In Chapter 8, we saw how cost curves can be derived from production
functions and input prices. Once a firm has a clear picture of its short-run
costs, the price at which it sells its output determines the quantity of output
that will maximize profit. Specifically, a profit-maximizing perfectly
competitive firm will supply output up to the point that price (marginal
revenue) equals marginal cost. The marginal cost curve of such a firm is
thus the same as its supply curve.
In this chapter, we turn from the short run to the long run. The condition in
which firms find themselves in the short run (Are they making profits? Are
they incurring losses?) determines what is likely to happen in the long run.
Remember that output (supply) decisions in the long run are less
constrained than in the short run, for two reasons. First, in the long run, the
firm can increase any or all of its inputs and thus has no fixed factor of
production that confines its production to a given scale. Second, firms are
free to enter industries to seek profits and to leave industries to avoid
losses.
In making decisions or understanding industry structure, the shape of the
long-run cost curve is important. As we saw in the short run, a fixed factor
of production eventually causes marginal cost to increase along with
output. In the long run, all factors can be varied. In the earlier sandwich
shop example, in the long run, we can add floor space and grills along with
more people to make the sandwiches. Under these circumstances, it is no
longer inevitable that increased volume comes with higher costs. In fact, as
we will see, long-run cost curves need not slope up at all. You might have
wondered why there are only a few automobile and steel companies in the
United States but dozens of firms producing books and furniture.
Differences in the shapes of the long-run cost curves in those industries do
a good job of explaining these differences in the industry structures.
We begin our discussion of the long run by looking at firms in three shortrun circumstances: (1) firms that earn economic profits, (2) firms that suffer
economic losses but continue to operate to reduce or minimize those
losses, and (3) firms that decide to shut down and bear losses just equal to
fixed costs. We then examine how these firms make their long-run
decisions in response to conditions in their markets. Although we continue
to focus on perfectly competitive firms, all firms are subject to the spectrum
of short-run profit or loss situations regardless of market structure.
Assuming perfect competition allows us to simplify our analysis and
provides us with a strong background for understanding the discussions of
imperfectly competitive behavior in later chapters.
Short Run Conditions and Long Run Cost
Before beginning our examination of firm behavior, let us review the
concept of profit. Recall that a normal rate of return is included in the
definition of total cost (Chapter 7). A normal rate of return is a rate that is
just sufficient to keep current investors interested in the industry. Because
we define profit as total revenue minus total cost and because total cost
includes a normal rate of return, our concept of profit takes into account the
opportunity cost of capital. When a firm is earning an above-normal rate of
return, it has a positive profit level; otherwise, it does not. When there are
positive profits in an industry, new investors are likely to be attracted to the
industry.
When we say that a firm is suffering a loss, we mean that it is earning a
rate of return that is below normal. Such a firm may be suffering a loss as
an accountant would measure it, or it may be earning at a very low—that is,
below normal—rate. Investors are not going to be attracted to an industry in
which there are losses. A firm that is breaking even, or earning a zero level
of profit, is one that is earning exactly a normal rate of return. New
investors are not attracted, but current ones are not running away either.
With these distinctions in mind, we can say that for any firm, one of three
conditions holds at any given moment: (1) The firm is making positive
profits, (2) the firm is suffering losses, or (3) the firm is just breaking even.
Profitable firms will want to maximize their profits in the short run, while
firms suffering losses will want to minimize those losses in the short run.
Maximizing Profits
The best way to understand the behavior of a firm that is currently earning
profits is by way of example. Example: The Blue Velvet Car Wash When a
firm earns revenues in excess of costs (including a normal rate of return),
we say it is earning positive or excess profits. Let us consider as an
example the Blue Velvet Car Wash. Looking at a few numbers will help you
see how the specifics of a business operation translate into economic
graphs.
Car washes require a facility. In the case of Blue Velvet, suppose investors
have put up $500,000 to construct a building and purchase all the
equipment required to wash cars. If the car wash closes, the building and
equipment can be sold for its original purchase price, but as long as the
firm is in business, that capital is tied up. If the investors could get 10
percent return on their investment in another business, then for them to
keep their money in this business, they will also expect 10 percent from
Blue Velvet. Thus, the annual cost of the capital needed for the business is
$50,000 (10 percent of $500,000).
The car wash is currently servicing 800 cars a week and can be open 50
weeks a year (2 weeks are needed for maintenance). The cost of the basic
maintenance contract on the equipment is $50,000 per year, and Blue
Velvet has a contract to pay for those services for a year whether it opens
the car wash or not. The fixed costs then for the car wash are $100,000 per
year: $50,000 for the capital costs and $50,000 for the equipment contract.
On a weekly basis, these costs amount to $2,000 per week. If the car wash
operates at the level of 800 cars per week, fixed costs are $2.50 per car
($2,000/800).
