Principles of Economics, Case and Fair,8e

1
(No Transcript)
2
LONG-RUN COSTS AND OUTPUT DECISIONS

• Short-Run Conditions and Long Run
  DirectionsMaximizing Profits and Minimizing
  LossesThe Short-Run Industry Supply
  CurveLong-Run Directions A Review
• Long-Run Costs Economies and Diseconomies of
  ScaleIncreasing Returns to ScaleConstant
  Returns to ScaleDecreasing Returns to Scale
• Long-Run Adjustments to Short-Run Shocks
• Short-Run Profits Expansion to
  EquilibriumShort-Run Losses Contraction to
  Equilibrium

3
LONG-RUN COSTS AND OUTPUT DECISIONS

• We begin our discussion of the long run by
  looking at firms in three short-run
  circumstances
• firms earning economic profits,
• firms suffering economic losses but continuing to
  operate to reduce or minimize those losses, and
• firms that decide to shut down and bear losses
  just equal to fixed costs.

4
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS
FIGURE 9.1 Graphic Representation Firm Earning
Positive Profits in the Short Run
At the market price of P5, the firm chooses to
supply q300. The ATC of 300 units is 4.20.
ProfitPq-TCPq-ATCq(P-ATC)q 240
5
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• Whenever a firm is making positive economic
  profits, it is doing better than the next best
  alternative.
• In this case, other firms will be attracted to
  this industry.
• In the long run, we expect that new firms enter
  this industry.

6
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• Firms may also experience economic losses in the
  short run.
• This is because it does not have the option of
  exiting in the short run.
• If revenues exceed variable costs, by continuing
  to produce a part of the revenues can be used to
  offset fixed costs and reduce losses, and it will
  be better for the firm to keep operating.
• However, if at the profit maximizing level of
  output a firm can not cover its variable costs,
  the firm should shut-down. Shut-down if TRor P

7
SHORT-RUN CONDITIONSAND 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.

8
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS
FIGURE 9.3 Short-Run Supply Curve of a Perfectly
Competitive Firm
9
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS
FIGURE 9.2 Firm Suffering Losses but continuing
to operate in the Short Run
At a market price of 3.5, the profit maximizing
level of output would be q225. Since the price
is above the AVC3.10, it is not optimal
shut-down. However, Because Pfirm incurs a loss. Profits/Losses(P-ATC)q
10
SHORT-RUN CONDITIONSAND 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
11
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• If firms are making an economic loss in the
  short-run, they will eventually want to exit the
  industry because this will imply that the next
  best alternative is more profitable.
• So whether or not firms shut-down or continue to
  operate, in the long run they will exit the
  industry if economic profits are negative.

12
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS
LONG-RUN DIRECTIONS A REVIEW
13
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• Long run equilibrium
• Firms are maximizing profits and there is no
  reason to enter or exit. This can only happen
  when there are zero economic profits being made.
• Profits0 means that entry will occur
• Profits
• Only if Profits 0 is there no reason for entry
  or exit to occur.

14
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• What will be the long run equilibrium level of
  output, price and scale of operations?
• Will depend on what long-run cost curves look
  like.
• In the short run, a firms scale of operations is
  fixed. However, in the long run this scale can be
  varied (all inputs are variable in the long run).
  
• All short-run average cost curves are U-shaped,
  because we assume a fixed scale of operations
  that constrains production and drives marginal
  cost upward as a result of diminishing returns.

15
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• In general, LRAC curves can have many shapes
  (upward sloping, downward sloping, flat)
  depending on the technology under question.
• LRAC is related to SRAC curve.
• The LRAC curve tells the minimum average costs
  for all possible scales of operations.

16
(No Transcript)
17
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS
FIGURE 9.5 The LRAC curve is the lower envelope
of all the short run average cost curves.
18
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• In long run, there are no fixed inputs, and
  nothing governing the overall shape of cost
  curves.
• Instead, we will see that the long run average
  cost (LRAC) curves may be flat, upward, or
  downward sloping
• What determines the shape of the LRAC curve?

