Costs and Output Decisions in the Long Run
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Costs and Output Decisions in the Long Run

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  • For educational purpose only.
    Copyright 2002 Prentice Hall Business Publishing
    Copyright Fernando Quijano and Yvonn Quijano
    Copyright Carl Case and Ray Fair
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Costs and Output Decisions in the Long Run Costs and Output Decisions in the Long Run Presentation Transcript

  • Costs and Output Decisions in the Long Run
  • The Concept of Profit 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.
  • Maximizing Profit–An Example 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. Blue Velvet Car Wash Weekly Costs TOTAL COSTS ( TC = TFC + TVC ) 2,000 $ 400 $ Profit ( TR  TC ) 1,600 $ 1,000 Other fixed costs (maintenance contract, insurance, etc.) 2. 4,000 $ Total revenue ( TR ) at P = $5 (800 x $5) 1,000 600 $ Labor Materials 1. 2. 1,000 $ Normal return to investors 1. 3,600 $ TOTAL VARIABLE COSTS ( TVC ) (800 WASHES) TOTAL FIXED COSTS ( TFC )
  • Firm Earning Positive Profits in the Short Run To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.
  • Firm Earning Positive Profits in the Short Run Profit is the difference between total revenue and total cost.
  • Minimizing 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.
  • 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. Operating profit (or loss) or net operating revenue equals total revenue minus total variable cost (TR – TVC).
  • Minimizing Losses A Firm Will Operate If Total Revenue Covers Total Variable Cost 1,200 $  Total profit/loss ( TR  TC ) 800 $ Operating profit/loss ( TR  TVC ) 2,000 $  Profit/loss ( TR  TC ) 2,000 1,600 3,600 $ $ + Fixed costs Variable costs Total costs 2,000 0 2,000 $ $ + Fixed costs Variable costs Total costs 2,400 $ Total Revenue ($3 x 800) 0 $ Total Revenue ( q = 0) CASE 2: OPERATE AT PRICE = $3 CASE 1: SHUT DOWN
  • Minimizing Losses When price equals $3.50, revenue is sufficient to cover total variable cost but not total cost.
  • 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.
  • Minimizing Losses The difference between ATC and AVC equals AFC . Then, AFC  q = TFC (the brown area).
  • Minimizing Losses The blue area equals losses. The green area equals operating profit.
  • Shutting Down to Minimize Loss A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost 2,400 $  Total profit/loss ( TR  TC ) 400 $  Operating profit/loss ( TR  TVC ) 2,000 $  Profit/loss ( TR  TC ) 2,000 1,600 3,600 $ $ + Fixed costs Variable costs Total costs 2,000 0 2,000 $ $ + Fixed costs Variable costs Total costs 1,200 $ Total revenue ($1.50 x 800) 0 $ Total Revenue ( q = 0) CASE 2: OPERATE AT PRICE = $1.50 CASE 1: SHUT DOWN
  • 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 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.
  • Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run 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. losses = fixed costs ( TR < TVC ) Contract: firms exit Shut down: 2. With operating losses (losses < fixed costs) ( TR  TVC ) Contract: firms exit P = MC: operate 1. With operating profit Losses Expand: new firms enter P = MC: operate TR > TC Profits LONG-RUN DECISION SHORT-RUN DECISION SHORT-RUN CONDITION
  • Long-Run Costs: Economies and Diseconomies of Scale Increasing returns to scale , or economies of scale, refers to an increase in a firm’s scale of production, which leads to lower average costs per unit produced.
  • Long-Run Costs: Economies and Diseconomies of Scale Constant returns to scale refers to an increase in a firm’s scale of production, which has no effect on average costs per unit produced.
  • Long-Run Costs: Economies and Diseconomies of Scale Decreasing returns to scale refers to an increase in a firm’s scale of production, which leads to higher average costs per unit produced.
  • 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 The long run average cost curve of a firm exhibiting economies of scale is downward-sloping.
  • Weekly Costs Showing Economies of Scale in Egg Production $.019 per egg Average cost 1,600,000 eggs Total output $30,904 19,230 Land and capital costs 2,431 Transport costs 4,115 Feed, other variable costs $ 5,128 Labor TOTAL WEEKLY COSTS CHICKEN LITTLE EGG FARMS INC. $.074 per egg Average cost 2,400 eggs Total output $177 17 Land and capital costs attributable to egg production 15 Transport costs 25 Feed, other variable costs $120 15 hours of labor (implicit value $8 per hour) TOTAL WEEKLY COSTS JONES FARM
  • 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.
  • Optimal Scale of Plant The optimal scale of plant is the scale that minimizes average cost.
  • Long-Run Adjustments to Short-Run Conditions Firms expand in the long-run when increasing returns to scale are available.
  • Long-Run Adjustments to Short-Run Conditions Prices will be driven down to the minimum point on the LRAC curve.
  • Short-Run Profits: Expansion to Equilibrium 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. 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.
  • Short-Run Losses: Contraction to Equilibrium When firms in an industry suffer losses, there is an incentive for them to exit.
  • Short-Run Losses: Contraction to Equilibrium As firms exit, the supply curve shifts from S to S’ , driving price up to P*.
  • Short-Run Losses: Contraction to Equilibrium The industry eventually returns to long-run equilibrium and losses are eliminated.
  • 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 this happens, price rises. This gradual price rise reduces losses for firms remaining in the industry until those losses are ultimately eliminated.
  • 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. 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 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.
  • The Long-Run Adjustment Mechanism 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. The central idea in our discussion of entry, exit, expansion, and contraction is this:
  • Internal Versus External 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.
  • The Long-Run Industry Supply Curve 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.
  • 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.
  • 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.
  • An Increasing-Cost Industry: External Diseconomies Construction Activity and the Price of Lumber Products, 1991 - 1994 Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21; Statistical Abstract of the United States , 1994, Tables 754, 755. 2.1 + NA 10.0 + 111,000 1994 3.0 + 24.6 + 9.5 + 100,917 1993 3.0 + 14.7 + 15.9 + 92,167 1992 - - - 79,500 1991 PERCENTAGE CHANGE IN CONSUMER PRICES PERCENTAGE CHANGE IN THE PRICE OF LUMBER PRODUCTS PERCENTAGE INCREASE OVER THE PREVIOUS YEAR MONTHLY AVERAGE, NEW HOUSING PERMITS YEAR