There are also variable costs associated with the business. To run a car
wash, one needs workers and soap and water. Workers can be hired by
the hour for $10.00 an hour, and at a customer level of 800 cars per week,
each worker can wash 8 cars an hour. At this service level, then, Blue
Velvet hires workers for 100 hours and has a wage bill of $1,000. The labor
cost of each car wash, when Blue Velvet serves 800 customers, is $1.25
($10/8).
The number of cars each worker can service depends on the number of
cars being worked on. When there is too little business and few workers, no
specialization is possible and cars washed per worker fall. With many cars
to service, workers start getting in one another’s way. We saw that at 800
cars per week, workers could wash 8 each per hour. Later when we graph
the operation, we will assume that the number of cars washed per worker
rises and then falls, reaching a maximum at a volume less than the current
800 cars.
Every car that is washed costs $0.75 in soap, adding $600 to the weekly
bill if 800 car washes are done. Table 9.1 summarizes the costs of Blue
Velvet at the 800 washes per week level.
The industry price is $5.00, and we have assumed that the total number of
car washes done in the market area in a week is 8,000; there are 10 firms
like Blue Velvet in this competitive marketplace all earning economic
profits. There are three key cost curves shown in the graph that represents
Blue Velvet. The average variable cost (AVC) curve shows what happens
to the per unit costs of workers and the other variable factor, soap, as we
change output. Initially as output increases workers can service more cars
per hour as they work together, thus causing the AVC to decline, but
eventually diminishing returns set in and AVC begins to rise. Now look at
the average total cost (ATC) curve. The average total cost curve falls at
first in response to the spreading of the fixed costs over more and more
units and eventually begins to rise as the inefficiencies in labor take their
toll. At the output of 800 washes, the ATC has a value of $4.50. Look back
at Table 9.1. The total cost of Blue Velvet at a service level of 800 cars is
$3,600. The $4.50 comes from dividing $3,600 by 800 cars. Finally, we see
the marginal cost (MC) curve, which rises after a certain point because of
the fixed factor of the building and equipment.
With a price of $5.00, Blue Velvet is producing 800 units and making a
profit (the gray box). Blue Velvet is a perfectly competitive firm, and it
maximizes profits by producing up to the point where price equals marginal
cost, here 800 car washes. Any units produced beyond 800 would add
more to cost than they would bring in revenue. Notice Blue Velvet is
producing at a level that is larger than the output that minimizes average
costs. The high price in the marketplace has induced Blue Velvet to
increase its service level even though the result is slightly less labor
productivity and thus higher per unit costs.
Both revenues and costs are shown graphically. Total revenue (TR) is
simply the product of price and quantity: P* q* = $5 800 = $4,000. On the
diagram, total revenue is equal to the area of the rectangle P*Aq*0. (The
area of a rectangle is equal to its length times its width.) At output q*,
average total cost is $4.50 (point B). Numerically, it is equal to the length of
line segment q*B. Because average total cost is derived by dividing total
cost by q, we can get back to total cost by multiplying average total cost by
q. That is,
ATC = tc/q
and so
TC = ATC x q
Total cost (TC), then, is $4.50 800 = $3,600, the area shaded blue in the
diagram. Profit is simply the difference between total revenue (TR) and
total cost (TC), or $400. This is the area that is shaded gray in the diagram.
This firm is earning positive profits.
A firm, like Blue Velvet, that is earning a positive profit in the short run and
expects to continue doing so has an incentive to expand its scale of
operation in the long run. Managers in these firms will likely be planning to
expand even as they concentrate on producing 800 units. We expect
greater output to be produced in the long run as firms react to profits
earned.
Minimizing Losses
A firm that is not earning a positive profit or breaking even is suffering a
loss. Firms suffering losses fall into two categories: (1) those that find it
advantageous to shut down operations immediately and bear losses equal
to total fixed costs and (2) those that continue to operate in the short run to
minimize their losses. The most important thing to remember here is that
firms cannot exit the industry in the short run. The firm can shut down, but it
cannot get rid of its fixed costs by going out of business. Fixed costs must
be paid in the short run no matter what the firm does.
Whether a firm suffering loss decides to produce or not to produce in the
short run depends on the advantages and disadvantages of continuing
production. If a firm shuts down, it earns no revenue and has no variable
costs to bear. If it continues to produce, it both earns revenue and incurs
variable costs. Because a firm must bear fixed costs whether or not it shuts
down, its decision depends solely on whether total revenue from operating
is sufficient to cover total variable cost. ATC = TC q.
