Scale Are Available
Firms will continue to expand as long as there are economies of scale

to be realized, and new firms will continue to enter as long as positive
profits are being earned.
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

where SRMC denotes short-run marginal cost, SRAC denotes short-

run average cost, and LRAC denotes long-run average cost. No other
price is an equilibrium price. 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.
ETP A HC
SHORT-RUN LOSSES: CONTRACTION TO

EQUILIBRIUM
ETP A HC
FIGURE 9.8 Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses
As long as losses are being sustained in an industry, firms will shut

down and leave the industry, thus reducing supply—shifting the
supply curve to the left. As this happens, price rises. This gradual
price rise reduces losses for firms remaining in the industry until
those losses are ultimately eliminated.
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.
ETP A HC
THE LONG-RUN ADJUSTMENT MECHANISM:

INVESTMENT FLOWS TOWARD PROFIT
OPPORTUNITIES
In efficient markets, investment capital flows toward profit opportunities.

The 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 products may join the
competition. The success of Ben and
Jerry’s has inspired a slew of imitators
ETP A HC
to compete in the ice cream industry.
long-run competitive equilibrium When

P = SRMC = SRAC = LRAC and profits are
zero.
ETP A HC
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.
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.
ETP A HC
REVIEW TERMS AND CONCEPTS
breaking even long-run competitive equilibrium

constant returns to scale operating profit (or loss) or net
decreasing returns to scale, operating revenue
or diseconomies of scale optimal scale of plant
increasing returns to scale, short-run industry supply curve
or economies of scale shut-down point

long-run average cost curve long-run competitive equilibrium,
(LRAC) P = SRMC = SRAC = LRAC
ETP A HC
Appendix
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.
ETP A HC
Appendix
TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 2000–2005
CONSTRUCTION
HOUSING MATERALS CONSUMER
STARTS PRICES PRICES
HOUSE PRICES % CHANGE % CHANGE OVER % CHANGE
%∆ OVER OVER THE THE PREVIOUS OVER THE
THE PREVIOUS HOUSING PREVIOUS YEAR PREVIOUS
YEAR YEAR STARTS YEAR YEAR
− − − −
2000 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%
ETP A HC
Appendix
THE LONG-RUN INDUSTRY SUPPLY CURVE

ETP A HC
FIGURE 9A.1 A Decreasing-Cost Industry: External Economies
Appendix
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.
ETP A HC
Appendix
ETP A HC
FIGURE 9A.2 An Increasing-Cost Industry: External Diseconomies
Appendix
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 that

shows no economies or diseconomies of
scale as the industry grows. Such
industries have flat, or horizontal, long-run
supply curves.
ETP A HC

Case Econ08 Ab - Az.ppt 09

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Case Econ08 Ab - Az.ppt 09

Uploaded by

Copyright:

Available Formats

Chapter

Fernando & Yvonn Quijano

Short-Run Conditions and Long-

Appendix: External Economies and

We begin our discussion of the long run by looking at firms

(1) firms earning economic profits,

(2) firms suffering economic losses but continuing to

breaking even The situation in which a firm

Example: The Blue Velvet Car Wash

TABLE 9.1 Blue Velvet Car Wash Weekly Costs

1.Normal return to investors $ 1,000 1.Labor $ 1,000 Total revenue (TR)

2.Other fixed costs $ 1,600 Profit (TR − TC) $ 400

insurance, etc.) 1,000

FIGURE 9.1 Firm Earning Positive Profits in the Short Run

■ If revenues exceed variable costs, operating

losses above fixed costs. In this case, the firm

Producing at a Loss to Offset Fixed Costs: The

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

Variable costs + 0 Variable costs + 1,600

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

Remember that average total cost is equal to average

ATC = AFC + AVC

AFC = ATC − AVC = $4.10 − $3.10 = $1.00

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

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

Total profit/loss (TR − TC) −$ 2,400

shut-down point The lowest point on the

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

THE SHORT-RUN INDUSTRY SUPPLY CURVE

LONG-RUN DIRECTIONS: A REVIEW

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

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

increasing returns to scale, or economies of

constant returns to scale An increase in a

decreasing returns to scale, or diseconomies

INCREASING RETURNS TO SCALE

Most of the economies of scale that immediately

Some economies of scale result not from technology

but from sheer size.

Example: Economies of Scale in Egg Production

Average cost $.074 per egg

CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTS

Total output 1,600,000 eggs

long-run average cost curve (LRAC) A graph

FIGURE 9.5 A Firm Exhibiting Economies of Scale

CONSTANT RETURNS TO SCALE

Technically, the term constant returns means that the

Constant returns to scale mean that the firm’s long-run

FIGURE 9.6 A Firm Exhibiting Economies and Diseconomies of Scale

It is important to note that economic efficiency requires

optimal scale of plant The scale of plant that

SHORT-RUN PROFITS: EXPANSION TO EQUILIBRIUM

Firms will continue to expand as long as there are economies of scale

In the long run, equilibrium price (P*) is equal to long-run average

P* = SRMC = SRAC = LRAC

where SRMC denotes short-run marginal cost, SRAC denotes short-

SHORT-RUN LOSSES: CONTRACTION TO

As long as losses are being sustained in an industry, firms will shut

Whether we begin with an industry in which firms are earning profits

P* = SRMC = SRAC = LRAC

THE LONG-RUN ADJUSTMENT MECHANISM:

In efficient markets, investment capital flows toward profit opportunities.