long -run costs and output decisions

1

Long-Run Costsand Output Decisions

Chapter 9

2

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.

3

SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS

breaking even The situation in which a firm is earning exactly a normal rate of return.

Example: The Blue Velvet Car Wash

MAXIMIZING PROFITS

Blue Velvet Car Wash Weekly Costs

TOTAL COSTS(TC = TFC + TVC)

2,000$

400$Profit (TR TC)1,600$

1,000

Other fixed costs (maintenance contract, insurance, etc.)

2.

4,000$Total revenue (TR)

at P = $5 (800 x $5)1,000

600$Labor

Materials1.2.

1,000$Normal return to investors1.

3,600$TOTAL VARIABLE COSTS(TVC) (800 WASHES)TOTAL FIXED COSTS (TFC)

Blue Velvet Car Wash Weekly Costs

TOTAL COSTS(TC = TFC + TVC)

2,000$

400$Profit (TR TC)1,600$

1,000

Other fixed costs (maintenance contract, insurance, etc.)

2.

4,000$Total revenue (TR)

at P = $5 (800 x $5)1,000

600$Labor

Materials1.2.

1,000$Normal return to investors1.

3,600$TOTAL VARIABLE COSTS(TVC) (800 WASHES)TOTAL FIXED COSTS (TFC)

4


Graphic Presentation

Firm Earning Positive Profits in the Short Run

5


MINIMIZING LOSSES operating profit (or loss) or net operating

revenue 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.

6


Producing at a Loss to Offset Fixed Costs: The Blue Velvet Revisited

A Firm Will Operate If Total Revenue Covers Total Variable Cost

1,200$Total profit/loss (TR TC)

800$Operating profit/loss (TR TVC)2,000$Profit/loss (TR TC)

2,0001,6003,600

$

$+

Fixed costsVariable costsTotal costs

2,0000

2,000

$

$+


2,400$Total Revenue ($3 x 800)0$Total Revenue (q = 0)

CASE 2: OPERATE AT PRICE = $3CASE 1: SHUT DOWN

A Firm Will Operate If Total Revenue Covers Total Variable Cost


800$Operating profit/loss (TR TVC)2,000$Profit/loss (TR TC)

2,0001,6003,600

$

$+


2,0000

2,000

$

$+


2,400$Total Revenue ($3 x 800)0$Total Revenue (q = 0)

CASE 2: OPERATE AT PRICE = $3CASE 1: SHUT DOWN

7


Graphic Presentation

Firm Suffering Losses but Showing an Operating Profit in the Short Run

8

SHORT-RUN CONDITIONSAND 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:

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.

ATC = AFC + AVCor

AFC = ATC AVC = $4.10 $3.10 = $1.00

9


Shutting Down to Minimize Loss

A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost


400$Operating profit/loss (TR TVC)2,000$Profit/loss (TR TC):

2,0001,6003,600

$

$+


2,0000

2,000

$

$+


1,200$Total revenue ($1.50 x 800)0$Total Revenue (q = 0)

CASE 2: OPERATE AT PRICE = $1.50CASE 1: SHUT DOWN

A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost


400$Operating profit/loss (TR TVC)2,000$Profit/loss (TR TC):

2,0001,6003,600

$

$+


2,0000

2,000

$

$+


1,200$Total revenue ($1.50 x 800)0$Total Revenue (q = 0)

CASE 2: OPERATE AT PRICE = $1.50CASE 1: SHUT DOWN

10

SHORT-RUN CONDITIONSAND LONG-RUN DIRECTIONS 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 profit-

maximizing level of output. At all prices below it, optimal short-run output is zero.

11


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

12


Short-Run Supply Curve of a Perfectly Competitive Firm

13


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 industry supply curve The sum of the marginal cost curves (above AVC) of all the firms in an industry.

THE SHORT-RUN INDUSTRY SUPPLY CURVE

14

SHORT-RUN CONDITIONS

AND LONG-RUN DIRECTIONS: A REVIEW

Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run

losses = fixed costs(TR < TVC)

Contract: firms exitShut down:2. With operating losses

(losses < fixed costs)(TR TVC)

Contract: firms exitP = MC: operate1. With operating profitLosses

Expand: new firms enterP = MC: operateTR > TCProfits

LONG-RUNDECISION

SHORT-RUNDECISION

SHORT-RUNCONDITION

Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run

losses = fixed costs(TR < TVC)

Contract: firms exitShut down:2. With operating losses

(losses < fixed costs)(TR TVC)

Contract: firms exitP = MC: operate1. With operating profitLosses

Expand: new firms enterP = MC: operateTR > TCProfits

LONG-RUNDECISION

SHORT-RUNDECISION

SHORT-RUNCONDITION

15

LONG-RUN COSTS: ECONOMIESAND 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.

16


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.

17


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.

18


A Firm Exhibiting Economies of Scale

19


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.

20

LONG-RUN COSTS: ECONOMIESAND DISECONOMIES OF SCALEDECREASING RETURNS TO SCALE

A Firm Exhibiting Economies and Diseconomies of Scale

21


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.

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.

22

LONG-RUN ADJUSTMENTS TO SHORT-RUN CONDITIONS

SHORT-RUN PROFITS: EXPANSION TO EQUILIBRIUM

Firms Expand in the Long Run When Increasing Returns to Scale

Are Available

23

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 short-run 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.

24

LONG-RUN ADJUSTMENTS TO SHORT-RUN CONDITIONSSHORT-RUN LOSSES: CONTRACTION TO EQUILIBRIUM

Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses

25

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.

26

LONG-RUN ADJUSTMENTS TO SHORT-RUN CONDITIONS

long-run competitive equilibrium When P = SRMC = SRAC = LRAC and profits are zero.

long -run costs and output decisions

Documents