Long-Run Costs and Output Decisions: The Market System

PART II THE MARKET SYSTEM
CHAPTER 9 Long-Run Costs and Output Decisions
Long-Run Costs and

Output Decisions
Prepared by:
Fernando & Yvonn Quijano
2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster
1 of 22
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, and
(3) firms that decide to shut down and bear losses just equal to
fixed costs.
breaking even The situation in which a

firm is earning exactly a normal rate of
return.
Short-Run Conditions and Long-Run Directions
Maximizing Profits
Example: The Blue Velvet Car Wash
TABLE 9.1 Blue Velvet Car Wash Weekly Costs
Total Variable Costs
(TVC) (800 Washes)
Total Fixed Costs (TFC)

1. Normal return to investors
2. Other fixed costs
(maintenance contract,
insurance, etc.)
$ 1,000
1. Labor
2. Materials
Total Costs
(TC = TFC + TVC)
$ 3,600
$ 1,000
600
Total revenue (TR)

at P = $5 (800 x $5)
$ 4,000
$ 1,600
Profit (TR TC)
1,000
$ 2,000
400
Maximizing 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.
Minimizing Losses
operating profit (or loss) or net
operating revenue 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.

Minimizing Losses
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
Total Revenue
(q = 0)
CASE 2: Operate at Price = $3

0
Total Revenue ($3 x 800)
Fixed costs
Variable costs
Total costs
$ 2,000
+
0
$ 2,000
Fixed costs
Variable costs
Total costs
Profit/loss (TR
TC)
$ 2,000
Operating profit/loss (TR TVC)

Total profit/loss (TR TC)
$ 2,400
$ 2,000
+ 1,600
$ 3,600
$
800
$ 1,200
Minimizing Losses
FIGURE 9.1 Firm Suffering Losses but Showing an Operating Profit in the Short Run
When price is sufficient to cover average variable costs, firms suffering short-run
losses will continue operating instead of shutting down.
Total revenues (P* q*) cover variable costs, leaving an operating profit of $90 to
cover part of fixed costs and reduce losses to $135.

Minimizing Losses
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)
Fixed costs
Variable costs
Total costs
$ 2,000
0
$ 2,000
Profit/loss (TR TC):
$ 2,000
Total revenue ($1.50 x 800)
$ 1,200
Fixed costs
Variable costs
Total costs
Operating profit/loss (TR TVC)

Total profit/loss (TR TC)
400
$
$ 2,400
$ 2,000
1,600
$ 3,600
Minimizing Losses
FIGURE 9.1 Firm
Suffering Losses but
Showing an Operating Profit
in the Short Run
At prices below average

variable cost, it pays a
firm to shut down rather
than continue operating.
Thus, 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.
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 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
A profit-maximizing perfectly competitive firm will produce up to the point where P* = If there are
only three firms in the industry, the industry supply curve is simply the sum of all the products
supplied by the three firms at each price. For example, at $6, firm 1 supplies 100 units, firm 2
supplies 200 units, and firm 3 supplies 150 units, for a total industry supply of 450.
Long-Run Directions: A Review
TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and
Short Run
Short-Run Condition
Profits
Losses
TR > TC
1. With operating profit
(TR TVC)
2. With operating losses
(TR < TVC)
Short-Run Decision
Long-Run Decision
P = MC: operate
Expand: new firms enter
P = MC: operate
Contract: firms exit
(losses < fixed costs)

Shut down:
Contract: firms exit
losses = fixed costs
Long-Run Costs: Economies and Diseconomies of Scale
increasing returns to scale, or economies of

scale An increase in a firms scale of production
leads to lower costs per unit produced.
constant returns to scale An increase in a firms
scale of production has no effect on costs per unit
produced.
decreasing returns to scale, or diseconomies of
scale An increase in a firms scale of production
leads to higher costs per unit produced.

Increasing Returns to Scale
Example: Economies of Scale in Egg Production
TABLE 9.5 Weekly Costs Showing Economies of Scale in Egg Production

Jones Farm
15 hours of labor (implicit value $8 per hour)
Feed, other variable costs
Transport costs
Land and capital costs attributable to egg
production
Total output
Average cost
Chicken Little Egg Farms Inc.
Labor
Feed, other variable costs
Transport costs
Land and capital costs
Total output
Average cost
Total Weekly Costs

$120
25
15
17
$177
2,400 eggs
$0.074 per egg
Total Weekly Costs
$ 5,128
4,115
2,431
19,230
$30,904
1,600,000 eggs
$0.019 per egg
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.
FIGURE 9.5 A Firm Exhibiting Economies of Scale
The long-run average cost curve of a firm shows the different scales on which the firm can
choose to operate in the long run. Each scale of operation defines a different short run. Here we
see a firm exhibiting economies of scale; moving from scale 1 to scale 3 reduces average cost.
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 firms longrun average cost curve remains flat.
Decreasing Returns to Scale
optimal scale of plant

The scale of plant that
minimizes average cost.
FIGURE 9.6 A Firm Exhibiting Economies and Diseconomies of Scale
Economies of scale push this firms average costs down to q*. Beyond q*, the firm
experiences diseconomies of scale; q* is the level of production at lowest average cost,
using optimal scale.
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
When economies of scale can be realized, firms have an incentive to expand. Thus, firms
will be pushed by competition to produce at their optimal scales. Price will be driven to the
minimum point on the LRAC curve.
Short-Run Profits: Expansion to Equilibrium
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
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.
Short-Run Losses: Contraction to Equilibrium
FIGURE 9.8 Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses
When firms in an industry suffer losses, there is an incentive for them to exit.
As firms exit, the supply curve shifts from S0 to S1, driving price up to P*. As price rises,
losses are gradually eliminated and the industry returns to equilibrium.
Short-Run Losses: Contraction to Equilibrium
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 plantthat is, at the minimum point on
their LRAC curve.
The Long-Run Adjustment Mechanism: Investment Flows Toward

Profit Opportunities
The entry and exit of firms in response to profit opportunities usually
involve the financial capital market. In capital markets, people are
constantly looking for profits.When firms in an industry do well, capital
is likely to flow into that industry in a variety of forms.
long-run competitive equilibrium When P =
SRMC = SRAC = LRAC and profits are zero.
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.
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.

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PART II THE MARKET SYSTEM

CHAPTER 9 Long-Run Costs and Output Decisions