Long-Run Costs and Output Decisions

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© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

Long-Run Costsand Output Decisions

Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve

Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijano and Yvonn Quijano

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2 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

Short-Run Conditionsand Long-Run Directions

• Profit is the difference between total revenue and total economic cost.

• Total economic cost includes a normal rate of return, or the rate that is just sufficient to keep current investors interested in the industry.

• Breaking even is a situation in which a firm earns exactly a normal rate of return.

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Maximizing Profits

• Revenue is sufficient to cover both fixed costs of $2,000 and variable costs of $1,600, leaving a positive economic profit of $400 per week.

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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Firm Earning Positive Profits in the Short Run

• To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.

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Firm Earning Positive Profits in the Short Run

• Profit is the difference between total revenue and total cost.

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Minimizing Losses

• Operating profit (or loss) or net operating revenue equals 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.

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Minimizing Losses

• 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.

• Operating profit (or loss) or net operating revenue equals total revenue minus total variable cost (TR – TVC).

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Minimizing Losses

• When price equals $3.50, revenue is sufficient to cover total variable cost but not total cost.

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Minimizing Losses

A Firm Will Operate If Total Revenue Covers Total Variable CostCASE 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) $ 800Total profit/loss (TR TC) $ 1,200

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Minimizing Losses

• As long as price is sufficient to cover average variable costs, the firm stands to gain by operating instead of shutting down.

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Minimizing Losses

• The difference between ATC and AVC equals AFC. Then, AFC q = TFC.

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Shutting Down to Minimize Loss

A Firm Will Shut Down If Total Revenue Is Less Than Total Variable CostCASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $1.50Total 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) $ 400Total profit/loss (TR TC) $ 2,400

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Short-Run Supply Curve of a Perfectly Competitive Firm

• The shut-down point is 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.

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Short-Run Supply Curve of a Perfectly Competitive Firm

• 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.

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The Short-Run Industry Supply Curve

• 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.

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Profits, 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

(TR TVC) (losses < fixed costs)

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

(TR < TVC) losses = fixed costs

• In the short-run, firms have to decide how much to produce in the current scale of plant.

• In the long-run, firms have to choose among many potential scales of plant.

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Long-Run Costs: Economies andDiseconomies of Scale

• Increasing returns to scale, or economies of scale, refers to an increase in a firm’s scale of production, which leads to lower average costs per unit produced.

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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 $.074 per egg

CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTSLabor $ 5,128Feed, other variable costs 4,115Transport costs 2,431Land and capital costs 19,230

$30,904Total output 1,600,000 eggsAverage cost $.019 per egg

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A Firm Exhibiting Economies of Scale

• The long run average cost curve of a firm exhibiting economies of scale is downward-sloping.

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The Long-Run Average Cost Curve

• The long-run average cost curve (LRAC) is a graph that shows the different scales on which a firm can choose to operate in the long-run. Each scale of operation defines a different short-run.

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Constant Returns to Scale

• Constant returns to scale refers to an increase in a firm’s scale of production, which has no effect on average costs per unit produced.

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Decreasing Returns to Scale

• Decreasing returns to scale, or diseconomies of scale, refers to an increase in a firm’s scale of production, which leads to higher average costs per unit produced.

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A Firm Exhibiting Economiesand Diseconomies of Scale

• The LRAC curve of a firm that eventually exhibits diseconomies of scale becomes upward-sloping.

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Optimal Scale of Plant

• The optimal scale of plant is the scale that minimizes average cost.

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Long-Run Adjustmentsto Short-Run Conditions

• Firms expand in the long-run when increasing returns to scale are available.

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Short-Run Profits:Expansion to Equilibrium

• Firms expand in the long run when increasing returns to scale are available.

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Short-Run Losses:Contraction to Equilibrium

• When firms in an industry suffer losses, there is an incentive for them to exit.

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• As firms exit, the supply curve shifts from S to S’, driving price up to P*.

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• The industry eventually returns to long-run equilibrium and losses are eliminated.

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Long-Run Competitive Equilibrium

• 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

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

• The central idea in our discussion of entry, exit, expansion, and contraction is this:

• In efficient markets, investment capital flows toward profit opportunities.

• The actual process is complex and varies from industry to industry.

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• The central idea in our discussion of entry, exit, expansion, and contraction is this:

Long-Run Adjustment Mechanism: Investment Flows Toward Profit Opportunities

• 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.

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Review Terms and Concepts

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

breaking even

constant return to scales

decreasing returns to scale, or diseconomies of scale

increasing returns to scale, or economies of scale

long-run average cost curve (LRAC)

long-run competitive equilibrium

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• Economies of scale that are found within the individual firm are called internal economies of scale.

• External economies of scale describe economies or diseconomies of scale on an industry-wide basis.

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• The long-run industry supply curve (LRIS) traces output over time as the industry expands.

• When an industry enjoys external economies, its long-run supply curve slopes down. Such an industry is called a decreasing-cost industry.

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Construction Activity and the Price of Lumber Products, 1991 - 1994

YEAR

MONTHLY AVERAGE, NEW

HOUSING PERMITS

PERCENTAGE INCREASE OVER THE PREVIOUS

YEAR

PERCENTAGE CHANGE IN THE

PRICE OF LUMBER

PRODUCTS

PERCENTAGE CHANGE IN CONSUMER

PRICES1991 79,500 - - -

1992 92,167 + 15.9 + 14.7 + 3.0

1993 100,917 + 9.5 + 24.6 + 3.0

1994 111,000 + 10.0 NA + 2.1

Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21; Statistical Abstract of the United States, 1994, Tables 754, 755.

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• In a decreasing cost industry, costs decline as a result of industry expansion, and the LRIS is downward-sloping.

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• In an increasing cost industry, costs rise as a result of industry expansion, and the LRIS is upward-sloping.

Long-Run Costs and Output Decisions

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