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© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
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© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
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  1. 1. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair CHAPTERCHAPTER 88 Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijanoand Yvonn Quijano Costs and Output Decisions inCosts and Output Decisions in the Long Runthe Long Run
  2. 2. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair The Concept of ProfitThe Concept of Profit • ProfitProfit is the difference between total revenueis the difference between total revenue and total cost.and total cost. • The economic concept of profit takes intoThe economic concept of profit takes into account the opportunity cost of capital.account the opportunity cost of capital. • Total economic cost includes a normal rate ofTotal economic cost includes a normal rate of return. Areturn. A normal rate of returnnormal rate of return is the rate that isis the rate that is just sufficient to keep current investors interestedjust sufficient to keep current investors interested in the industry.in the industry. • Breaking evenBreaking even is a situation in which a firm isis a situation in which a firm is earning exactly a normal rate of return.earning exactly a normal rate of return.
  3. 3. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Blue Velvet Car Wash Weekly CostsBlue Velvet Car Wash Weekly Costs Maximizing Profit–An ExampleMaximizing Profit–An Example • If Blue Velvet washes 800 cars each week, itIf Blue Velvet washes 800 cars each week, it takes in revenues of $4,000.takes in revenues of $4,000. • This revenue is sufficient to cover both fixed costsThis revenue is sufficient to cover both fixed costs of $2,000 and variable costs of $1,600, leaving aof $2,000 and variable costs of $1,600, leaving a positive economic profit of $400 per week.positive economic profit of $400 per week. TOTAL FIXED COSTS (TOTAL FIXED COSTS (TFCTFC)) TOTAL VARIABLE COSTSTOTAL VARIABLE COSTS ((TVCTVC) (800 WASHES)) (800 WASHES) TOTAL COSTSTOTAL COSTS ((TCTC == TFCTFC ++ TVCTVC)) $$ 3,6003,600 1.1. Normal return toNormal return to investorsinvestors $$ 1,0001,000 1.1. 2.2. LaborLabor MaterialsMaterials $$1,0001,000 600600 Total revenue (Total revenue (TRTR)) atat PP = $5 (800 x $5)= $5 (800 x $5) $$ 4,0004,000 2.2. Other fixed costsOther fixed costs (maintenance contract,(maintenance contract, insurance, etc.)insurance, etc.) 1,0001,000 $$1,6001,600 Profit (Profit (TRTR −− TCTC)) $$ 400400 $$ 2,0002,000
  4. 4. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Firm Earning Positive Profits in theFirm Earning Positive Profits in the Short RunShort Run • To maximize profit, the firm sets the level of outputTo maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.where marginal revenue equals marginal cost.
  5. 5. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Firm Earning Positive Profits in theFirm Earning Positive Profits in the Short RunShort Run • Profit is the difference between total revenue andProfit is the difference between total revenue and total cost.total cost.
  6. 6. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Minimizing LossesMinimizing Losses • Operating profit (or loss)Operating profit (or loss) oror netnet operating revenueoperating revenue equals total revenueequals total revenue minus total variable cost (TR – TVC).minus total variable cost (TR – TVC). • If revenues exceed variable costs, operatingIf revenues exceed variable costs, operating profit is positive and can be used to offset fixedprofit is positive and can be used to offset fixed costs and reduce losses, and it will pay the firmcosts and reduce losses, and it will pay the firm to keep operating.to keep operating.
  7. 7. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Minimizing LossesMinimizing Losses • If revenues are smaller than variable costs, theIf revenues are smaller than variable costs, the firm suffers operating losses that push totalfirm suffers operating losses that push total losses above fixed costs. In this case, the firmlosses above fixed costs. In this case, the firm can minimize its losses by shutting down.can minimize its losses by shutting down. • Operating profit (or loss)Operating profit (or loss) oror netnet operating revenueoperating revenue equals total revenueequals total revenue minus total variable cost (TR – TVC).minus total variable cost (TR – TVC).
