1 of 33 © 2014 Pearson Education, Inc. CHAPTER OUTLINE 9 Long-Run Costs and Output Decisions Short-Run Conditions and Long-Run Directions Maximizing Profits Minimizing Losses The Short-Run Industry Supply Curve Long-Run Directions: A Review Long-Run Costs: Economies and Diseconomies of Scale Increasing Returns to Scale Constant Returns to Scale Decreasing Returns to Scale U-Shaped Long-Run Average Costs Long-Run Adjustments to Short-Run Conditions Short-Run Profits: Moves In and Out of Equilibrium The Long-Run Adjustment Mechanism: Investment Flows Toward Profit Opportunities Output Markets: A Final Word Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve

2 of 33 © 2014 Pearson Education, Inc. Regardless of the structure of the Market (i.e., Market Structure): 1.Firm’s choose their output level (quantity supplied) so as to maximize their profits Profits = Total Revenues (price x quantity supplied) x Total Costs (which depend on quantity supplied 2.In Perfectly Competitive Markets: Market price is not determined by firm’s output decision, but is whatever clears the entire market (so it faces a horizontal demand curve) Firm can only control it’s costs – so looks for the least (minimum) cost way to produce the output Firm can maximize profits by finding the level of output where the last unit produced is just equal to the market price Since all marginal costs are increasing (i.e., total costs are increasing at an increasing rate) -> makes a profit on all prior units

3 of 33 © 2014 Pearson Education, Inc. Short-run versus the Long-run in PC Markets In the long-run: 1.All firms earn a Zero economic profit But do earn a (+) accounting profit Earn a “normal rate of return” (same rate as other firms) for the industry they are in Otherwise new firms would enter the industry if they earned a + economic profit Increase in supply would drive price back towards zero economic profit 2. In the short-run can earn either positive or negative economic profit Positive econ profit - > new firms enter the market -> price changes to drive price back to zero econ profit Negative econ profit -> existing firms exit the market (e.g. recession) until price changes and drives economic profits up to zero

4 of 33 © 2014 Pearson Education, Inc. TABLE 9.1 Blue Velvet Car Wash Weekly Costs TFC Total Fixed Cost TVC Total Variable Cost (800 Washes) TC Total Cost (800 Washes) TR Total Revenue (P = $5) TC= TFC + TVC 1.Normal return to investors $1, Labor Soap $1, = $2,000 + $1,600 = $3,600 TR = $5 × 800 = $4,000 2.Other fixed costs (maintenance contract)1,000 $1,600 Profit = TR  TC = $400 $2,000 Short-Run Conditions and Long-Run Directions breaking even The situation in which a firm is earning exactly a normal rate of return. Maximizing Profits Example: The Blue Velvet Car Wash: earning a (+) economic profit

5 of 33 © 2014 Pearson Education, Inc. Cars WashedFixed CostVariableTot CostsATCAFC 0$2,000.00$0.00$2,000.00#DIV/0! 800$2,000.00$1,600.00$3,600.00$4.50$2.50 PriceTot RevProfitRev-Var 54000$400.00$2, $0.00$2, $400.00$1,600.00

6 of 33 © 2014 Pearson Education, Inc.  FIGURE 9.1 Firm Earning a Positive Profit in the Short Run A profit-maximizing perfectly competitive firm will produce up to the point where P* = MC. Profit is the difference between total revenue and total cost. At q* = 800, total revenue is $5 × 800 = $4,000, total cost is $4.50 × 800 = $3,600, and profit = $4,000  $3,600 = $400. A PC Firm Earning an Economic Profit (shhort-run) Because average total cost is derived by dividing total cost by q, we can get back to total cost by multiplying average total cost by q. and so TC = ATC × q.

7 of 33 © 2014 Pearson Education, Inc.  FIGURE 9.2 Short-Run Supply Curve of a Perfectly Competitive Firm At prices below average variable cost, it pays a firm to shut down rather than continue operating. Thus, 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.

8 of 33 © 2014 Pearson Education, Inc. TABLE 9.2 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run Short-Run Condition Short-Run DecisionLong-Run Decision ProfitsTR > TCP = MC: operateExpand: new firms enter Losses 1. TR  TVC P = MC: operateContract: firms exit (loss < total fixed cost) 2. TR < TVCShut down:Contract: firms exit loss = total fixed cost Long-Run Directions: A Review

9 of 33 © 2014 Pearson Education, Inc.  FIGURE 9.6 Equilibrium for an Industry with U-shaped Cost Curves Long-Run Adjustments to Short-Run Conditions Starting at Equilibrium

10 of 33 © 2014 Pearson Education, Inc. Final Equilibrium Depends on Industry’s Cost Structure 6 10 Average Total Cost Because fixed costs are variable in the long run, the average-total-cost curve in the short run differs from the average-total-cost curve in the long run. Quantity of Cars per Day 0 ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run 10,000 $12,000 1,000 1,200 Economies of scale Diseconomies of scale Constant returns to scale

11 of 33 © 2014 Pearson Education, Inc. long-run industry supply curve (LRIS) A curve 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. 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 that shows no economies or diseconomies of scale as the industry grows. Such industries have flat, or horizontal, long-run supply curves. The Long-Run Industry Supply Curve

12 of 33 © 2014 Pearson Education, Inc.  Short-run Industry Response to an Increase in Demand – no entry yet

13 of 33 © 2014 Pearson Education, Inc. New Equilibrium with Higher Demand – with entry and constant- returns to scale

14 of 33 © 2014 Pearson Education, Inc.  FIGURE 9A.1 A Decreasing-Cost Industry: External Economies In a decreasing-cost industry, average cost declines as the industry expands. As demand expands from D 0 to D 1, price rises from P 0 to P 1. As new firms enter and existing firms expand, supply shifts from S 0 to S 1, driving price down. If costs decline as a result of the expansion to LRAC 2, the final price will be below P 0 at P 2. The long-run industry supply curve (LRIS) slopes downward in a decreasing-cost industry.

15 of 33 © 2014 Pearson Education, Inc.  FIGURE 9A.2 An Increasing-Cost Industry: External Diseconomies In an increasing-cost industry, average cost increases as the industry expands. As demand shifts from D 0 to D 1, price rises from P 0 to P 1. As new firms enter and existing firms expand output, supply shifts from S 0 to S 1, driving price down. If long-run average costs rise, as a result, to LRAC 2, the final price will be P 2. The long-run industry supply curve (LRIS) slopes up in an increasing-cost industry.

16 of 33 © 2014 Pearson Education, Inc. Average total cost in the short and long runs 6 16 Average Total Cost Because fixed costs are variable in the long run, the average-total-cost curve in the short run differs from the average-total-cost curve in the long run. Quantity of Cars per Day 0 ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run 10,000 $12,000 1,000 1,200 Economies of scale Diseconomies of scale Constant returns to scale