Long-Run Costs and Output Decisions
Short-Run Conditions and Long-Run Directions
Long-Run Costs: Economies and Diseconomies of Scale
Long-Run Adjustments to Short-Run Conditions
Output Markets
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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.
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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)
$
400
1,000
$ 2,000
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
Graphic Presentation
FIGURE 9.1 Firm Earning Positive Profits in the Short Run
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
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.
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
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)
CASE 2: OPERATE AT PRICE = $3
$
0
Total Revenue ($3 x 800)
Fixed costs
Variable costs
Total costs
$ 2,000
+
0
$ 2,000
Fixed costs
Variable costs
Total costs
Profit/loss (TR - TC)
- $ 2,000
Operating profit/loss (TR - TVC)
Total profit/loss (TR - TC)
$ 2,400
$ 2,000
+ 1,600
$ 3,600
$
800
- $ 1,200
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
Graphic Presentation
FIGURE 9.2 Firm Suffering Losses but Showing an Operating Profit in the Short Run
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
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.
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
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)
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
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
negative—that 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 profitmaximizing level of output. At all prices below it, optimal short-run output is zero.
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
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).
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
FIGURE 9.3 Short-Run Supply Curve of a Perfectly Competitive Firm
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
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
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
LONG-RUN DIRECTIONS: A REVIEW
TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and
Short Run
SHORT-RUN
CONDITION
Profits
Losses
TR > TC
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
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
increasing returns to scale, or economies of
scale An increase in a firm’s scale of
production leads to lower costs per unit
produced.
constant returns to scale An increase in a
firm’s scale of production has no effect on costs
per unit produced.
decreasing returns to scale, or diseconomies
of scale An increase in a firm’s scale of
production leads to higher costs per unit
produced.
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
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.
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
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
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
Graphic Presentation
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.
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
FIGURE 9.5 A Firm Exhibiting Economies of Scale
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
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 firm’s long-run
average cost curve remains flat.
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
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.
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
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.
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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS
SHORT-RUN PROFITS: EXPANSION TO
EQUILIBRIUM
FIGURE 9.7 Firms Expand in the Long Run When Increasing Returns
to Scale Are Available
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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS
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.
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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS
SHORT-RUN LOSSES: CONTRACTION TO
EQUILIBRIUM
FIGURE 9.8 Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses
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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS
As long as losses are being sustained in an industry, firms will shut
down and leave the industry, thus reducing supply—shifting 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 plant—that is, at the minimum point on
their LRAC curve.
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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS
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.
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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS
long-run competitive equilibrium When
P = SRMC = SRAC = LRAC and profits are
zero.
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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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.
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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
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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.
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Appendix
TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 2000–2005
CONSTRUCTION
HOUSING
MATERALS
CONSUMER
STARTS
PRICES
PRICES
HOUSE PRICES
% CHANGE
% CHANGE
% CHANGE
OVER THE
OVER THE
OVER THE
%D OVER
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%
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Appendix
THE LONG-RUN INDUSTRY SUPPLY CURVE
FIGURE 9A.1 A Decreasing-Cost Industry: External Economies
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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 economies—that is,
average costs decrease as the industry
grows. The long-run supply curve for such
an industry has a negative slope.
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Appendix
FIGURE 9A.2 An Increasing-Cost Industry: External Diseconomies
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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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