  8. 8. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair A Firm Will Operate If Total Revenue Covers Total Variable CostA Firm Will Operate If Total Revenue Covers Total Variable Cost Minimizing LossesMinimizing Losses CASE 1: SHUT DOWNCASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $3CASE 2: OPERATE AT PRICE = $3 Total Revenue (Total Revenue (qq = 0)= 0) $$ 00 Total Revenue ($3 x 800)Total Revenue ($3 x 800) $$ 2,4002,400 Fixed costsFixed costs Variable costsVariable costs Total costsTotal costs ++ $$ $$ 2,0002,000 00 2,0002,000 Fixed costsFixed costs Variable costsVariable costs Total costsTotal costs ++ $$ $$ 2,0002,000 1,6001,600 3,6003,600 Profit/loss (Profit/loss (TRTR −− TCTC)) −− $$ 2,0002,000 Operating profit/loss (Operating profit/loss (TRTR −− TVCTVC)) $$ 800800 Total profit/loss (Total profit/loss (TRTR −− TCTC)) −− $$ 1,2001,200
  9. 9. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Minimizing LossesMinimizing Losses • When price equals $3.50, revenue is sufficient toWhen price equals $3.50, revenue is sufficient to cover total variable cost but not total cost.cover total variable cost but not total cost.
  10. 10. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Minimizing LossesMinimizing Losses • As long as price (which is equal to average revenue perAs long as price (which is equal to average revenue per unit) is sufficient to cover average variable costs, the firmunit) is sufficient to cover average variable costs, the firm stands to gain by operating instead of shutting down.stands to gain by operating instead of shutting down.
  11. 11. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Minimizing LossesMinimizing Losses • The difference betweenThe difference between ATCATC andand AVCAVC equalsequals AFCAFC. Then,. Then, AFCAFC  qq == TFCTFC (the brown area).(the brown area).
  12. 12. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Minimizing LossesMinimizing Losses • The blue area equals losses.The blue area equals losses. • The green area equals operating profit.The green area equals operating profit.
  13. 13. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair A Firm Will Shut Down If Total Revenue Is Less Than Total VariableA Firm Will Shut Down If Total Revenue Is Less Than Total Variable CostCost Shutting Down to Minimize LossShutting Down to Minimize Loss CASE 1: SHUT DOWNCASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $1.50CASE 2: OPERATE AT PRICE = $1.50 Total Revenue (Total Revenue (qq = 0)= 0) $$ 00 Total revenue ($1.50 x 800)Total revenue ($1.50 x 800) $$ 1,2001,200 Fixed costsFixed costs Variable costsVariable costs Total costsTotal costs ++ $$ $$ 2,0002,000 00 2,0002,000 Fixed costsFixed costs Variable costsVariable costs Total costsTotal costs ++ $$ $$ 2,0002,000 1,6001,600 3,6003,600 Profit/loss (Profit/loss (TRTR −− TCTC)) −− $$ 2,0002,000 Operating profit/loss (Operating profit/loss (TRTR −− TVCTVC)) −− $$ 400400 Total profit/loss (Total profit/loss (TRTR −− TCTC)) −− $$ 2,4002,400
  14. 14. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Short-Run Supply Curve of a PerfectlyShort-Run Supply Curve of a Perfectly Competitive FirmCompetitive Firm • The short-runThe short-run supply curve of asupply curve of a competitive firm iscompetitive firm is the part of itsthe part of its marginal cost curvemarginal cost curve that lies above itsthat lies above its average variableaverage variable cost curve.cost curve.
  15. 15. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair The Short-Run Industry Supply CurveThe Short-Run Industry Supply Curve • The industry supply curve in the short-run is theThe industry supply curve in the short-run is the horizontal sum of the marginal cost curves (abovehorizontal sum of the marginal cost curves (above AVCAVC)) of all the firms in an industry.of all the firms in an industry.
