1. Long-Run Costs and Output Decisions
Short-Run Conditions and Long-Run Directions Long-Run Costs: Economies and Diseconomies of Scale Long-Run Adjustments to Short-Run Conditions
Output Markets

2. LONG-RUN COSTS AND OUTPUT DECISIONS
We begin our discussion of the long run by looking at firms in three short-run circumstances:
firms earning economic profits,
firms suffering economic losses but continuing to operate to reduce or minimize those losses, and
firms that decide to shut down and bear losses just equal to fixed costs.

3. 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
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.
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

4. SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
Graphic Presentation
FIGURE 9.1 Firm Earning Positive Profits in the Short Run

5. SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
MINIMIZING LOSSES
operating profit (or loss) or net operating revenue Total revenue minus
total 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.

6. SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
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) $
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

7. SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
Graphic Presentation
FIGURE 9.2 Firm Suffering Losses but Showing an Operating Profit in the Short Run

8. SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
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:
ATC = AFC + AVC or
AFC = ATC - AVC = $ $3.10 = $1.00
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.

9. SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
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) $
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
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.

10. SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
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.
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 (Figure 9.3).

11. SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
FIGURE 9.3 Short-Run Supply Curve of a Perfectly Competitive Firm

12. SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
THE SHORT-RUN INDUSTRY SUPPLY CURVE
short-run industry supply curve The sum of the marginal cost curves (above AVC) of all the firms in an industry.
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

13. SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
LONG-RUN DIRECTIONS: A REVIEW
TABLE 9.4 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

14. LONG-RUN COSTS: ECONOMIES AND 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.

15. LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE
INCREASING RETURNS TO SCALE
The Sources of Economies of Scale
Most of the economies of scale that immediately
come to mind are technological in nature.
Some economies of scale result not from technology but from sheer size.

16. LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE
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)
$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

17. LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE
Graphic Presentation
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.

18. LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE
FIGURE 9.5 A Firm Exhibiting Economies of Scale

19. LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE
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.

20. LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE
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.

21. LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE
It is important to note that economic efficiency requires taking advantage of economies of scale (if they exist) and avoiding diseconomies of scale.
optimal scale of plant The scale of plant that minimizes average cost.

22. 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

23. 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 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.

24. LONG-RUN ADJUSTMENTS TO SHORT-RUN CONDITIONS
SHORT-RUN LOSSES: CONTRACTION TO EQUILIBRIUM
FIGURE 9.8 Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses

25. LONG-RUN ADJUSTMENTS TO SHORT-RUN CONDITIONS
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.

26. LONG-RUN ADJUSTMENTS TO SHORT-RUN CONDITIONS
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.

27. LONG-RUN ADJUSTMENTS TO SHORT-RUN CONDITIONS
long-run competitive equilibrium When P = SRMC = SRAC = LRAC and profits are zero.
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.

28. 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.

29. REVIEW TERMS AND CONCEPTS
breaking even
constant returns to scale
decreasing returns to scale, or diseconomies of scale
increasing returns to scale, or economies of scale
long-run average cost curve (LRAC)
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

30. Appendix EXTERNAL ECONOMIES AND DISECONOMIES
AND THE LONG-RUN INDUSTRY SUPPLY CURVE
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.

31. Appendix
TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 2000–2005
YEAR
HOUSE PRICES %D 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
6.6
1710
2.9%
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%

32. Appendix THE LONG-RUN INDUSTRY SUPPLY CURVE
FIGURE 9A.1 A Decreasing-Cost Industry: External Economies

33. 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.

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

35. 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 that
shows no economies or diseconomies of
scale as the industry grows. Such industries have flat, or horizontal, long-run supply curves.