1. Long Run Costs and Output Decisions Ch-9

2. The Concept of Profit
Profit is the difference between total revenue and total cost.
The economic concept of profit takes into account the opportunity cost of capital.
Total economic cost includes a normal rate of return. A normal rate of return is the rate that is just sufficient to keep current investors interested in the industry.
Breaking even is a situation in which a firm is earning exactly a normal rate of return.

3. Maximizing Profit–An Example
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.
Labor Materials 1,
Total revenue (TR) at P = $5 (800 x $5)
4,000 2.
Other fixed costs (maintenance contract, insurance, etc.)
1,600
Profit (TR - TC)
400
2,000
If Blue Velvet washes 800 cars each week, it takes in revenues of $4,000 at a given price of $5 for each wash
This 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.

4. Firm Earning Positive Profits in the Short Run
To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.

5. Firm Earning Positive Profits in the Short Run
Profit is the difference between total revenue and total cost

6. Minimizing Losses
Operating profit (or loss) or net operating revenue = 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.

7. Minimizing Losses
Operating profit (or loss) or net operating revenue = TR – TVC
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.

8. Minimizing Losses
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) $
Total Revenue ($3 x 800)
2,400
Fixed costs Variable costs Total costs +
$ $
2, ,000
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

9. Minimizing Losses
When price equals $3.50, revenue is sufficient to cover total variable cost but not total cost.

10. Minimizing Losses
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.

11. Minimizing Losses
The difference between ATC and AVC equals AFC. Then, AFC  q = TFC (the brown area).

12. Minimizing Losses The blue area equals losses.
The green area equals operating profit.

13. Shutting Down to Minimize Loss
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) $
Total revenue ($1.50 x 800)
1,200
Fixed costs Variable costs Total costs +
$ $
2, ,000
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

14. 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.

15. 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.

16. Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run
SHORT-RUN CONDITION
SHORT-RUN DECISION
LONG-RUN DECISION
Profits
TR > TC
P = MC: operate
Expand: new firms enter
Losses
1. With operating profit
Contract: firms exit
(TR  TVC)
(losses < fixed costs)
2. With operating losses
Shut down:
(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.

17. Long-Run Costs: Economies and Diseconomies of Scale
In the long run, the shape of the long run average cost curve depends on how costs vary with the scale of operation
Increasing returns to scale/ economies of scale, refers to an increase in a firm’s scale of production, which leads to lower average costs per unit produced.

18. Long-Run Costs: Economies and Diseconomies of 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.

19. Long-Run Costs: Economies and Diseconomies of Scale
Decreasing returns to scale / Diseconomies of scale refers to an increase in a firm’s scale of production, which leads to higher average costs per unit produced.

20. 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.
Since the increasing, constant and decreasing returns to scale are found within the firm, they are called internal economies of scale

21. Increasing Returns to Scale/ Economies of scale
Technically speaking, returns to scale refer to the relationship between input and output; in an increasing returns to scale, a given percentage increase in input leads to a larger percentage increase in output
Hence, with fixed input prices, increasing returns to scale also mean that as output rises, average cost of production falls.
Sources of economies of scale:
Technology
Size of the firm-e.g.-buying inputs in bulk and getting huge discounts

22. Weekly Costs Showing Economies of Scale in Egg Production
JONES FARM
TOTAL WEEKLY COSTS
15 hours of labor (implicit value $8 per hour)
$120
Feed, other variable costs 25
Transport costs 15
Land and capital costs attributable to egg production 17
$177
Total output
2,400 eggs
Average cost
$.074 per egg
CHICKEN LITTLE EGG FARMS INC.
Labor
$ 5,128
4,115
2,431
Land and capital costs
19,230
$30,904
1,600,000 eggs
$.019 per egg

23. Long Run Average Cost Curve (LRAC)
LRAC curve shows different scales on which a firm can choose to operate
Hence it traces out the position of all its short run curves , each corresponding to a different scale
Hence LRAC is the ‘envelope’ of a series of short run curves; it wraps around the set of all possible short run curves
Each point on the LRAC represents the minimum cost at which the associated output can be produced

24. The Long-Run Average Cost Curve
The long run average cost curve of a firm exhibiting economies of scale is downward-sloping.

25. A Firm Exhibiting Economies and Diseconomies of Scale
The long-run average cost curve of a firm that eventually exhibits diseconomies of scale becomes upward-sloping.

26. Optimal Scale of Plant
The optimal scale of plant is the scale that minimizes average cost.

27. Long-Run Adjustments to Short-Run Conditions
The industry will not be in long run equilibrium if firms have an incentive to enter or exit an industry
When firms are earning economic profits or suffering losses,i.e, the industry is not in equilibrium and hence the firms will change their, behavior.

28. Short-Run Profits: Expansion to equilibrium
Firms expand in the long-run when increasing returns to scale are available.

29. Short-Run Profits: Expansion to equilibrium
Prices will be driven down to the minimum point on the LRAC curve.

30. Short-Run Profits: Expansion to Equilibrium
In the above case, since scale economies existed, hence the firms will expand their output till all scale economies are exhausted
The existence of positive profits will also attract new entrants to an industry.
Because of the above two factors, the supply curve shifts to the right, and price falls.
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.
Each firm will choose a scale of plant that produces its product at minimum of LRAC- Competition drives firms to use most efficient technology in the short run and most efficient scale of plant in the long run.

31. Short-Run Profits: Expansion to Equilibrium
Hence in the long run, equilibrium price is equal to LRAC, SRMC, and SRAC and profits are equal to zero
P*= SRMC=SRAC=LRAC,
Where P* is the equilibrium price in long run

32. Short-Run Losses: Contraction to Equilibrium
When firms in an industry suffer losses, there is an incentive for them to exit.

33. Short-Run Losses: Contraction to Equilibrium
With losses , the long run picture changes. Firms will exit the industry. As firms exit, the supply curve shifts from S to S’, driving price up to P*.

34. Short-Run Losses: Contraction to Equilibrium
The industry eventually returns to long-run equilibrium and losses are eliminated.

35. Short-Run Profits: Contraction to Equilibrium
As long as losses are being sustained in an industry, firms will shut down and leave the industry, thus reducing supply.
As this happens, price rises.
This gradual price rise reduces losses for firms remaining in the industry until those losses are ultimately eliminated.

36. Long-Run Equilibrium in Perfectly Competitive Output Markets
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.
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.
At this point, individual firms are operating at the most efficient scale of plant; at the minimum point of LRAC

37. The Long-Run Adjustment Mechanism
The central idea in our discussion of entry, exit, expansion, and contraction is this:
In efficient markets, investment capital flows toward profit opportunities.
The actual process is complex and varies from industry to industry.