  16. 16. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Profits, Losses, and Perfectly CompetitiveProfits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short RunFirm Decisions in the Long and Short Run SHORT-RUNSHORT-RUN CONDITIONCONDITION SHORT-RUNSHORT-RUN DECISIONDECISION LONG-RUNLONG-RUN DECISIONDECISION ProfitsProfits TR > TCTR > TC P = MC: operateP = MC: operate Expand: new firms enterExpand: new firms enter LossesLosses 1. With operating profit1. With operating profit P = MC: operateP = MC: operate Contract: firms exitContract: firms exit ((TRTR ≥≥ TVCTVC)) (losses < fixed costs)(losses < fixed costs) 2. With operating losses2. With operating losses Shut down:Shut down: Contract: firms exitContract: firms exit ((TRTR << TVCTVC)) losses = fixed costslosses = fixed costs • In the short-run, firms have to decide how much toIn the short-run, firms have to decide how much to produce in the current scale of plant.produce in the current scale of plant. • In the long-run, firms have to choose among manyIn the long-run, firms have to choose among many potential scales of plant.potential scales of plant.
  17. 17. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Long-Run Costs: Economies andLong-Run Costs: Economies and Diseconomies of ScaleDiseconomies of Scale • Increasing returns to scaleIncreasing returns to scale, or, or economies of scale,economies of scale, refers to anrefers to an increase in a firm’s scale ofincrease in a firm’s scale of production, which leads toproduction, which leads to lowerlower average costs per unit produced.average costs per unit produced.
  18. 18. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Long-Run Costs: Economies andLong-Run Costs: Economies and Diseconomies of ScaleDiseconomies of Scale • Constant returns to scaleConstant returns to scale refers torefers to an increase in a firm’s scale ofan increase in a firm’s scale of production, which hasproduction, which has no effectno effect onon average costs per unit produced.average costs per unit produced.
  19. 19. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Long-Run Costs: Economies andLong-Run Costs: Economies and Diseconomies of ScaleDiseconomies of Scale • Decreasing returns to scaleDecreasing returns to scale refersrefers to an increase in a firm’s scale ofto an increase in a firm’s scale of production, which leads toproduction, which leads to higherhigher average costs per unit produced.average costs per unit produced.
  20. 20. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair The Long-Run Average Cost CurveThe Long-Run Average Cost Curve • TheThe long-run average costlong-run average cost curve (LRAC)curve (LRAC) is a graph thatis a graph that shows the different scales onshows the different scales on which a firm can choose towhich a firm can choose to operate in the long-run. Eachoperate in the long-run. Each scale of operation defines ascale of operation defines a different short-run.different short-run.
  21. 21. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair The Long-Run Average Cost CurveThe Long-Run Average Cost Curve • The long run average cost curve of a firmThe long run average cost curve of a firm exhibiting economies of scale is downward-exhibiting economies of scale is downward- sloping.sloping.
  22. 22. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Weekly Costs Showing Economies ofWeekly Costs Showing Economies of Scale in Egg ProductionScale in Egg Production JONES FARMJONES FARM TOTAL WEEKLY COSTSTOTAL WEEKLY COSTS 15 hours of labor (implicit value $8 per hour)15 hours of labor (implicit value $8 per hour) $120$120 Feed, other variable costsFeed, other variable costs 2525 Transport costsTransport costs 1515 Land and capital costs attributable to egg productionLand and capital costs attributable to egg production 1717 $177$177 Total outputTotal output 2,400 eggs2,400 eggs Average costAverage cost $.074 per egg$.074 per egg CHICKEN LITTLE EGG FARMS INC.CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTSTOTAL WEEKLY COSTS LaborLabor $ 5,128$ 5,128 Feed, other variable costsFeed, other variable costs 4,1154,115 Transport costsTransport costs 2,4312,431 Land and capital costsLand and capital costs 19,23019,230 $30,904$30,904 Total outputTotal output 1,600,000 eggs1,600,000 eggs Average costAverage cost $.019 per egg$.019 per egg
  23. 23. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair A Firm Exhibiting Economies andA Firm Exhibiting Economies and Diseconomies of ScaleDiseconomies of Scale • The long-run average cost curve of a firmThe long-run average cost curve of a firm that eventually exhibits diseconomies ofthat eventually exhibits diseconomies of scale becomes upward-sloping.scale becomes upward-sloping.
