Costs and Output Decisions in the Long Run

1
Costs and Output Decisions in the Long Run

• In this chapter we finish our discussion of how
  profit-maximizing firms decide how much to supply
  in the short-run and the long-run.
• Profit is the difference between total revenue
  and total cost.
• The economic concept of profit takes into account
  the opportunity cost of capital.
• Total economic cost includes a normal rate of
  return. A normal rate of return is the rate that
  is just sufficient to keep current investors
  interested in the industry.
• Breaking even is a situation in which a firm is
  earning exactly a normal rate of return so that
  economic profits are zero.

2
Firm Earning Positive Profits in the Short Run

• To maximize profit, the firm sets the level of
  output where marginal revenue equals marginal
  cost.

3
Firm Earning Positive Profits in the Short Run
Example from Ch. 7
Widget Market
Widget Firm
S
MC
ATC
d
70
P70
ATC46.67
AVC
D
q6
Algebra
Profits
Total costs
4
Minimizing Losses

• 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.

5
Minimizing Losses
Suppose the market price of widgets falls to 30.
The firm finds its new profit-maximizing output
level where PMC. This occurs at q4. However,
the firm earns a negative economic profit.
Widget Market
MC
Widget Firm
S
ATC
ATC40
AVC
d
P30
30
D
q 4
Algebra
Losses (negative profit)
6
Minimizing Losses and the Shut-down Point
How low can price fall until the firm would be
better off shutting down (q 0)? Remember
that in the short-run, if the firm produces
nothing, its revenues are zero but its costs
equal TFC ? profits -TFC As long as price is
sufficient to cover average variable costs (P gt
AVC), the firm stands to gain by operating
instead of shutting down . Shutdown point a
market price that, when it intersects MC, it also
equals AVC. This will occur only at the minimum
point on the AVC curve. (See chapter 7)
7
Short-Run Supply Curve of a Perfectly Competitive
Firm

• 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. This
  explains why supply curves are upward sloping
  because MC is upward slopingand why is MC upward
  sloping?

8
The Short-Run Industry Supply 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.

9
Profits, Losses, and Perfectly Competitive Firm
Decisions in the Long and Short Run
SHORT-RUNCONDITION SHORT-RUNDECISION LONG-RUNDECISION
Profits TR gt TC Operate where PMC Expansion new firms enter
Losses 1. With operating profit Operate where PMC Contract firms exit
(TC ? TR ? TVC) (losses lt fixed costs)
2. With operating losses Shut down b/c at PMC Contract firms exit
(TVC gtTR) losses fixed costs

• 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.

10
Long-Run Costs Economies and Diseconomies of
Scale
The long-run is a time period during which all
inputs are variable (including the scale of
production) and firms can enter and exit the
industry. We want to analyze how average total
cost changes as output changes

• 1) Increasing returns to scale, or economies of
  scale, refers to an increase in a firms scale of
  production, which leads to lower average total
  costs per unit produced.

11
Long-Run Costs Economies and Diseconomies of
Scale (cont)

• Constant returns to scale refers to an increase
  in a firms scale of production, which has no
  effect on average total costs per unit produced.
• 3) Decreasing returns to scale refers to an
  increase in a firms scale of production, which
  leads to higher average total costs per unit
  produced.

12
The Long-Run Average Cost Curve

• 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.
• Here is a diagram of a long run average cost
  curve of a firm exhibiting economies of scale. It
  is downward-sloping

13
Weekly Costs Showing Economies of Scale in Egg
Production
JONES FARM JONES FARM TOTAL WEEKLY COSTS TOTAL WEEKLY COSTS
15 hours of labor (implicit value 8 per hour) 15 hours of labor (implicit value 8 per hour) 120
Feed, other variable costs Feed, other variable costs 25
Transport costs Transport costs 15
Land and capital costs attributable to egg production Land and capital costs attributable to egg production 17
177
Total output 2,400 eggs
Average cost
CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTS TOTAL WEEKLY COSTS
Labor Labor 5,128
Feed, other variable costs Feed, other variable costs 4,115
Transport costs Transport costs 2,431
Land and capital costs Land and capital costs 19,230
30,904
Total output 1,600,000 eggs
Average cost
14
A Firm Exhibiting Economies and Diseconomies of
Scale

• The long-run average cost curve of a firm that
  eventually exhibits diseconomies of scale becomes
  upward-sloping.

15
About the Long-Run Average Cost Curve
LRAC shows the lowest average cost for producing
each level of output LRAC is tangent to every
SRATC but not necessarily at the Min SRATC
points. As we trace production along a SRATC,
the firm is altering its production in the
presence of a fixed factor (fixed scale of
production). SRATC increases because of the
fixed factor. As we trace production along the
LRAC, the firm is altering the optimal plant size
as q changes.
16
Optimal Scale of Plant

• The optimal scale of plant is the scale that
  minimizes average cost.

17
Long-Run Adjustments toShort-Run Conditions

• Firms expand in the long-run when increasing
  returns to scale are available.
• Prices will be driven down to the minimum point
  on the LRAC curve.

18
The Path to Long-Run Equilibrium

• Suppose the current short-run has firms earning
  positive profits?
• This will attract new entrants to an industry.
• As capital flows into the industry, the supply
  curve shifts to the right, and price falls.
• 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.
• When does it settle down (reach equilibrium)?

19
The Path to Long-Run Equilibrium

• Suppose the current short-run has firms earning
  losses (negative profits) ?
• There is an incentive for some firms to exit the
  industry.
• As firms exit, the supply curve shifts left,
  driving price up.
• This gradual price rise reduces losses for firms
  remaining in the industry until those losses are
  ultimately eliminated.
• When does it settle down (reach equilibrium)?

20
Long-Run Adjustments to Short-Run Conditions

• As firms exit, the supply curve shifts from S to
  S, driving price up to P.

21
Long-Run Equilibrium

• The industry eventually returns to long-run
  equilibrium and losses are eliminated.

22
Long-Run Equilibrium in Perfectly Competitive
Output Markets

• 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.
• 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.
• The four-way intersection
• P MC min SRATC min LRAC

23
The Long-Run Adjustment Mechanism

• The central idea in our discussion of entry,
  exit, expansion, and contraction is this
• In efficient markets, investment capital flows
  toward profit opportunities.
• The actual process is complex and varies from
  industry to industry.
• Investmentin the form of new firms and expanding
  old firmswill 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.