8.1Costs and Output Decisions in the Long Run

In this chapter we finish our discussion of how profit-maximizing firms decide how much to supply in the short-run and the long-run.

• 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 so that economic profits are zero.

8.2Firm Earning Positive Profits in the Short Run

• To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.

8.3Firm Earning Positive Profits in the Short Run: Example from Ch. 7

Widget Market Widget Firm

d

D

S

P=$70$70

AVC

MC

ATC

q*=6

ATC=$46.67

Profits

Total costs

Algebra:

qatcp

qatcqp

TCTR

)(

8.4Minimizing Losses

• 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 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.

8.5Minimizing Losses

Widget Market Widget Firm

d

D

S

P=$30$30AVC

MC

ATC

q* = 4

ATC=$40

Losses (negative profit)

Algebra:

qafcqavcp

qafcqavcqp

TFCTVCTR

TCTR

)(

Suppose the market price of widgets falls to $30. The firm finds its new profit-maximizing output level where P=MC. This occurs at q*=4. However, the firm earns a negative economic profit.

8.6Minimizing Losses and the Shut-down Point

How low can price fall until the firm would be better off shutting down (q* = 0)?

Remember that in the short-run, if the firm produces nothing, its revenues are zero but its costs equal TFC profits = -$TFC

As long as price is sufficient to cover average variable costs (P > AVC), the firm stands to gain by operating instead of shutting down .

Shutdown point: a market price that, when it intersects MC, it also equals AVC. This will occur only at the minimum point on the AVC curve. (See chapter 7)

8.7Short-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. This explains why supply curves are upward sloping: because MC is upward sloping…and why is MC upward sloping?

8.8The 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.

8.9Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run

SHORT-RUNCONDITION

SHORT-RUNDECISION

LONG-RUNDECISION

Profits TR > TC Operate where P=MC Expansion new firms enter

Losses 1. With “operating” profit Operate where P=MC Contract: firms exit

(TC TR TVC) (losses < fixed costs)

2. With operating losses Shut down: b/c at P=MC Contract: firms exit

(TVC >TR) 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.

8.10Long-Run Costs: Economies and Diseconomies of Scale

1) Increasing returns to scale, or economies of scale, refers to an increase in a firm’s scale of production, which leads to lower average total costs per unit produced.

The long-run is a time period during which all inputs are variable (including the scale of production) and firms can enter and exit the industry.

We want to analyze how average total cost changes as output changes:

8.11Long-Run Costs: Economies and Diseconomies of Scale (con’t)

2) Constant returns to scale refers to an increase in a firm’s scale of production, which has no effect on average total costs per unit produced.

3) Decreasing returns to scale refers to an increase in a firm’s scale of production, which leads to higher average total costs per unit produced.

8.12The 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.

Here is a diagram of a long run average cost curve of a firm exhibiting economies of scale. It is downward-sloping:

8.13Weekly Costs Showing Economies of Scale in Egg Production

JONES FARM TOTAL WEEKLY COSTS

15 hours of labor (implicit value $8 per hour) $120Feed, other variable costs 25Transport costs 15Land and capital costs attributable to egg production 17

$177Total output 2,400 eggsAverage cost

CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTS

Labor $ 5,128Feed, other variable costs 4,115Transport costs 2,431Land and capital costs 19,230

$30,904Total output 1,600,000 eggsAverage cost

8.14A 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.

8.15About the Long-Run Average Cost Curve

LRAC shows the lowest average cost for producing each level of output

LRAC is tangent to every SRATC but not necessarily at the Min SRATC points. As we trace production along a SRATC, the firm is altering its production in the presence of a fixed factor (fixed scale of production). SRATC increases because of the fixed factor. As we trace production along the LRAC, the firm is altering the optimal plant size as q changes.

8.16Optimal Scale of Plant

• The optimal scale of plant is the scale that minimizes average cost.

8.17Long-Run Adjustments toShort-Run Conditions

• Firms expand in the long-run when increasing returns to scale are available.

• Prices will be driven down to the minimum point on the LRAC curve.

8.18The Path to Long-Run Equilibrium

Suppose the current short-run has firms earning positive profits

• This will attract new entrants to an industry.

• 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.

When does it settle down (reach “equilibrium”)?

8.19The Path to Long-Run Equilibrium

Suppose the current short-run has firms earning losses (negative profits)

• There is an incentive for some firms to exit the industry.

• As firms exit, the supply curve shifts left, driving price up.

• This gradual price rise reduces losses for firms remaining in the industry until those losses are ultimately eliminated.

When does it settle down (reach “equilibrium”)?

8.20Long-Run Adjustments to Short-Run Conditions

• As firms exit, the supply curve shifts from S to S’, driving price up to P*.

8.21Long-Run Equilibrium

• The industry eventually returns to long-run equilibrium and losses are eliminated.

8.22Long-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.

The “four-way intersection”

P* = MC = min SRATC = min LRAC

8.23The 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.• 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.