Transcript Long-Run Costs and Output Decisions

CHAPTER
8
Long-Run Costs
and Output Decisions
Appendix: External Economies and Diseconomies and the
Long-Run Industry Supply Curve
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 8: Long-Run Costs and Output Decisions
Short-Run Conditions
and 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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C H A P T E R 8: Long-Run Costs and Output Decisions
Maximizing Profits
Blue Velvet Car Wash Weekly Costs
TOTAL VARIABLE COSTS
(TVC) (800 WASHES)
TOTAL FIXED COSTS (TFC)
1. Normal return to
investors
$ 1,000
2. Other fixed costs
(maintenance contract,
insurance, etc.)
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)
$ 400
1,000
$ 2,000
• 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.
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C H A P T E R 8: Long-Run Costs and Output Decisions
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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C H A P T E R 8: Long-Run Costs and Output Decisions
Firm Earning Positive
Profits in the Short Run
• Profit is the difference between total revenue and
total cost.
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C H A P T E R 8: Long-Run Costs and Output Decisions
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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C H A P T E R 8: Long-Run Costs and Output Decisions
Minimizing Losses
• Operating profit (or loss) or net
operating revenue equals total
revenue minus total variable cost
(TR – TVC).
• 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.
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C H A P T E R 8: Long-Run Costs and Output Decisions
Minimizing Losses
• When price equals $3.50, revenue is sufficient to
cover total variable cost but not total cost.
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C H A P T E R 8: Long-Run Costs and Output Decisions
Minimizing Losses
A Firm Will Operate If Total Revenue Covers Total Variable
Cost
CASE 1: SHUT DOWN
Total Revenue (q = 0)
CASE 2: OPERATE AT PRICE = $3
$
0
Total Revenue ($3 x 800)
$ 2,400
Fixed costs
Variable costs
Total costs
$ 2,000
+
0
$ 2,000
Fixed costs
Variable costs
Total costs
$ 2,000
+ 1,600
$ 3,600
Profit/loss (TR - TC)
- $ 2,000
Operating profit/loss (TR - TVC)
Total profit/loss (TR - TC)
$ 800
- $ 1,200
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C H A P T E R 8: Long-Run Costs and Output Decisions
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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C H A P T E R 8: Long-Run Costs and Output Decisions
Minimizing Losses
• The difference between ATC and AVC equals AFC.
Then, AFC  q = TFC.
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C H A P T E R 8: Long-Run Costs and Output Decisions
Shutting Down to Minimize Loss
A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost
CASE 1: SHUT DOWN
Total Revenue (q = 0)
CASE 2: OPERATE AT PRICE = $1.50
$
0
Total revenue ($1.50 x 800)
$ 1,200
Fixed costs
Variable costs
Total costs
$ 2,000
+
0
$ 2,000
Fixed costs
Variable costs
Total costs
$ 2,000
+ 1,600
$ 3,600
Profit/loss (TR - TC)
- $ 2,000
Operating profit/loss (TR - TVC)
Total profit/loss (TR - TC)
- $ 400
- $ 2,400
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C H A P T E R 8: Long-Run Costs and Output Decisions
Short-Run Supply Curve
of a Perfectly Competitive Firm
© 2004 Prentice Hall Business Publishing
• 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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C H A P T E R 8: Long-Run Costs and Output Decisions
Short-Run Supply Curve
of a Perfectly Competitive Firm
© 2004 Prentice Hall Business Publishing
• 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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C H A P T E R 8: Long-Run Costs and Output Decisions
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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C H A P T E R 8: Long-Run Costs and Output Decisions
Profits, Losses, and Perfectly Competitive
Firm Decisions in the Long and Short Run
SHORT-RUN
CONDITION
Profits
TR > TC
Losses 1. With operating profit
(TR  TVC)
2. With operating losses
(TR < TVC)
SHORT-RUN
DECISION
LONG-RUN
DECISION
P = MC: operate
Expand: new firms enter
P = MC: operate
Contract: firms exit
(losses < fixed costs)
Shut down:
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.
