The document discusses long-run costs and output decisions for firms. It begins by examining three short-run scenarios: firms earning profits, firms operating at a loss but with positive operating profit, and firms shutting down due to losses exceeding operating profit. In the long run, firms earning profits will expand while loss-making firms will contract or exit. The document then analyzes long-run costs in the form of economies of scale (increasing returns), constant returns, and diseconomies of scale (decreasing returns). It concludes that in long-run competitive equilibrium, price will equal minimum long-run average cost and firms will operate at optimal scale, with profits driven to zero.

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PowerPoint Lectures for
Principles of Economics,
9e
By
Karl E. Case,
Ray C. Fair &
Sharon M. Oster
; ;

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9
PART II THE MARKET SYSTEM
Long-Run Costs and
Output Decisions
Fernando & Yvonn Quijano
Prepared by:

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9
PART II THE MARKET SYSTEM
CHAPTER OUTLINE
Short-Run Conditions and Long-
Run Directions
Maximizing Profits
Minimizing Losses
The Short-Run Industry Supply Curve
Long-Run Directions: A Review
Long-Run Costs: Economies and
Diseconomies of Scale
Increasing Returns to Scale
Constant Returns to Scale
Decreasing Returns to Scale
Long-Run Adjustments
to Short-Run Conditions
Short-Run Profits: Expansion to Equilibrium
Short-Run Losses: Contraction to
Equilibrium
The Long-Run Adjustment Mechanism:
Investment Flows toward Profit
Opportunities
Output Markets: A Final Word
Appendix: External Economies and
Diseconomies and the Long-Run Industry
Supply Curve
Long-Run Costs and
Output Decisions

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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, 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.

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Short-Run Conditions and Long-Run Directions
Example: The Blue Velvet Car Wash
Maximizing Profits
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
$ 1,000
600
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

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Short-Run Conditions and Long-Run Directions
 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.
Maximizing Profits

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Short-Run Conditions and Long-Run Directions
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

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Short-Run Conditions and Long-Run Directions
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 costs
Variable costs
Total costs
+
$
$
2,000
0
2,000
Fixed costs
Variable costs
Total costs
+
$
$
2,000
1,600
3,600
Profit/loss (TR
− TC)
− $ 2,000 Operating profit/loss (TR − TVC) $ 800
Total profit/loss (TR − TC) − $ 1,200
Minimizing Losses

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Short-Run Conditions and Long-Run Directions
 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

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Short-Run Conditions and Long-Run Directions
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) $ 0 Total revenue ($1.50 x 800) $ 1,200
Fixed costs
Variable costs
Total costs
+
$
$
2,000
0
2,000
Fixed costs
Variable costs
Total costs
+
$
$
2,000
1,600
3,600
Profit/loss (TR − TC): − $ 2,000 Operating profit/loss (TR − TVC) − $ 400
Total profit/loss (TR − TC) − $ 2,400
Minimizing Losses

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Short-Run Conditions and Long-Run Directions
 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.
Minimizing Losses

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Short-Run Conditions and Long-Run Directions
short-run industry supply curve The sum of the marginal
cost curves (above AVC) of all the firms in an industry.
The Short-Run Industry Supply Curve
 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.

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Short-Run Conditions and Long-Run Directions
Long-Run Directions: A Review
TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and
Short 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

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Long-Run Costs: Economies and Diseconomies of Scale
increasing returns to scale, or economies of
scale An increase in a firm’s scale of production
leads to lower costs per unit produced.
constant returns to scale An increase in a firm’s
scale of production has no effect on costs per unit
produced.
decreasing returns to scale, or diseconomies of
scale An increase in a firm’s scale of production
leads to higher costs per unit produced.

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Long-Run Costs: Economies and Diseconomies of Scale
Example: Economies of Scale in Egg Production
TABLE 9.5 Weekly Costs Showing Economies of Scale in Egg Production
Jones Farm Total Weekly Costs
15 hours of labor (implicit value $8 per hour) $120
Feed, other variable costs 25
Transport costs 15
Land and capital costs attributable to egg
production
17
$177
Total output 2,400 eggs
Average cost $0.074 per egg
Chicken Little Egg Farms Inc. Total Weekly Costs
Labor $ 5,128
Feed, other variable costs 4,115
Transport costs 2,431
Land and capital costs 19,230
$30,904
Total output 1,600,000 eggs
Average cost $0.019 per egg
Increasing Returns to Scale

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Long-Run Costs: Economies and Diseconomies of Scale
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.

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Long-Run Costs: Economies and Diseconomies of Scale
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 firm’s long-
run average cost curve remains flat.

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Long-Run Costs: Economies and Diseconomies of Scale
Decreasing Returns to Scale
 FIGURE 9.6 A Firm Exhibiting Economies and Diseconomies of Scale
Economies of scale push this firm’s 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.
optimal scale of plant
The scale of plant that
minimizes average cost.

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Long-Run Costs: Economies and Diseconomies of Scale
Blood bank merger ‘good’
for Manatee
Bradenton Herald.com
“Northwest needed to be aligned
with a larger organization to
achieve economy of scale,” said
J.B. Gaskins, Florida Blood
Services vice president. “That
economy of scale is good for the
whole network, including Manatee
County.”

