1 of 36 long-run costs and output decisions short-run conditions and long-run directions long-run...

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Long-Run Costs and Output Decisions

Short-Run Conditions and Long-Run DirectionsLong-Run Costs: Economies and Diseconomies of ScaleLong-Run Adjustments to Short-Run Conditions

Output Markets

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LONG-RUN COSTS AND OUTPUT DECISIONS

We begin our discussion of the long run by looking at firms in three short-run circumstances:

(1) firms earning economic profits,

(2) firms suffering economic losses but continuing to operate to reduce or minimize those losses, and

(3) firms that decide to shut down and bear losses just equal to fixed costs.

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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

TABLE 9.1 Blue Velvet Car Wash Weekly Costs

TOTAL FIXED COSTS (TFC)TOTAL VARIABLE COSTS(TVC) (800 WASHES)

TOTAL COSTS(TC = TFC + TVC) $ 3,600

1. Normal return to investors $ 1,000 1.2.

LaborMaterials

$ 1,000600

Total revenue (TR) at P = $5 (800 x $5) $ 4,000

2. Other fixed costs (maintenance contract, insurance, etc.) 1,000

$ 1,600 Profit (TR TC) $ 400

$ 2,000

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Graphic Presentation

FIGURE 9.1 Firm Earning Positive Profits in the Short Run

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MINIMIZING LOSSES

operating profit (or loss) or net operating revenue Total revenue minustotal variable cost (TR TVC).

In general,

■ 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.

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

TABLE 9.2 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 costsVariable costsTotal costs

+$

$

2,0000

2,000


+$

$

2,0001,6003,600

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

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

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FIGURE 9.2 Firm Suffering Losses but Showing an Operating Profit in the Short Run

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ATC = AFC + AVCor

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

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 averagevariable costs, the firm stands to gain by operating instead of shutting down.

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Shutting Down to Minimize Loss

TABLE 9.3 A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost

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

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


+$

$

2,0000

2,000


+$

$

2,0001,6003,600

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

Total profit/loss (TR TC) $ 2,400

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.

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The short-run supply curve of a competitive firm is that portion of its marginal costcurve that lies above its average variable cost curve (Figure 9.3).

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.

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FIGURE 9.3 Short-Run Supply Curve of a Perfectly Competitive Firm

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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

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

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LONG-RUN DIRECTIONS: A REVIEW

TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run

SHORT-RUNCONDITION

SHORT-RUNDECISION

LONG-RUNDECISION

Profits TR > TC P = MC: operate Expand: new firms enter

Losses 1. With operating profit P = MC: operate Contract: firms exit

(TR TVC) (losses < fixed costs)

2. With operating losses Shut down: Contract: firms exit

(TR < TVC) losses = fixed costs

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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.

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INCREASING RETURNS TO SCALE

The Sources of Economies of Scale

Most of the economies of scale that immediatelycome to mind are technological in nature.

Some economies of scale result not from technology but from sheer size.

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Example: Economies of Scale in Egg Production

TABLE 9.5 Weekly Costs Showing Economies of Scale in Egg Production

JONES FARM TOTAL WEEKLY COSTS

15 hours of labor (implicit value $8 per hour) $120Feed, other variable costs 25Transport costs 15Land and capital costs attributable to egg production 17

$177Total output 2,400 eggsAverage cost $.074 per egg

CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTS

Labor $ 5,128Feed, other variable costs 4,115Transport costs 2,431Land and capital costs 19,230

$30,904

Total output 1,600,000 eggs

Average cost $.019 per egg

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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.

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FIGURE 9.5 A Firm Exhibiting Economies of Scale

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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.

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DECREASING RETURNS TO SCALE

FIGURE 9.6 A Firm Exhibiting Economies and Diseconomies of Scale

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.

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optimal scale of plant The scale of plant that minimizes average cost.

It is important to note that economic efficiency requires taking advantage of economies of scale (if they exist) and avoiding diseconomies of scale.

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LONG-RUN ADJUSTMENTS TO SHORT-RUN CONDITIONS

SHORT-RUN PROFITS: EXPANSION TO EQUILIBRIUM

FIGURE 9.7 Firms Expand in the Long Run When Increasing Returns to Scale Are Available

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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.

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SHORT-RUN LOSSES: CONTRACTION TO EQUILIBRIUM

FIGURE 9.8 Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses

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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.

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THE LONG-RUN ADJUSTMENT MECHANISM: INVESTMENT FLOWS TOWARD PROFIT OPPORTUNITIES

In efficient markets, investment capital flows toward profit opportunities. The actual process is complex and varies from industry to industry.

When firms in an industry are making positive profits, capital is likely to flow into that industry. Entrepreneurs start new firms, and firms producing entirely different products may join the competition.

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Investment—in the form of new firms and expanding old firms—will over time tendto favor those industries in which profits are being made, and over time industries inwhich firms are suffering losses will gradually contract from disinvestment.

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

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OUTPUT MARKETS: A FINAL WORD

In the last four chapters, we have been building a model of a simple market system under the assumption of perfect competition.

You have now seen what lies behind the demand curves and supply curves in competitive output markets. The next two chapters take up competitive input markets and complete the picture.

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breaking evenconstant returns to scaledecreasing returns to scale,

or diseconomies of scaleincreasing returns to scale,

or economies of scalelong-run average cost curve

(LRAC)

REVIEW TERMS AND CONCEPTS

long-run competitive equilibrium

operating profit (or loss) or net operating revenue

optimal scale of plant

short-run industry supply curve

shut-down point

long-run competitive equilibrium,

P = SRMC = SRAC = LRAC

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EXTERNAL ECONOMIES AND DISECONOMIESAND THE LONG-RUN INDUSTRY SUPPLY CURVE

Appendix

When long-run average costs decrease as a result of industry growth, we say that there are external economies.

When average costs increase as a result of industry growth, we say that there are external diseconomies.

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Appendix

TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 2000–2005

YEAR

HOUSE PRICES % OVER

THE PREVIOUS YEAR

HOUSING STARTS

HOUSING STARTS

% CHANGE OVER THE PREVIOUS

YEAR

CONSTRUCTION MATERALS

PRICES% CHANGE OVER THE PREVIOUS

YEAR

CONSUMER PRICES

% CHANGE OVER THE PREVIOUS

YEAR

2000 1573

2001 7.5 8.2 1661 5.6% 0% 2.8%

2002 7.5 6.6 1710 2.9% 1.5% 1.5%

2003 7.9 6.4 1853 8.4% 1.6% 2.3%

2004 12.0 1949 5.2% 8.3% 2.7%

2005 13.4 2053 5.3% 5.4% 2.5%

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Appendix

THE LONG-RUN INDUSTRY SUPPLY CURVE

FIGURE 9A.1 A Decreasing-Cost Industry: External Economies

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Appendix

long-run industry supply curve (LRIS) A graph that traces out price and total output over time as an industry expands.

decreasing-cost industry An industry that realizes external economies—that is, average costs decrease as the industry grows. The long-run supply curve for such an industry has a negative slope.

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Appendix

FIGURE 9A.2 An Increasing-Cost Industry: External Diseconomies

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Appendix

increasing-cost industry An industry that encounters external diseconomies—that is, average costs increase as the industry grows. The long-run supply curve for such an industry has a positive slope.

constant-cost industry An industry thatshows no economies or diseconomies ofscale as the industry grows. Such industries have flat, or horizontal, long-run supply curves.

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