19
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• Slope of LRAC curve will be governed by the type
  of economics of scale.
• increasing returns to scale, or economies of
  scale If by increasing all inputs by x percent,
  then output increases by more than x percent,
  then the firm exhibits increasing returns to
  scale.
• As output increases, the average costs decrease
• LRAC curve is downward sloping
• constant returns to scale If by increasing all
  inputs by x percent, then output increases by
  exactly x percent, then the firm exhibits
  constant returns to scale.
• As output increases, the average costs dont
  change
• LRAC curve is flat
• decreasing returns to scale, or diseconomies of
  scale If by increasing all inputs by x percent,
  then output increases by less than x percent,
  then the firm exhibits decreasing returns to
  scale.
• As output increases, the average costs increase
• LRAC curve is upward sloping

20
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• increasing returns to scale (IRS), or economies
  of scale
• If double all inputs, output more than doubles.
• IRS will imply that the firms LRAC decreases as
  output increases. Firms get more efficient the
  more they produce.

21
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• increasing returns to scale (IRS), or economies
  of scale
• Example Suppose that there are 2 inputs used to
  produce a good capital (K) and labor (L). In the
  long run both can be varied.
• If L10 and K10, then q20.
• If L20 and K20 (doubling all inputs), then q50
  (more than doubled).
• Assume that PL5 and PK5
• Then the Long run average costs of producing 20
  units is
• LRAC Total Costs/q(PLLPKK)/q100/205
• Then the Long run average costs of producing 50
  units is
• LRAC Total Costs/q(PLLPKK)/q200/504

22
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• increasing returns to scale (IRS), or economies
  of scale LRAC curve is downward sloping. It is
  much more efficient to produce on a larger scale.

5
LRAC
4
q
20
50
23
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• The Sources of Economies of Scale
• Technology
• It may be that it is only cost efficient to buy
  certain machinery that is highly productive only
  if you are producing a large amount of output.
• Example If a firm is only producing 10 cars, it
  may not buy expensive machinery that could do
  assembly operations. If a firm is producing 1
  million cars, it is more likely worth the
  expenditure.
• Size
• A firm may be able to get price discounts when it
  buys large quantities. Therefore, larger firms
  are more able to have lower costs.
• Example Wal-Mart has been able to get suppliers
  of goods to charge much less than a small store
  because they buy so much.

24
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• constant returns to scale (CRS) If double all
  inputs, output exactly doubles.
• CRS will imply that the firms LRAC is flat.
• Example Suppose that there are 2 inputs used to
  produce a good capital (K) and labor (L). In the
  long run both can be varied.
• If L10 and K10, then q20.
• If L20 and K20 (double all inputs), then q40
  (output exactly doubled).
• Assume that PL5 and PK5
• Then the Long run average costs of producing 20
  units is
• LRAC Total Costs/q(PLLPKK)/q100/205
• Then the Long run average costs of producing 40
  units is
• LRAC Total Costs/q(PLLPKK)/q200/405

25
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• constant returns to scale (CRS), LRAC curve is
  flat

LRAC
5

q
20
40
26
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• Decreasing returns to scale (DRS) (diseconomies
  of scale) If double all inputs, output less than
  doubles.
• DRS will imply that the firms LRAC is upward
  sloping.
• Example Suppose that there are 2 inputs used to
  produce a good capital (K) and labor (L). In the
  long run both can be varied.
• If L10 and K10, then q20.
• If L20 and K20 (doubled all inputs), then q25
  (output less than doubled).
• Assume that PL5 and PK5
• Then the Long run average costs of producing 20
  units is
• LRAC Total Costs/q(PLLPKK)/q100/205
• Then the Long run average costs of producing 25
  units is
• LRAC Total Costs/q(PLLPKK)/q200/258

27
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• decreasing returns to scale (DRS), LRAC curve is
  upward sloping. Implies that larger firms are
  less efficient.