Producing at a Loss to Offset Fixed Costs: Blue Velvet Revisited Suppose
consumers suddenly decide that car washing is a waste of money and
demand falls. The price begins to fall, and Blue Velvet is no longer so
profitable. We can see what Blue Velvet’s management will decide to do by
looking back at Figure 9.1. With an upward-sloping marginal cost curve, as
price begins to fall, the Blue Velvet management team first will choose to
reduce the number of cars it services. As long as the price is greater than
ATC (which is minimized at about $4.35 on the graph), Blue Velvet
continues to make a profit. What happens if the price falls below this level,
say to $3 per car?
Now Blue Velvet has to decide not only how many cars to wash but
whether to be open at all. If the car wash closes, there are no labor and
soap costs. But Blue Velvet still has to pay for its unbreakable year-long
contract, and it still owns its building, which will take some time to sell. So,
the fixed costs of $2,000 per week remain. For Blue Velvet, the key
question is can it do better than losing $2,000? The answer depends on
whether the market price is greater or less than average variable costs—
the costs per unit for the variable factors. If the price is greater than the
average variable cost, then Blue Velvet can pay for its workers and the
soap and have something left for the investors. It will still lose money, but it
will be less than $2,000. If price is less than average variable cost, the firm
will not only lose its $2,000 but also have added losses on every car it
washes. So, the simple answer for Blue Velvet is that it should stay open
and wash cars as long as it covers its variable costs. Economists call this
the shutdown point. At all prices above this shutdown point, the marginal
cost curve shows the profit-maximizing level of output. At all points below
this point, optimal short-run output is zero.
We can now refine our earlier statement, from Chapter 8, that a perfectly
competitive firm’s marginal cost curve is its short-run supply curve. As we
have just seen, a firm will shut down when the market price is less than the
minimum point on the AVC curve. Also recall (or notice from the graph) that
the marginal cost curve intersects the AVC at AVC’s lowest point. It
therefore follows that 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. For Blue Velvet, the firm will shut down at a price of about $1.50
(reading off the graph). Figure 9.2 shows the short-run supply curve for the
general case of a perfectly competitive firm like Blue Velvet.
The Short-Run Industry Supply Curve
Supply in a competitive industry is the sum of the quantity supplied by the
individual firms in the industry at each price level. The short-run industry
supply curve is the sum of the individual firm supply curves—that is, the
marginal cost curves (above AVC) of all the firms in the industry. Because
quantities are being added—that is, because we are finding the total
quantity supplied in the industry at each price level—the curves are added
horizontally.
Figure 9.3 shows the supply curve for an industry with three identical
firms.1 At a price of $6, each firm produces 150 units, which is the output
where P = MC. The total amount supplied on the market at a price of $6 is
thus 450. At a price of $5, each firm produces 120 units, for an industry
supply of 360. Below $4.50, all firms shut down; P is less than AVC.
Two things can cause the industry supply curve to shift. In the short run,
the industry supply curve shifts if something—a decrease in the price of
some input, for instance—shifts the marginal cost curves of all the
individual firms simultaneously. For example, when the cost of producing
components of home computers decreased, the marginal cost curves of all
computer manufacturers shifted downward. Such a shift amounted to the
same thing as an outward shift in their supply curves. Each firm was willing
to supply more computers at each price level because computers were now
cheaper to produce.
In the long run, an increase or decrease in the number of firms—and,
therefore, in the number of individual firm supply curves—shifts the total
industry supply curve. If new firms enter the industry, the industry supply
curve moves to the right; if firms exit the industry, the industry supply curve
moves to the left.
We return to shifts in industry supply curves and discuss them further when
we take up long-run adjustments later in this chapter.
Long-Run Directions: A Review Table 9.2 summarizes the different
circumstances that perfectly competitive firms may face as they plan for the
long run. Profit-making firms will produce up to the point where price and
marginal cost are equal in the short run. If there are positive profits, in the
long run, there is an incentive for firms to expand their scales of plant and
for new firms to enter the industry.
A firm suffering loss will produce if and only if revenue is sufficient to cover total variable cost. Such
firms, like profitable firms, will also produce up to the point where P = MC. If a firm suffering loss cannot
cover total variable cost by operating, it will shut down and bear losses equal to total fixed cost.
Whether a firm that is suffering losses decides to shut down in the short run or not, the losses create an
incentive to contract in the long run. When firms are suffering losses, they generally exit the industry in
the long run.
Thus, the short-run profits of firms cause them to expand or contract when opportunities exist to
change their scale of plant. If expansion is desired because economic profits are positive, firms must
consider what their costs are likely to be at different scales or operation. (When we use the term “scale
of operation,” you may find it helpful to picture factories of varying sizes.) Just as firms have to analyze
different technologies to arrive at a cost structure in the short run, they must also compare their costs at
different scales of plant to arrive at long-run costs. Perhaps a larger scale of operations will reduce
average production costs and provide an even greater incentive for a profit-making firm to expand, or
perhaps large firms will run into problems that constrain growth. The analysis of long-run possibilities is
even more complex than the short-run analysis because more things are variable—scale of plant is not
fixed, for example, and there are no fixed costs because firms can exit their industry in the long run. In
theory, firms may choose any scale of operation; so, they must analyze many possible options.
