8 © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Long-Run Costs and Output Decisions

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 38 Short-Run Conditions and Long-Run Directions In the long-run 1.The firm has no fixed factor of production. 2.Firms are free to enter and exit industries. Normal rate of return is a rate that is just sufficient to keep investors satisfied.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 38 Short-Run Conditions and Long-Run Directions For any firm one of three conditions hold at any given moment: 1)The firm is making positive profits 2)The firm is suffering losses 3)The firm is just breaking even. Breaking even, or earning a zero profit is a situation in which a firm earns exactly a normal rate of return.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 38 Maximizing Profits Revenue is sufficient to cover both fixed costs of $2,000 and variable costs of $1,600, leaving a positive economic profit of $400 per week. 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, Labor Materials $1, 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

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 38 Firm Earning Positive Profits in the Short Run To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 38 Firm Earning Positive Profits in the Short Run Profit is the difference between total revenue and total cost.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 38 Minimizing Losses There are two types of firms that suffer from losses 1)Those which shut down immediately and bear losses equal to fixed costs. 2)Those that continue their operations in the short-run to minimize losses. The decision to shut down depends on whether revenues from operating are sufficient to cover variable costs.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 38 Minimizing Losses A Firm Will Operate If Total Revenue Covers Total Variable Cost CASE 1: SHUT DOWNCASE 2: OPERATE AT PRICE = $3 Total Revenue (q = 0)$0Total Revenue ($3 x 800)$2,400 Fixed costs Variable costs Total costs +$ 2, ,000 Fixed costs Variable costs Total costs +$ 2,000 1,600 3,600 Profit/loss (TR  TC)  $2,000 Operating profit/loss (TR  TVC) $800 Total profit/loss (TR  TC)  $1,200

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 38 Shutting Down to Minimize Loss A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost CASE 1: SHUT DOWNCASE 2: OPERATE AT PRICE = $1.50 Total Revenue (q = 0)$0Total revenue ($1.50 x 800)$1,200 Fixed costs Variable costs Total costs +$ 2, ,000 Fixed costs Variable costs Total costs +$ 2,000 1,600 3,600 Profit/loss (TR  TC)  $2,000 Operating profit/loss (TR  TVC)  $400 Total profit/loss (TR  TC)  $2,400

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 38 Minimizing Losses 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. Operating profit (or loss) or net operating revenue equals total revenue minus total variable cost (TR – TVC).

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 38 Minimizing Losses The difference between ATC and AVC equals AFC. Then, AFC  q = TFC.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 38 Short-Run Supply Curve of a Perfectly Competitive Firm The shut-down 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.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 38 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.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 38 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.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 38 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run SHORT-RUN CONDITION SHORT-RUN DECISION LONG-RUN DECISION ProfitsTR > TCP = MC: operateExpand: new firms enter Losses1. With operating profitP = MC: operateContract: firms exit (TR  TVC) (losses < fixed costs) 2. With operating lossesShut down:Contract: firms exit (TR < TVC) 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.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 38 Long-Run versus Short Run Costs Short-run cost curves are U-shaped. This follows from fixed factor of production. As output increases beyond a certain point, the fixed factor causes diminishing returns to variable factors and thus increasing marginal cost. The shape of firm’s long-run average cost curve depends on how costs vary with scale of operation. For some firms, increased scale reduces costs. For others, increased scale leads to inefficiency and waste.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 38 Long-Run Costs: Economies and Diseconomies of Scale Increasing returns to scale, or economies of scale, refers to an increase in a firm’s scale of production, which leads to lower average costs per unit produced. (Automobile production, a bus carrying 100 people versus 100 people driving 100 cars)

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 38 Weekly Costs Showing Economies of Scale in Egg Production JONES FARMTOTAL WEEKLY COSTS 15 hours of labor (implicit value $8 per hour)$120 Feed, other variable costs25 Transport costs15 Land and capital costs attributable to egg production17 $177 Total output2,400 eggs Average cost$.074 per egg CHICKEN LITTLE EGG FARMS INC.TOTAL WEEKLY COSTS Labor$ 5,128 Feed, other variable costs4,115 Transport costs2,431 Land and capital costs19,230 $30,904 Total output1,600,000 eggs Average cost$.019 per egg

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 38 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.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 38 A Firm Exhibiting Economies of Scale The long run average cost curve of a firm exhibiting economies of scale is downward- sloping.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 38 Constant Returns to Scale Constant returns to scale refers to an increase in a firm’s scale of production, which has no effect on average costs per unit produced.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 38 Decreasing Returns to Scale Decreasing returns to scale, or diseconomies of scale, refers to an increase in a firm’s scale of production, which leads to higher average costs per unit produced.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 38 A Firm Exhibiting Economies and Diseconomies of Scale The LRAC curve of a firm that eventually exhibits diseconomies of scale becomes upward-sloping.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 38 Optimal Scale of Plant All SRAC curves are U-shaped since there is a fixed scale of plant that constrains production and drives marginal cost as a result of diminishing marginal returns. In the long run scale of plant can be changed and the shape of the LRAC curve depends on how costs vary with scale.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 38 Optimal Scale of Plant The optimal scale of plant is the scale that minimizes average cost.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 38 Long-Run Adjustments to Short-Run Conditions The industry is not in equilibrium if firms have an incentive to enter or exit in the long run. Firms expand in the long-run when increasing returns to scale are available.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 38 Short-Run Profits: Expansion to Equilibrium Firms will continue to expand as long as there are EOS to be realized, and new firms will continue to enter as long as there are positive profits

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 38 Short-Run Losses: Contraction to Equilibrium When firms in an industry suffer losses, there is an incentive for them to exit.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 38 Short-Run Losses: Contraction to Equilibrium As firms exit, the supply curve shifts from S to S’, driving price up to P*.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 38 Short-Run Losses: Contraction to Equilibrium The industry eventually returns to long-run equilibrium and losses are eliminated.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 38 Long-Run Competitive Equilibrium 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.

C H A P T E R 8: Long-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 38 The Long-Run Adjustment Mechanism: Investment Flows Toward Profit Opportunities The central idea in our discussion of entry, exit, expansion, and contraction is this: In efficient markets, investment capital flows toward profit opportunities. Investment—in the form of new firms and expanding old firms—will 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.