Case Econ08 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
CHAPTER 9: Long-Run Costs and

Output Decisions
Long-Run Costs
and Output Decisions
Chapter Outline
Short-Run Conditions and LongRun Directions
Maximizing Profits
Minimizing Losses
The 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 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
Appendix: External Economies and
Diseconomies and the Long-Run Industry
Supply Curve

Output Decisions
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.

Output Decisions
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
(TVC) (800 WASHES)
TOTAL FIXED COSTS (TFC)

1. Normal return to investors
2. Other fixed costs
(maintenance contract,
insurance, etc.)
$ 1,000
1. Labor
2. Materials
TOTAL COSTS
(TC = TFC + TVC)
$ 3,600
$ 1,000
600
Total revenue (TR)

at P = $5 (800 x $5)
$ 4,000
$ 1,600
Profit (TR TC)
1,000
$ 2,000
400

Output Decisions
Graphic Presentation
FIGURE 9.1 Firm Earning Positive Profits in the Short Run


Output Decisions
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
losses above fixed costs. In this case, the firm
can minimize its losses by shutting down.

Output Decisions
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
Total Revenue (q = 0)
Fixed costs
Variable costs
Total costs
Profit/loss (TR TC)
CASE 2: OPERATE AT PRICE = $3

$
$ 2,000
+
0
$ 2,000
$ 2,000
Total Revenue ($3 x 800)

Fixed costs
Variable costs
Total costs
Operating profit/loss (TR TVC)
Total profit/loss (TR TC)
$ 2,400
$ 2,000
+ 1,600
$ 3,600
$
800
$ 1,200

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

Output Decisions
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
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.

Output Decisions
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
Total Revenue (q = 0)
Fixed costs
Variable costs
Total costs
Profit/loss (TR TC):
CASE 2: OPERATE AT PRICE = $1.50

$
$ 2,000
+
0
$ 2,000
$ 2,000
Total revenue ($1.50 x 800)

Fixed costs
Variable costs
Total costs
Operating profit/loss (TR TVC)
Total profit/loss (TR TC)
$ 1,200
$ 2,000
+ 1,600
$ 3,600
$ 400
$ 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
negativethat 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. 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 iszero.

Output Decisions
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.
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).

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


Output Decisions
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.
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

Output Decisions
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
Losses
TR > TC
1. With operating profit
(TR TVC)
2. With operating losses
(TR < TVC)
P = MC: operate
Expand: new firms enter
P = MC: operate
Contract: firms exit
(losses < fixed costs)

Shut down:
Contract: firms exit
losses = fixed costs

Output Decisions
LONG-RUN COSTS: ECONOMIES

AND DISECONOMIES OF SCALE
increasing returns to scale, or economies of
scale An increase in a firms scale of production
leads to lower costs per unit produced.
constant returns to scale An increase in a
firms scale of production has no effect on costs
per unit produced.
decreasing returns to scale, or diseconomies
of scale An increase in a firms scale of
production leads to higher costs per unit
produced.


Output Decisions
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.


Output Decisions
Example: Economies of Scale in Egg Production

TABLE 9.5 Weekly Costs Showing Economies of Scale in Egg Production
JONES FARM
15 hours of labor (implicit value $8 per hour)
Feed, other variable costs
Transport costs
Land and capital costs attributable to egg production
Total output
Average cost
CHICKEN LITTLE EGG FARMS INC.
Labor
Feed, other variable costs
Transport costs
Land and capital costs
Total output
Average cost
TOTAL WEEKLY COSTS

$120
25
15
17
$177
2,400 eggs
$.074 per egg
TOTAL WEEKLY COSTS
$ 5,128
4,115
2,431
19,230
$30,904
1,600,000 eggs
$.019 per egg

Output Decisions

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.

Output Decisions

FIGURE 9.5 A Firm Exhibiting Economies of Scale



Output Decisions
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 firms long-run
average cost curve remains flat.


Output Decisions
DECREASING RETURNS TO SCALE
FIGURE 9.6 A Firm Exhibiting Economies and Diseconomies of Scale
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.

Output Decisions

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.
LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS

Output Decisions
SHORT-RUN PROFITS: EXPANSION TO EQUILIBRIUM
FIGURE 9.7 Firms Expand in the Long Run When Increasing Returns
to Scale Are Available

Output Decisions
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 shortrun 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.

