Transcript Chapter 8: Costs and Output Decisions in the Long Run

Costs and Output Decisions in the Long Run
8.1
In this chapter we finish our discussion of how profitmaximizing firms decide how much to supply in the shortrun and the long-run.
• Profit is the difference between total revenue and total cost.
• The economic concept of profit takes into account the
opportunity cost of capital.
• Total economic cost includes a normal rate of return. A
normal rate of return is the rate that is just sufficient to
keep current investors interested in the industry.
• Breaking even is a situation in which a firm is earning
exactly a normal rate of return so that economic profits are
zero.
Firm Earning Positive Profits in the Short Run
• To maximize profit, the firm sets the level of output
where marginal revenue equals marginal cost.
8.2
Firm Earning Positive Profits in the Short Run: Example
from Ch. 7
Widget Market
S
8.3
Widget Firm
MC
ATC
$70
d
P=$70
ATC=$46.67
AVC
D
Algebra:
  TR  TC
 p  q  atc  q
 ( p  atc )  q
q*=6
Profits
Total costs
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.
• 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.
8.4
8.5
Minimizing Losses
Suppose the market price of widgets falls to $30. The firm finds its new
profit-maximizing output level where P=MC. This occurs at q*=4.
However, the firm earns a negative economic profit.
Widget Market
Widget Firm
S
MC
ATC
ATC=$40
$30
AVC
P=$30
d
D
Algebra:
  TR  TC
 TR  TVC  TFC
 p  q  avc  q  afc  q
 ( p  avc)  q  afc  q
q* = 4
Losses (negative profit)
Minimizing Losses and the Shut-down Point
8.6
How low can price fall until the firm would be better off shutting down
(q* = 0)?
Remember that in the short-run, if the firm produces nothing, its revenues
are zero but its costs equal TFC  profits = -$TFC
As long as price is sufficient to cover average variable costs
(P > AVC), the firm stands to gain by operating instead of shutting down .
Shutdown point: a market price that, when it intersects MC, it also equals
AVC. This will occur only at the minimum point on the AVC curve. (See
chapter 7)
Short-Run Supply Curve of a Perfectly
Competitive Firm
8.7
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. This explains why
supply curves are upward
sloping: because MC is upward
sloping…and why is MC
upward sloping?
The Short-Run Industry Supply Curve
8.8
• 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.
Profits, Losses, and Perfectly Competitive Firm Decisions
in the Long and Short Run
SHORT-RUN
CONDITION
Profits
Losses
TR > TC
1. With “operating” profit
(TC  TR  TVC)
2. With operating losses
(TVC >TR)
SHORT-RUN
DECISION
8.9
LONG-RUN
DECISION
Operate where P=MC
Expansion new firms enter
Operate where P=MC
Contract: firms exit
(losses < fixed costs)
Shut down: b/c at P=MC
Contract: firms exit
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.
Long-Run Costs: Economies and Diseconomies
of Scale
8.10
The long-run is a time period during which all inputs are
variable (including the scale of production) and firms can
enter and exit the industry.
We want to analyze how average total cost changes as output
changes:
1) Increasing returns to scale, or economies of scale, refers to
an increase in a firm’s scale of production, which leads to
lower average total costs per unit produced.
Long-Run Costs: Economies and Diseconomies
of Scale (con’t)
8.11
2) Constant returns to scale refers to an increase in a firm’s
scale of production, which has no effect on average total
costs per unit produced.
3) Decreasing returns to scale refers to an increase in a firm’s
scale of production, which leads to higher average total
costs per unit produced.
The Long-Run Average Cost Curve
8.12
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.
Here is a diagram of a long run average cost curve of a firm exhibiting
economies of scale. It is downward-sloping:
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
8.13
TOTAL WEEKLY COSTS
$120
25
15
17
$177
2,400 eggs
TOTAL WEEKLY COSTS
$ 5,128
4,115
2,431
19,230
$30,904
1,600,000 eggs
A Firm Exhibiting Economies and Diseconomies
of Scale
8.14
• The long-run average cost curve of a firm that eventually
exhibits diseconomies of scale becomes upward-sloping.
About the Long-Run Average Cost Curve
8.15
LRAC shows the lowest average cost for producing each level of output
LRAC is tangent to every SRATC but not necessarily at the Min SRATC
points. As we trace production along a SRATC, the firm is altering its
production in the presence of a fixed factor (fixed scale of production).
SRATC increases because of the fixed factor. As we trace production along
the LRAC, the firm is altering the optimal plant size as q changes.
Optimal Scale of Plant
• The optimal scale of plant is the scale that minimizes
average cost.
8.16
Long-Run Adjustments to
Short-Run Conditions
8.17
• Firms expand in the long-run when increasing returns to scale are
available.
• Prices will be driven down to the minimum point on the LRAC curve.
The Path to Long-Run Equilibrium
Suppose the current short-run has firms earning positive
profits
• This will attract new entrants to an industry.
• As capital flows into the industry, the supply curve shifts
to the right, and price falls.
• 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.
When does it settle down (reach “equilibrium”)?
8.18
The Path to Long-Run Equilibrium
8.19
Suppose the current short-run has firms earning losses
(negative profits) 
• There is an incentive for some firms to exit the industry.
• As firms exit, the supply curve shifts left, driving price up.
• This gradual price rise reduces losses for firms remaining
in the industry until those losses are ultimately eliminated.
When does it settle down (reach “equilibrium”)?
Long-Run Adjustments to Short-Run Conditions
• As firms exit, the supply curve shifts from S to S’,
driving price up to P*.
8.20
Long-Run Equilibrium
• The industry eventually returns to long-run equilibrium
and losses are eliminated.
8.21
Long-Run Equilibrium in Perfectly Competitive
Output Markets
8.22
• 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.
• 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.
The “four-way intersection”
P* = MC = min SRATC = min LRAC
The Long-Run Adjustment Mechanism
8.23
• 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.
• 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.