1. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 8 Prepared by: Fernando Quijano and Yvonn Quijano Costs and Output Decisions in the Long Run

2. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Concept of Profit Profit is the difference between total revenue and total cost.Profit is the difference between total revenue and total cost. The economic concept of profit takes into account the opportunity cost of capital.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. 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.Breaking even is a situation in which a firm is earning exactly a normal rate of return.

3. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Blue Velvet Car Wash Weekly Costs Maximizing Profit–An Example If Blue Velvet washes 800 cars each week, it takes in revenues of $4,000.If Blue Velvet washes 800 cars each week, it takes in revenues of $4,000. 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.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. 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 $ 1,000 600 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

4. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Firm Earning Positive Profits in the Short Run To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.

5. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Firm Earning Positive Profits in the Short Run Profit is the difference between total revenue and total cost.Profit is the difference between total revenue and total cost.

6. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Minimizing Losses Operating profit (or loss) or net operating revenue equals total revenue minus total variable cost (TR – TVC).Operating profit (or loss) or net operating revenue equals total revenue minus total variable cost (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. 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. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Minimizing Losses 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. 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).Operating profit (or loss) or net operating revenue equals total revenue minus total variable cost (TR – TVC).

8. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair A Firm Will Operate If Total Revenue Covers Total Variable Cost Minimizing Losses CASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $3 Total Revenue (q = 0) $0 Total Revenue ($3 x 800) $2,400 Fixed costs Variable costs Total costs + $$$$$$$$ 2,000 0 2,000 Fixed costs Variable costs Total costs + $$$$$$$$ 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

9. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Minimizing Losses When price equals $3.50, revenue is sufficient to cover total variable cost but not total cost.When price equals $3.50, revenue is sufficient to cover total variable cost but not total cost.

10. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Minimizing Losses The difference between ATC and AVC equals AFC. Then, AFC q = TFC (the brown area).The difference between ATC and AVC equals AFC. Then, AFC q = TFC (the brown area).

12. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Minimizing Losses The blue area equals losses.The blue area equals losses. The green area equals operating profit.The green area equals operating profit.

13. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost Shutting Down to Minimize Loss CASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $1.50 Total Revenue (q = 0) $0 Total revenue ($1.50 x 800) $1,200 Fixed costs Variable costs Total costs + $$$$$$$$ 2,000 0 2,000 Fixed costs Variable costs Total costs + $$$$$$$$ 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

14. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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 P = MC: operate Contract: firms exit (TR TVC) (losses < fixed costs) (losses < fixed costs) 2. With operating losses Shut down: Contract: firms exit (TR < TVC) losses = fixed costs losses = fixed costs In the short-run, firms have to decide how much to produce in the current scale of plant.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.In the long-run, firms have to choose among many potential scales of plant.

17. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Long-Run Costs: Economies and Diseconomies of Scale Increasing returns to scale, or economies of scale, refers to an increase in a firms scale of production, which leads to lower average costs per unit produced.Increasing returns to scale, or economies of scale, refers to an increase in a firms scale of production, which leads to lower average costs per unit produced.

18. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Long-Run Costs: Economies and Diseconomies of Scale Constant returns to scale refers to an increase in a firms scale of production, which has no effect on average costs per unit produced.Constant returns to scale refers to an increase in a firms scale of production, which has no effect on average costs per unit produced.

19. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Long-Run Costs: Economies and Diseconomies of Scale Decreasing returns to scale refers to an increase in a firms scale of production, which leads to higher average costs per unit produced.Decreasing returns to scale refers to an increase in a firms scale of production, which leads to higher average costs per unit produced.

20. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.

21. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Long-Run Average Cost Curve The long run average cost curve of a firm exhibiting economies of scale is downward- sloping.The long run average cost curve of a firm exhibiting economies of scale is downward- sloping.

22. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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. TOTAL WEEKLY COSTS Labor $ 5,128 Feed, other variable costs 4,115 Transport costs 2,431 Land and capital costs 19,230 $30,904 Total output 1,600,000 eggs Average cost $.019 per egg

23. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.The long-run average cost curve of a firm that eventually exhibits diseconomies of scale becomes upward-sloping.

24. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Optimal Scale of Plant The optimal scale of plant is the scale that minimizes average cost.The optimal scale of plant is the scale that minimizes average cost.

25. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Long-Run Adjustments to Short-Run Conditions Firms expand in the long-run when increasing returns to scale are available.Firms expand in the long-run when increasing returns to scale are available.

26. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Long-Run Adjustments to Short-Run Conditions Prices will be driven down to the minimum point on the LRAC curve.Prices will be driven down to the minimum point on the LRAC curve.

27. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Short-Run Profits: Expansion to Equilibrium The existence of positive profits will attract new entrants to an industry.The existence of positive profits will attract new entrants to an industry. As capital flows into the industry, the supply curve shifts to the right, and price falls.As capital flows into the industry, 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.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.

28. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Short-Run Losses: Contraction to Equilibrium When firms in an industry suffer losses, there is an incentive for them to exit.When firms in an industry suffer losses, there is an incentive for them to exit.

29. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Short-Run Losses: Contraction to Equilibrium As firms exit, the supply curve shifts from S to S, driving price up to P*.As firms exit, the supply curve shifts from S to S, driving price up to P*.

30. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Short-Run Losses: Contraction to Equilibrium The industry eventually returns to long-run equilibrium and losses are eliminated.The industry eventually returns to long-run equilibrium and losses are eliminated.

31. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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 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.As this happens, price rises. This gradual price rise reduces losses for firms remaining in the industry until those losses are ultimately eliminated.This gradual price rise reduces losses for firms remaining in the industry until those losses are ultimately eliminated.

32. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.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.

33. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Long-Run Adjustment Mechanism The central idea in our discussion of entry, exit, expansion, and contraction is this:The central idea in our discussion of entry, exit, expansion, and contraction is this: In efficient markets, investment capital flows toward profit opportunities. In efficient markets, investment capital flows toward profit opportunities. The actual process is complex and varies from industry to industry. The actual process is complex and varies from industry to industry.

34. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The central idea in our discussion of entry, exit, expansion, and contraction is this:The central idea in our discussion of entry, exit, expansion, and contraction is this: The Long-Run Adjustment Mechanism Investmentin the form of new firms and expanding old firmswill 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. Investmentin the form of new firms and expanding old firmswill 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.

35. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Internal Versus External Economies of Scale Economies of scale that are found within the individual firm are called internal economies of scale.Economies of scale that are found within the individual firm are called internal economies of scale. External economies of scale describe economies or diseconomies of scale on an industry-wide basis.External economies of scale describe economies or diseconomies of scale on an industry-wide basis.

36. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Long-Run Industry Supply Curve The long-run industry supply curve (LRIS) traces output over time as the industry expands.The long-run industry supply curve (LRIS) traces output over time as the industry expands. When an industry enjoys external economies, its long-run supply curve slopes down. Such an industry is called a decreasing-cost industry.When an industry enjoys external economies, its long-run supply curve slopes down. Such an industry is called a decreasing-cost industry.

37. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair A Decreasing-Cost Industry: External Economies In a decreasing cost industry, costs decline as a result of industry expansion, and the LRIS is downward-sloping.In a decreasing cost industry, costs decline as a result of industry expansion, and the LRIS is downward-sloping.

38. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair An Increasing-Cost Industry: External Diseconomies In an increasing cost industry, costs rise as a result of industry expansion, and the LRIS is upward-sloping.In an increasing cost industry, costs rise as a result of industry expansion, and the LRIS is upward-sloping.

39. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Construction Activity and the Price of Lumber Products, 1991 - 1994 An Increasing-Cost Industry: External Diseconomies YEAR MONTHLY AVERAGE, NEW HOUSING PERMITS PERCENTAGE INCREASE OVER THE PREVIOUS YEAR PERCENTAGE CHANGE IN THE PRICE OF LUMBER PRODUCTS PERCENTAGE CHANGE IN CONSUMER PRICES 199179,500--- 199292,167+15.9+14.7+3.0 1993100,917+9.5+24.6+3.0 1994111,000+10.0NA+2.1 Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21; Statistical Abstract of the United States, 1994, Tables 754, 755.