Output Decisions
SHORT-RUN LOSSES: CONTRACTION TO
EQUILIBRIUM
FIGURE 9.8 Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses

Output Decisions
As long as losses are being sustained in an industry, firms will shut
down and leave the industry, thus reducing supplyshifting 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 plantthat is, at the minimum point on their
LRAC curve.

Output Decisions
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 Jerrys has inspired a slew of imitators
to compete in the ice cream industry.

Output Decisions
long-run competitive equilibrium When

P = SRMC = SRAC = LRAC and profits are
zero.
Investmentin the form of new firms and expanding old firmswill 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 Decisions
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.

Output Decisions
REVIEW TERMS AND CONCEPTS
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)
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

Output Decisions
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.

Output Decisions
Appendix
TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 20002005
CONSTRUCTION
HOUSING
MATERALS
CONSUMER
STARTS
PRICES
PRICES
HOUSE PRICES
% CHANGE
% CHANGE
% CHANGE
% OVER
OVER THE
OVER THE
OVER THE
THE PREVIOUS HOUSING
PREVIOUS
PREVIOUS
PREVIOUS
YEAR
YEAR
STARTS
YEAR
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%
Appendix

Output Decisions
THE LONG-RUN INDUSTRY SUPPLY CURVE
FIGURE 9A.1 A Decreasing-Cost Industry: External Economies


Output Decisions
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 economiesthat is,
average costs decrease as the industry
grows. The long-run supply curve for such
an industry has a negative slope.

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

Output Decisions
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.

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Chapter

Fernando & Yvonn Quijano

CHAPTER 9: Long-Run Costs and

CHAPTER 9: Long-Run Costs and

LONG-RUN COSTS AND OUTPUT DECISIONS

firms earning economic profits,

firms suffering economic losses but continuing to

firms that decide to shut down and bear losses just

CHAPTER 9: Long-Run Costs and

TOTAL FIXED COSTS (TFC)

Total revenue (TR)

Profit (TR TC)

CHAPTER 9: Long-Run Costs and

FIGURE 9.1 Firm Earning Positive Profits in the Short Run

CHAPTER 9: Long-Run Costs and

CHAPTER 9: Long-Run Costs and

Producing at a Loss to Offset Fixed Costs: The

CASE 2: OPERATE AT PRICE = $3

Total Revenue ($3 x 800)

CHAPTER 9: Long-Run Costs and

CHAPTER 9: Long-Run Costs and

ATC = AFC + AVC

CHAPTER 9: Long-Run Costs and

Shutting Down to Minimize Loss

CASE 2: OPERATE AT PRICE = $1.50

Total revenue ($1.50 x 800)

CHAPTER 9: Long-Run Costs and

CHAPTER 9: Long-Run Costs and

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

CHAPTER 9: Long-Run Costs and

THE SHORT-RUN INDUSTRY SUPPLY CURVE

short-run industry supply curve The

CHAPTER 9: Long-Run Costs and

LONG-RUN DIRECTIONS: A REVIEW

Expand: new firms enter

Contract: firms exit

(losses < fixed costs)

Contract: firms exit

losses = fixed costs

CHAPTER 9: Long-Run Costs and

LONG-RUN COSTS: ECONOMIES

LONG-RUN COSTS: ECONOMIES

CHAPTER 9: Long-Run Costs and

INCREASING RETURNS TO SCALE

The Sources of Economies of Scale

LONG-RUN COSTS: ECONOMIES

CHAPTER 9: Long-Run Costs and

Example: Economies of Scale in Egg Production

TOTAL WEEKLY COSTS

CHAPTER 9: Long-Run Costs and

LONG-RUN COSTS: ECONOMIES

CHAPTER 9: Long-Run Costs and

LONG-RUN COSTS: ECONOMIES

FIGURE 9.5 A Firm Exhibiting Economies of Scale

LONG-RUN COSTS: ECONOMIES

CHAPTER 9: Long-Run Costs and

CONSTANT RETURNS TO SCALE

LONG-RUN COSTS: ECONOMIES

CHAPTER 9: Long-Run Costs and

DECREASING RETURNS TO SCALE

FIGURE 9.6 A Firm Exhibiting Economies and Diseconomies of Scale

CHAPTER 9: Long-Run Costs and

LONG-RUN COSTS: ECONOMIES