  24. 24. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Optimal Scale of PlantOptimal Scale of Plant • The optimal scale of plant is the scale thatThe optimal scale of plant is the scale that minimizes average cost.minimizes average cost.
  25. 25. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Long-Run Adjustments toLong-Run Adjustments to Short-Run ConditionsShort-Run Conditions • Firms expand in the long-run whenFirms expand in the long-run when increasing returns to scale are available.increasing returns to scale are available.
  26. 26. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Long-Run Adjustments toLong-Run Adjustments to Short-Run ConditionsShort-Run Conditions • Prices will be driven down to the minimumPrices will be driven down to the minimum point on the LRAC curve.point on the LRAC curve.
  27. 27. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Short-Run Profits:Short-Run Profits: Expansion to EquilibriumExpansion to Equilibrium • The existence of positive profits will attractThe existence of positive profits will attract new entrants to an industry.new entrants to an industry. • As capital flows into the industry, the supplyAs capital flows into the industry, the supply curve shifts to the right, and price falls.curve shifts to the right, and price falls. • Firms will continue to expand as long asFirms will continue to expand as long as there are economies of scale to be realized,there are economies of scale to be realized, and new firms will continue to enter as longand new firms will continue to enter as long as positive profits are being earned.as positive profits are being earned.
  28. 28. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Short-Run Losses:Short-Run Losses: Contraction to EquilibriumContraction to Equilibrium • When firms in an industry suffer losses,When firms in an industry suffer losses, there is an incentive for them to exit.there is an incentive for them to exit.
  29. 29. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Short-Run Losses:Short-Run Losses: Contraction to EquilibriumContraction to Equilibrium • As firms exit, the supply curve shifts fromAs firms exit, the supply curve shifts from SS toto S’S’, driving price up to, driving price up to P*.P*.
  30. 30. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Short-Run Losses:Short-Run Losses: Contraction to EquilibriumContraction to Equilibrium • The industry eventually returns to long-runThe industry eventually returns to long-run equilibrium and losses are eliminated.equilibrium and losses are eliminated.
  31. 31. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Short-Run Profits:Short-Run Profits: Contraction to EquilibriumContraction to Equilibrium • As long as losses are being sustained in anAs long as losses are being sustained in an industry, firms will shut down and leave theindustry, firms will shut down and leave the industry, thus reducing supply.industry, thus reducing supply. • As this happens, price rises.As this happens, price rises. • This gradual price rise reduces losses for firmsThis gradual price rise reduces losses for firms remaining in the industry until those losses areremaining in the industry until those losses are ultimately eliminated.ultimately eliminated.
  32. 32. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Long-Run Equilibrium in PerfectlyLong-Run Equilibrium in Perfectly Competitive Output MarketsCompetitive Output Markets • Whether we begin with an industry in whichWhether we begin with an industry in which firms are earning profits or suffering losses,firms are earning profits or suffering losses, the final long-run competitive equilibriumthe final long-run competitive equilibrium condition is the same.condition is the same. • In the long-run, equilibrium price (In the long-run, equilibrium price (PP*) is equal*) is equal to long-run average cost, short-run marginalto long-run average cost, short-run marginal cost, and short-run average cost. Profits arecost, and short-run average cost. Profits are driven to zero.driven to zero.