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C H A P T E R 8: Long-Run Costs and Output Decisions
Long-Run Costs: Economies and
Diseconomies 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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C H A P T E R 8: Long-Run Costs and Output Decisions
Weekly Costs Showing
Economies of Scale in Egg Production
JONES FARM
TOTAL WEEKLY COSTS
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 WEEKLY COSTS
$ 5,128
4,115
2,431
19,230
$30,904
1,600,000 eggs
$.019 per egg
Total output
Average cost
© 2004 Prentice Hall Business Publishing
$120
25
15
17
$177
2,400 eggs
$.074 per egg
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C H A P T E R 8: Long-Run Costs and Output Decisions
A Firm Exhibiting Economies of Scale
• The long run average cost curve of a firm
exhibiting economies of scale is downwardsloping.
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C H A P T E R 8: Long-Run Costs and Output Decisions
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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C H A P T E R 8: Long-Run Costs and Output Decisions
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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C H A P T E R 8: Long-Run Costs and Output Decisions
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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C H A P T E R 8: Long-Run Costs and Output Decisions
A Firm Exhibiting Economies
and Diseconomies of Scale
• The LRAC curve of a firm that eventually
exhibits diseconomies of scale becomes
upward-sloping.
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C H A P T E R 8: Long-Run Costs and Output Decisions
Optimal Scale of Plant
• The optimal scale of plant is the scale
that minimizes average cost.
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C H A P T E R 8: Long-Run Costs and Output Decisions
Long-Run Adjustments
to Short-Run Conditions
• Firms expand in the long-run when
increasing returns to scale are available.
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C H A P T E R 8: Long-Run Costs and Output Decisions
Short-Run Profits:
Expansion to Equilibrium
• Firms expand in the long run when
increasing returns to scale are available.
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C H A P T E R 8: Long-Run Costs and Output Decisions
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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C H A P T E R 8: Long-Run Costs and Output Decisions
Short-Run Losses:
Contraction to Equilibrium
• As firms exit, the supply curve shifts from S
to S’, driving price up to P*.
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C H A P T E R 8: Long-Run Costs and Output Decisions
Short-Run Losses:
Contraction to Equilibrium
• The industry eventually returns to long-run
equilibrium and losses are eliminated.
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C H A P T E R 8: Long-Run Costs and Output Decisions
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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C H A P T E R 8: Long-Run Costs and Output Decisions
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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C H A P T E R 8: Long-Run Costs and Output Decisions
Long-Run Adjustment Mechanism:
Investment Flows Toward Profit Opportunities
• The central idea in our discussion of
entry, exit, expansion, and
contraction is this:
• 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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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 8: Long-Run Costs and Output Decisions
Review Terms and Concepts
breaking even
operating profit (or loss) or net operating
revenue
constant return to scales
decreasing returns to scale, or
diseconomies of scale
increasing returns to scale, or
economies of scale
optimal scale of plant
short-run industry supply curve
shut-down point
long-run average cost curve (LRAC)
long-run competitive equilibrium:
P = SRMC = SRAC = LRAC
long-run competitive equilibrium
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 8: Long-Run Costs and Output Decisions
Appendix: External Economies and Diseconomies
and the Long-Run Industry Supply Curve
• 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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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 8: Long-Run Costs and Output Decisions
Appendix: External Economies and Diseconomies
and the Long-Run Industry Supply Curve
• 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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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 8: Long-Run Costs and Output Decisions
Appendix: External Economies and Diseconomies
and the Long-Run Industry Supply Curve
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
1991
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
PERCENTAGE
CHANGE IN
CONSUMER
PRICES
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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Karl Case, Ray Fair
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C H A P T E R 8: Long-Run Costs and Output Decisions
Appendix: External Economies and Diseconomies
and the Long-Run Industry Supply Curve
• In a decreasing cost industry, costs decline
as a result of industry expansion, and the
LRIS is downward-sloping.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
37 of 38
C H A P T E R 8: Long-Run Costs and Output Decisions
Appendix: External Economies and Diseconomies
and the Long-Run Industry Supply Curve
• In an increasing cost industry, costs rise as
a result of industry expansion, and the
LRIS is upward-sloping.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
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