09-Long Run Part1

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2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

MIDTERM Covers chapters 1 to 8, including appendix to

chapters 1, 6 and 7. You are allowed to use calculators. I do NOT expect you to calculate derivatives. You have to put 1 sentence explanation or a

clearly labeled graph for each multiple choicequestion. I expect you to show all work for calculations.

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Schedule for next week Monday 7th: review of material in class.

You can send emails with your questions and thetopics you want me to review until Saturday midnight.Extra office hours: 3 to 4.30 pm.

Tuesday 8th: lecture during x-hours.regular office hours 9.30 to 11 am.

Wednesday 9th: EXAM during class. Friday 11th: HOLIDAY! NO class and NO office

hours.

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Review Chapter 8 Total Cost= Total Fixed Cost + Total Variable

Cost Marginal cost: additional cost of producing onemore unit of output

Profit maximizing condition: MC = MR.

Under perfect competition, firms are price-takers, i.e. MR = P*

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FIGURE 8.10 The Profit-Maximizing Level of Output for a Perfectly Competitive Firm

If price is above marginal cost, as it is at 100 and 250 units of output, profits can be increased byraising output; each additional unit increases revenues by more than it costs to produce theadditional output. Beyond q* = 300, however, added output will reduce profits. At 340 units of output,an additional unit of output costs more to produce than it will bring in revenue when sold on themarket. Profit-maximizing output is thus q*, the point at which P * = MC .

The Profit-Maximizing Level of Output

Output Decisions


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Short-Run Costs and Output Decisions

FIGURE 8.1 Decisions Facing Firms

Firm decision making:

(1) Minimize Cost => Pick least cost technology for givenlevel of output and given input prices,

i.e. MP L/MPK = P L/P K(2) Maximize Profits => Pick output level where MC = MR

in perfect competition: P* = MR => MC = P*.


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Output Decisions

Comparing Costs and Revenues to Maximize Profit

A Numerical Example

Case Study in Marginal Analysis: An Ice CreamParlor An analysis of fixed costs,variable costs, revenues, profits,

and opening longer hours wereused by this ice cream parlor todetermine whether to stay inbusiness.


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Output Decisions

The Short-Run Supply Curve

FIGURE 8.11 Marginal Cost Is the Supply Curve of a Perfectly Competitive Firm

At any market price, a the marginal cost curve shows the output level that maximizes profit. Thus, themarginal cost curve of a perfectly competitive profit-maximizing firm is the firms short-run supplycurve.a This is true except when price is so low that it pays a firm to shut downa point that will be discussed inChapter 9.


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Long-Run Costs andOutput DecisionsChapter 9


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Long-Run Costs and Output Decisions

We begin our discussion of the long run by looking

at firms in three short-run circumstances:

1. firms earning economic profits,2. firms suffering economic losses but continuing

to operate to reduce or minimize those losses,and3. firms that decide to shut down and bear losses

just equal to fixed costs.

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Breaking Even Normal rate of return is required to keep

investors interested in an industry. Our definition of economic profit included thenormal rate of return as a opportunity cost of capital.

Breaking Even The situation in which a firm isearning exactly a normal rate of return.

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Short-Run Conditions and Long-Run Directions

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

$ 1,000600

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

1. Firms Earning Profits


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1. Firms Earning Profits

FIGURE 9.1 Firm Earning Positive Profits in the Short Run A profit-maximizing perfectly competitive firm will produce up to the point where P * = MC .Profits are the difference between total revenue and total costs. At q* = 300, total revenue is$5 300 = $1,500, total cost is $4.20 300 = $1,260, and total profit = $1,500 - $1,260 =$240.


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Minimizing Losses operating profit (or loss) or net operating revenue

Total revenue - total variable cost ( TR - TVC ).

2. If revenues exceed variable costs, operatingprofit is positive and can be used to offset fixedcosts and reduce losses, and it will pay the firm

to keep operating.3. If revenues are smaller than variable costs, thefirm suffers operating losses that push totallosses above fixed costs. In this case, the firmcan minimize its losses by shutting down.

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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)

$ 0 Total Revenue ($3 x 800) $ 2,400

Fixed costsVariable costsTotal costs

+$

$

2,0000

2,000


+$

$

2,0001,6003,600

Profit/loss ( TR - TC )

- $ 2,000 Operating profit/loss ( TR - TVC ) $ 800

Total profit/loss ( TR - TC ) - $ 1,200

2. Minimizing Losses by Operating


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2. Minimizing Losses

FIGURE 9.1 Firm Suffering Losses but Showing an Operating Profit in the Short RunWhen price is sufficient to cover average variable costs, firms suffering short-runlosses will continue operating instead of shutting down.Total revenues (P* q*) cover variable costs, leaving an operating profit of $90 tocover part of fixed costs and reduce losses to $135.


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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) $ 0 Total revenue ($1.50 x 800) $ 1,200


+$

$

2,0000

2,000


+$

$

2,0001,6003,600

Profit/loss ( TR - TC ): - $ 2,000 Operating profit/loss ( TR - TVC ) - $ 400Total profit/loss ( TR - TC ) - $ 2,400

3. Minimizing Losses by ShuttingDown

Shutting Down to Minimize Costs: The Blue Velvet Revisited II


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3. Minimizing Losses

FIGURE 9.1 Firm Suffering Lossesbut Showing an Operating Profit inthe Short Run

At prices below averagevariable cost, it pays a firm toshut down rather than continueoperating.Thus, the short-run supply curveof a competitive firm is the partof its marginal cost curve thatlies above its average variablecost curve.

shut-down point The lowest point on the average variable cost curve. When price falls below the minimum point on AVC, total revenue isinsufficient to cover variable costs and the firm will shut down and bearlosses equal to fixed costs.


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short-run industry supply curve The sum of the marginalcost 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 MarginalCost Curves (above AVC) of All the Firms in an Industry A profit-maximizing perfectly competitive firm will produce up to the point where P * = MC. If thereare only three firms in the industry, the industry supply curve is simply the sum of all the productssupplied by the three firms at each price. For example, at $6, firm 1 supplies 100 units, firm 2supplies 200 units, and firm 3 supplies 150 units, for a total industry supply of 450.

The Short-Run Industry Supply Curve


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TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long andShort 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)2. With operating losses Shut down: Contract: firms exit

(TR < TVC ) losses = fixed costs

A Summary

Documents

09-Long Run Part1