  33. 33. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair The Long-Run Adjustment MechanismThe Long-Run Adjustment Mechanism • The central idea in our discussion of entry,The central idea in our discussion of entry, exit, expansion, and contraction is this:exit, expansion, and contraction is this: • In efficient markets, investment capital flowsIn efficient markets, investment capital flows toward profit opportunities.toward profit opportunities. • The actual process is complex and varies fromThe actual process is complex and varies from industry to industry.industry to industry.
  34. 34. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair • The central idea in our discussion of entry,The central idea in our discussion of entry, exit, expansion, and contraction is this:exit, expansion, and contraction is this: The Long-Run Adjustment MechanismThe Long-Run Adjustment Mechanism • Investment—in the form of new firms andInvestment—in the form of new firms and expanding old firms—will over time tend to favorexpanding old firms—will over time tend to favor those industries in which profits are being made,those industries in which profits are being made, and over time industries in which firms areand over time industries in which firms are suffering losses will gradually contract fromsuffering losses will gradually contract from disinvestment.disinvestment.
  35. 35. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Internal Versus ExternalInternal Versus External Economies of ScaleEconomies of Scale • Economies of scale that are foundEconomies of scale that are found within the individual firm are calledwithin the individual firm are called internal economies of scale.internal economies of scale. • External economies of scaleExternal economies of scale describe economies or diseconomiesdescribe economies or diseconomies of scale on an industry-wide basis.of scale on an industry-wide basis.
  36. 36. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair The Long-Run Industry Supply CurveThe Long-Run Industry Supply Curve • TheThe long-run industry supply curvelong-run industry supply curve (LRIS)(LRIS) traces output over time as thetraces output over time as the industry expands.industry expands. • When an industry enjoys externalWhen an industry enjoys external economies, its long-run supply curveeconomies, its long-run supply curve slopes down. Such an industry isslopes down. Such an industry is called acalled a decreasing-cost industry.decreasing-cost industry.
  37. 37. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair A Decreasing-Cost Industry:A Decreasing-Cost Industry: External EconomiesExternal Economies • In a decreasing cost industry, costs decline as aIn a decreasing cost industry, costs decline as a result of industry expansion, and the LRIS isresult of industry expansion, and the LRIS is downward-sloping.downward-sloping.
  38. 38. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair An Increasing-Cost Industry:An Increasing-Cost Industry: External DiseconomiesExternal Diseconomies • In an increasing cost industry, costs rise as aIn an increasing cost industry, costs rise as a result of industry expansion, and the LRIS isresult of industry expansion, and the LRIS is upward-sloping.upward-sloping.
  39. 39. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Construction Activity and the Price of LumberConstruction Activity and the Price of Lumber Products, 1991 - 1994Products, 1991 - 1994 An Increasing-Cost Industry: ExternalAn Increasing-Cost Industry: External DiseconomiesDiseconomies YEARYEAR MONTHLYMONTHLY AVERAGE, NEWAVERAGE, NEW HOUSINGHOUSING PERMITSPERMITS PERCENTAGEPERCENTAGE INCREASEINCREASE OVER THEOVER THE PREVIOUSPREVIOUS YEARYEAR PERCENTAGEPERCENTAGE CHANGE IN THECHANGE IN THE PRICE OFPRICE OF LUMBERLUMBER PRODUCTSPRODUCTS PERCENTAGEPERCENTAGE CHANGE INCHANGE IN CONSUMERCONSUMER PRICESPRICES 19911991 79,50079,500 -- -- -- 19921992 92,16792,167 ++ 15.915.9 ++ 14.714.7 ++ 3.03.0 19931993 100,917100,917 ++ 9.59.5 ++ 24.624.6 ++ 3.03.0 19941994 111,000111,000 ++ 10.010.0 NANA ++ 2.12.1 Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21;Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21; Statistical Abstract of the United StatesStatistical Abstract of the United States, 1994, Tables 754, 755., 1994, Tables 754, 755.
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