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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.

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Long-Run Adjustments to Short-Run Conditions
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 Profits: Expansion to Equilibrium

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Long-Run Adjustments to Short-Run Conditions
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.

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Long-Run Adjustments to Short-Run Conditions
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 plant—that is, at the minimum point on
their LRAC curve.
Short-Run Losses: Contraction to Equilibrium

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Long-Run Adjustments to Short-Run Conditions
The Long-Run Average Cost Curve:
Flat or U-Shaped?
The structure of the industry in the long run will depend on
whether existing firms expand faster than new firms enter.
There is an element of randomness in the way industries
expand. Most industries contain some large firms and
some small firms,

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Long-Run Adjustments to Short-Run Conditions
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.
long-run competitive equilibrium When P =
SRMC = SRAC = LRAC and profits are zero.
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.

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Why Are Hot Dogs So
Expensive in Central
Park?
In New York, you need a
license to operate a hot dog
cart, and a license to operate
in the park costs more. Since
hot dogs are $.50 more in the
park, the added cost of a
license each year must be roughly $.50 per hot dog sold. In
fact, in New York City, licenses to sell hot dogs in the park
are auctioned off for many thousands of dollars, while
licenses to operate outside the park cost only about $1,000.
Long-Run Adjustments to Short-Run Conditions
The Long-Run Adjustment Mechanism: Investment Flows Toward
Profit Opportunities

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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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REVIEW TERMS AND CONCEPTS
breaking even
constant returns to scale
decreasing returns to scale,
or diseconomies of scale
increasing returns to scale, or
economies of scale
long-run average cost curve
(LRAC)
long-run competitive equilibrium
operating profit (or loss) or net
operating revenue
optimal scale of plant
short-run industry supply curve
shut-down point
long-run competitive equilibrium,
P = SRMC = SRAC = LRAC

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EXTERNAL ECONOMIES AND DISECONOMIES AND THE LONG-
RUN INDUSTRY SUPPLY CURVE
When long-run average costs
decrease as a result of industry
growth, we say that there are
external economies.
When average costs increase as a
result of industry growth, we say that
there are external diseconomies.
A P P E N D I X

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TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 2000–2005
Year
House Prices %
Change Over the
Previous Year
Housing Starts
(Thousands)
Housing Starts
% Change Over
The Previous Year
Construction
Materials Prices %
Change Over The
Previous Year
Consumer Prices
% Change Over
The Previous
Year
2000 − 1,573 − − −
2001 7.5 1,661 5.6% 0% 2.8%
2002 7.5 1,710 2.9% 1.5% 1.5%
2003 7.9 1,853 8.4% 1.6% 2.3%
2004 12.0 1,949 5.2% 8.3% 2.7%
2005 13.0 2,053 5.3% 5.4% 2.5%
A P P E N D I X
Example of an expanding industry facing external diseconomies of scale
EXTERNAL ECONOMIES AND DISECONOMIES AND THE LONG-
RUN INDUSTRY SUPPLY CURVE

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long-run industry supply curve (LRIS) A graph that traces
out price and total output over time as an industry expands.
decreasing-cost industry An industry that realizes external
economies—that is, average costs decrease as the industry
grows. The long-run supply curve for such an industry has a
negative slope.
A P P E N D I X
increasing-cost industry An industry that encounters
external diseconomies—that is, average costs increase as the
industry grows. The long-run supply curve for such an industry
has a positive slope.
constant-cost industry An industry that
shows no economies or diseconomies of
scale as the industry grows. Such industries have flat, or
horizontal, long-run supply curves.
THE LONG-RUN INDUSTRY SUPPLY CURVE

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Appendix
THE LONG-RUN INDUSTRY SUPPLY CURVE
A P P E N D I X
 FIGURE 9A.1 A Decreasing-Cost Industry: External Economies
In a decreasing-cost industry, average cost declines as the industry expands. As demand
expands from D0 to D1, price rises from P0 to P1.
As new firms enter and existing firms expand, supply shifts from S0 to S1, driving price
down. If costs decline as a result of the expansion to LRAC2, the final price will be below
P0 at P2.
The long-run industry supply curve (LRIS) slopes downward in a decreasing-cost industry.

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Appendix
A P P E N D I X
THE LONG-RUN INDUSTRY SUPPLY CURVE
 FIGURE 9A.2 An Increasing-Cost Industry: External Diseconomies
In an increasing-cost industry, average cost increases as the industry expands. As
demand shifts from D0 to D1, price rises from P0 to P1.
As new firms enter and existing firms expand output, supply shifts from S0 to S1, driving
price down. If long-run average costs rise, as a result, to LRAC2, the final price will be P2.
The long-run industry supply curve (LRIS) slopes up in an increasing-cost industry.

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constant-cost industry
decreasing-cost industry
external economies and diseconomies
increasing-cost industry
long-run industry supply curve (LRIS)
REVIEW TERMS AND CONCEPTS