For any firm one of three conditions hold at any given moment:
 The firm is making positive profits
 The firm is suffering losses
 The firm is just breaking even.
Breaking even, or earning a zero profit
is a situation in which a firm earns exactly a normal rate of return.
To maximize profit, the firm sets the level of output where marginal
revenue equals marginal cost.
There are two types of firms that suffer from losses:
 Those which shut down immediately and bear losses equal to
fixed costs.
 Those that continue their operations in the short-run to minimize
losses.
The decision to shut down depends on whether revenues from
operating are sufficient to cover variable costs.
The difference between ATC and AVC equals AFC. Then,
AFC x q = TFC.
A Firm Will Operate If Total Revenue Covers Total Variable Cost
CASE 1: SHUT DOWN
CASE 2: OPERATE AT PRICE = $3
Total Revenue (q = 0)
$ 0
Total Revenue ($3 x 800)
$ 2,400
Fixed costs
Variable costs
Total costs
Profit/loss (TR - TC)
$ 2,000
+
0
$ 2,000
- $ 2,000
Fixed costs
$ 2,000
Variable costs
+ 1,600
Total costs
$ 3,600
Operating profit/loss (TR - TVC) $ 800
Total profit/loss (TR - TC)
- $ 1,200
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.
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.
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.
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.
SHORT-RUN
CONDITION
Profits
TR > TC
Losses 1. With operating profit
(TR  TVC)
2. With operating losses
(TR < TVC)
SHORT-RUN
DECISION
P = MC: operate
P = MC: operate
(losses < fixed costs)
Shut down:
losses = fixed costs
LONG-RUN
DECISION
Expand: new firms enter
Contract: firms exit
Contract: firms exit
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.
 Short-run cost curves are U-shaped. This follows from fixed
factor of production. As output increases beyond a certain point,
the fixed factor causes diminishing returns to variable factors
and thus increasing marginal cost.
 The shape of firm’s long-run average cost curve depends on how
costs vary with scale of operation. For some firms, increased
scale reduces costs. For others, increased scale leads to
inefficiency and waste.
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.
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.
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.
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
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.
The long run average cost curve of a firm exhibiting economies of scale is
downward-sloping.
The LRAC curve of a firm that eventually exhibits diseconomies of
scale becomes upward-sloping.
All SRAC curves are U-shaped since there is a fixed scale of plant that constrains
production and drives marginal cost as a result of diminishing marginal returns. In the
long run scale of plant can be changed and the shape of the LRAC curve depends on
how costs vary with scale.
The optimal scale of plant is the scale that minimizes average cost.
 The industry is not in equilibrium if firms have an incentive to enter or
exit in the long run.
 Firms expand in the long-run when increasing returns to scale are
available.
Firms will continue to expand as long as there are EOS to be
realized, and new firms will continue to enter as long as there are
positive profits.
When firms in an industry suffer losses, there is an incentive for them to exit.
As firms exit, the supply curve shifts from S to S’, driving price up to P*.
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
The central idea in our discussion of entry, exit, expansion, and
contraction is this:
 In efficient markets, investment capital flows toward profit
opportunities.
 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.