copyright 2002, pearson education canada1 costs and output decisions in the long run chapter 9

Copyright 2002, Pearson Education Canada1

Costs and Output Decisions in the Long Run

Chapter 9


Supply Decisions in the Long Run

Output (supply) decisions in the long run are less constrained than in the short run for two reasons: There is no fixed factor of production that

confines production to a given scale Firms are free to enter and exit in order to

seek profits or avoid losses


Breaking Even

Breaking even refers to the situation in which a firm is earning exactly a normal profit rate.

Economic profits are zero: TR - TC = 0


Firm Earning Economic Profits in the Short Run (Figure 9.1)

The firm produces at the point where MC = price and manages to make a profit of TR - TC or $1500 - $1260 = $240.


Minimizing Losses

Operating profit (or loss) or net operating revenue is total revenue minus total variable cost (TR - TVC).

Firms suffering losses fall into two categories: Those that find it advantageous to shut down

operations immediately and suffer losses equal to fixed costs

Those that continue to operate in the short run to minimize losses


A Firm Will Operate If Total Revenue Covers Total Variable Cost (Table 9.2)


Firm Suffering Economic Losses But Showing an Operating Profit in the Short Run (Figure 9.2)


Shutdown Point

The shutdown 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.


Short-Run Supply Curve of a Perfectly Competitive Firm (Figure 9.3)

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.


Short-Run Industry Supply Curve (Figure 9.4)

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


Long-Run Costs: Economies and Diseconomies of Scale

Increasing returns to scale or economies of scale are occur when an increase in a firm’s scale in production leads to lower average costs per unit produced.

Constant returns to scale occur when an increase in a firm’s scale of production has no effect on average costs per unit produced.

Decreasing returns to scale or diseconomies of scale occur when an increase in a firm’s scale of production leads to higher average costs per unit produced.


Long-Run Average Cost Curve (Figure 9.5)

The long-run average cost curve is a graph that shows the different scales on which a firm can choose to operate in the long run. In the graph below the firm exhibits economies of scale.


A Firm Exhibiting Economies and Diseconomies of Scale (Figure 9.6)

Beyond q* the firm experience diseconomies of scale, and therefore q* is the level of production at lowest average cost, using optimal scale of plant.


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 economic profits are being earned.

In the long run, equilibrium price (P*) is equal to long-run average cost, short-run average cost, and short-run marginal cost. Economic profits are driven to zero.


Firms Expand Along in the Long Run When Increasing Returns to Scale Are Available (Figure 9.7)

Firms will be pushed by competition to produce at their optimal scales and the price will be driven to the minimum point on the LRAC curve. Profits will be driven to zero.


Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses (Figure 9.8)

As long as losses are being sustained in an industry, firms will shut down and leave the industry. The shift in supply and the gradual price rise reduce losses until profits are zero again.


Long-run Competitive Equilibrium

Long-run competitive equilibrium exists when:

P = SRMC = SRAC = LRAC

and economic profit is equal to zero.


Investment Flows Toward Profit Opportunities

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

Investment, in the form of new firms and expanding old firms, will, over time, tend to favour those industries in which profits are being made.

At the same time, industries in which firms are suffering losses will gradually contract from disinvestment.


Review Terms & Concepts

breaking even constant returns to

scale decreasing returns to

scale (diseconomies of scale)

increasing returns to scale (economies of scale)

long-run average cost (LRAC)

long-run competitive equilibrium

operating profit (or loss)

optimal scale of plant short-run industry

supply curve shut down point

copyright 2002, pearson education canada1 costs and output decisions in the long run chapter 9

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