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.