LRAC

8
5

q
25
20
28
LONG-RUN COSTS ECONOMIESAND DISECONOMIES OF SCALE
DRS
IRS
FIGURE 9.6 A Firm Exhibiting Economies and
Diseconomies of Scale
There may be different returns to scale over
different ranges of output.
29
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• optimal scale of plant The scale of plant that
  minimizes average cost.
• If a firm has IRS over all ranges of output, then
  this will imply that being as large as possible
  is optimal.
• If firms in an industry have IRS over all ranges
  of output, this can not be a perfectly
  competitive industry. Why?
• Because if one firm gets bigger than the others
  it can undercut (price lower than) all others and
  steal all the demand.

30
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• If an industry has decreasing returns to scale
  over all ranges of output, it implies that firms
  should be infinitesimally small.
• It is unlikely that firms have DRS over all
  ranges of output. DRS would usually set in when
  firms were very large.
• For example, in very large and bureaucratic
  institutions it is difficult to coordinate tasks
  and to be flexible.
• It is also more likely that labor would unionize.
  
• Both tend to increase costs but only after firms
  reach a certain size.

31
SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

• For firms with CRS, any scale is optimal.
• For firms with U-Shaped LRAC curves, the optimal
  scale is at the minimum of the LRAC curve.

32
LONG-RUN ADJUSTMENTS TO SHORT-RUN CONDITIONS

• long-run competitive equilibrium
• Firms are maximizing profits (PSRMC),
• There is no incentive for entry or exit, so there
  are zero economic profits. (PSRAC)
• Costs are being minimized so that firms operate
  at the most efficient scale (PSRMCSRACmin
  LRAC).
• Industry Supply Industry Demand
• When P SRMC SRAC LRAC.

33
Long run equilibrium
Typical Firm
Industry
P
P0
34
LONG-RUN ADJUSTMENTS TO SHORT-RUN SHOCKS

• How does the market adjust to a long run
  equilibrium?
• EXAMPLE 1 Demand Increase
• Suppose that the industry starts off in a long
  run equilibrium. Then there is a demand increase.
• What is the new short run equilibrium and how
  does the market reach a new long run equilibrium?

35
EXAMPLE 1 New Short Run Equilibrium
The demand increase causes the equilibrium price
to rise to P1 and the equilibrium industry
quantity to rise to Q1. Firm output increases to
q1 where the new price (demand) intersects the
SRMC curve and the firm earns positive profits
36
EXAMPLE 1 New Long Run Equilibrium

• Because firms are making positive economic
  profits, new firms will enter. This will increase
  the industry supply curve.
• Entry will continue to occur until price is
  driven back down to the where there are no more
  economic profits.

37
EXAMPLE 1 New Long Run Equilibrium
Entry causes supply to increase until market
price is driven back down to P0 and the
equilibrium industry quantity goes to Q2. Firm
output decreases back to q0 where firms earn zero
profits. The end result is the original price,
the same firm output, more firms and a larger
industry equilibrium quantity.
38
LONG-RUN ADJUSTMENTS TO SHORT-RUN SHOCKS

• EXAMPLE 2 Demand decrease
• Suppose that the industry starts off in a long
  run equilibrium. Then there is a demand decrease.
• What is the new short run equilibrium and how
  does the market reach a new long run equilibrium?

39
EXAMPLE 2 New Short Run Equilibrium
The demand decrease causes the equilibrium price
to fall to P1 and the industry quantity to fall
to Q1. The firm output falls to q1. Since Pmin
AVC, the firm produces a positive output) even
though it incurs a loss.
40
EXAMPLE 2 New Long Run Equilibrium

• Because firms are making economic losses, in the
  long run firms will exit the industry. This will
  decrease the industry supply curve.
• Exit will continue to occur until price is driven
  back up to where economic profits/losses are zero.

41
EXAMPLE 2 New Long Run Equilibrium
Supply drops until price goes back to P0. The
firms that remain in the industry go back to
producing q0. There are fewer firms and less
produced/sold in the industry at Q2. Remaining
firms make zero economic profits/losses.