Now let us turn to an analysis of cost curves in the long run.
Long Run Costs: Economies and Diseconomies of Scale
The shapes of short-run cost curves follow directly from the assumption of
a fixed factor of production. As output increases beyond a certain point, the
fixed factor (which we usually think of as fixed scale of plant) causes
diminishing returns to other factors and thus increasing marginal costs. In
the long run, however, there is no fixed factor of production. Firms can
choose any scale of production. They can build small or large factories,
double or triple output, or go out of business completely.
The shape of a firm’s long-run average cost curve shows how costs vary
with scale of operations. In some firms, production technology is such that
increased scale, or size, reduces costs. For others, increased scale leads
to higher per-unit costs. When an increase in a firm’s scale of production
leads to lower average costs, we say that there are increasing returns to
scale, or economies of scale. When average costs do not change with the
scale of production, we say that there are constant returns to scale. Finally,
when an increase in a firm’s scale of production leads to higher average
costs, we say that there are decreasing returns to scale, or diseconomies
of scale. Because these economies of scale are a property of production
characteristics of the individual firm, they are considered internal
economies of scale. In the Appendix to this chapter, we talk about external
economies of scale, which describe economies or diseconomies of scale
on an industry-wide basis.
Increasing Returns to Scale
Technically, the phrase increasing returns to scale refers to the relationship
between inputs and outputs. When we say that a production function
exhibits increasing returns, we mean that a given percentage of increase in
inputs leads to a larger percentage of increase in the production of output.
For example, if a firm doubled or tripled inputs, it would more than double
or triple output. When firms can count on fixed input prices—that is, when
the prices of inputs do not change with output levels—increasing returns to
scale also means that as output rises, average cost of production falls. The
term economies of scale refer directly to this reduction in cost per unit of
output that follows from larger-scale production.
The Sources of Economies of Scale
Most of the economies of scale that immediately come to mind are
technological in nature. Automobile production, for example, would be more
costly per unit if a firm were to produce 100 cars per year by hand. In the
early 1900s, Henry Ford introduced standardized production techniques
that increased output volume, reduced costs per car, and made the
automobile available to almost everyone. The new technology is not very
cost-effective at small volumes of cars, but at larger volumes costs are
greatly reduced. Ford’s innovation provided a source of scale economics at
the plant level of the auto firm.
Some economies of scale result not from technology but from firm-level
efficiencies and bargaining power that can come with size. Very large
companies, for instance, can buy inputs in volume at discounted prices.
Large firms may also produce some of their own inputs at considerable
savings, and they can certainly save in transport costs when they ship
items in bulk. Wal-Mart has become the largest retailer in the United States
in part because of scale economies of this type. Economics of scale have
come from advantages of larger firm size rather than gains from plant size.
Economies of scale can be seen all around us. A bus that carries 50 people
between Vancouver and Seattle uses less labor, capital, and gasoline than
50 people driving 50 different automobiles. The cost per passenger
(average cost) is lower on the bus. Roommates who share an apartment
are taking advantage of economies of scale. Costs per person for heat,
electricity, and space are lower when an apartment is shared than if each
person rents a separate apartment.
Example: Economies of Scale in Egg Production Nowhere are economies
of scale more visible than in agriculture. Consider the following example. A
few years ago, a major agribusiness moved to a small Ohio town and set
up a huge egg-producing operation. The new firm, Chicken Little Egg
Farms Inc., is completely mechanized. Complex machines feed the
chickens and collect and box the eggs. Large refrigerated trucks transport
the eggs all over the state daily. In the same town, some small farmers still
own fewer than 200 chickens. These farmers collect the eggs, feed the
chickens, clean the coops by hand, and deliver the eggs to county markets.
Table 9.3 presents some hypothetical cost data for Homer Jones’s small
operation and for Chicken Little Inc. Jones has his operation working well.
He has several hundred chickens and
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.
ACTIVITY
1. Ajax is a competitive firm operating under the following conditions: Price of output is $5,
the profit-maximizing level of output is 20,000 units of output, and the total cost (full
economic cost) of producing 20,000 units is $120,000. The firm’s only fixed factor of
production is a $300,000 stock of capital (a building). If the interest rate available on
comparable risks is 10 percent, should this firm shut down immediately in the short run?
Explain your answer.
2.
For cases A through F in the following table, would you (1) operate or shut down in the
short run and (2) expand your plant or exit the industry in the long run?
Total Revenue
Total Cost
Total Fixed Cost
A
B
C
D
E
F
150
0
150
0
500
200
0
150
0
500
200
0
250
0
200
500
0
600
0
150
0
500
0
700
0
150
0
500
0
400
0
150
0