CHAPTER 8 LongRun Costs and Output Decisions Appendix

CHAPTER 8 Long-Run Costs and Output Decisions Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair

C H A P T E R 8: Long-Run Costs and Output Decisions Short-Run Conditions and Long-Run Directions • Profit is the difference between total revenue and total economic cost. • Total economic cost includes a normal rate of return, or the rate that is just sufficient to keep current investors interested in the industry. • Breaking even is a situation in which a firm earns exactly a normal rate of return. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2

C H A P T E R 8: Long-Run Costs and Output Decisions Maximizing Profits Blue Velvet Car Wash Weekly Costs TOTAL VARIABLE COSTS (TVC) (800 WASHES) TOTAL FIXED COSTS (TFC) 1. Normal return to investors $ 1, 000 2. Other fixed costs (maintenance contract, insurance, etc. ) 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) $ 400 1, 000 $ 2, 000 • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 3

C H A P T E R 8: Long-Run Costs and Output Decisions Firm Earning Positive Profits in the Short Run • To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 4

C H A P T E R 8: Long-Run Costs and Output Decisions Firm Earning Positive Profits in the Short Run • Profit is the difference between total revenue and total cost. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 5

C H A P T E R 8: Long-Run Costs and Output Decisions 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 6

C H A P T E R 8: Long-Run Costs and Output Decisions Minimizing Losses • Operating profit (or loss) or net operating revenue equals total revenue minus total variable cost (TR – TVC). • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 7

C H A P T E R 8: Long-Run Costs and Output Decisions Minimizing Losses • When price equals $3. 50, revenue is sufficient to cover total variable cost but not total cost. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 8

C H A P T E R 8: Long-Run Costs and Output Decisions Minimizing Losses 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) $ 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) Total profit/loss (TR - TC) $ 800 - $ 1, 200 © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 9

C H A P T E R 8: Long-Run Costs and Output Decisions Minimizing Losses • As long as price is sufficient to cover average variable costs, the firm stands to gain by operating instead of shutting down. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 10

C H A P T E R 8: Long-Run Costs and Output Decisions Minimizing Losses • The difference between ATC and AVC equals AFC. Then, AFC q = TFC. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 11

C H A P T E R 8: Long-Run Costs and Output Decisions Shutting Down to Minimize Loss A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost CASE 1: SHUT DOWN Total Revenue (q = 0) CASE 2: OPERATE AT PRICE = $1. 50 $ 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) Total profit/loss (TR - TC) - $ 400 - $ 2, 400 © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 12

C H A P T E R 8: Long-Run Costs and Output Decisions Short-Run Supply Curve of a Perfectly Competitive Firm © 2004 Prentice Hall Business Publishing • The shut-down point is 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. Principles of Economics, 7/e Karl Case, Ray Fair 13

C H A P T E R 8: Long-Run Costs and Output Decisions Short-Run Supply Curve of a Perfectly Competitive Firm © 2004 Prentice Hall Business Publishing • 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. Principles of Economics, 7/e Karl Case, Ray Fair 14

C H A P T E R 8: Long-Run Costs and Output Decisions 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 15

C H A P T E R 8: Long-Run Costs and Output Decisions Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run SHORT-RUN CONDITION Profits TR > TC Losses 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 • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 16

C H A P T E R 8: Long-Run Costs and Output Decisions 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 17

C H A P T E R 8: Long-Run Costs and Output Decisions Weekly Costs Showing Economies of Scale in Egg Production JONES FARM TOTAL WEEKLY COSTS 15 hours of labor (implicit value $8 per hour) Feed, other variable costs Transport costs Land capital costs attributable to egg production Total output Average cost CHICKEN LITTLE EGG FARMS INC. Labor Feed, other variable costs Transport costs Land capital costs TOTAL WEEKLY COSTS $ 5, 128 4, 115 2, 431 19, 230 $30, 904 1, 600, 000 eggs $. 019 per egg Total output Average cost © 2004 Prentice Hall Business Publishing $120 25 15 17 $177 2, 400 eggs $. 074 per egg Principles of Economics, 7/e Karl Case, Ray Fair 18

C H A P T E R 8: Long-Run Costs and Output Decisions A Firm Exhibiting Economies of Scale • The long run average cost curve of a firm exhibiting economies of scale is downwardsloping. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 19

C H A P T E R 8: Long-Run Costs and Output Decisions 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 20

C H A P T E R 8: Long-Run Costs and Output Decisions Constant Returns to 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 21

C H A P T E R 8: Long-Run Costs and Output Decisions Decreasing Returns to Scale • Decreasing returns to scale, or diseconomies of scale, refers to an increase in a firm’s scale of production, which leads to higher average costs per unit produced. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 22

C H A P T E R 8: Long-Run Costs and Output Decisions A Firm Exhibiting Economies and Diseconomies of Scale • The LRAC curve of a firm that eventually exhibits diseconomies of scale becomes upward-sloping. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 23

C H A P T E R 8: Long-Run Costs and Output Decisions Optimal Scale of Plant • The optimal scale of plant is the scale that minimizes average cost. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 24

C H A P T E R 8: Long-Run Costs and Output Decisions Long-Run Adjustments to Short-Run Conditions • Firms expand in the long-run when increasing returns to scale are available. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 25

C H A P T E R 8: Long-Run Costs and Output Decisions Short-Run Profits: Expansion to Equilibrium • Firms expand in the long run when increasing returns to scale are available. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 26

C H A P T E R 8: Long-Run Costs and Output Decisions Short-Run Losses: Contraction to Equilibrium • When firms in an industry suffer losses, there is an incentive for them to exit. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 27

C H A P T E R 8: Long-Run Costs and Output Decisions Short-Run Losses: Contraction to Equilibrium • As firms exit, the supply curve shifts from S to S’, driving price up to P*. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 28

C H A P T E R 8: Long-Run Costs and Output Decisions Short-Run Losses: Contraction to Equilibrium • The industry eventually returns to long-run equilibrium and losses are eliminated. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 29

C H A P T E R 8: Long-Run Costs and Output Decisions Long-Run Competitive 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 30

C H A P T E R 8: Long-Run Costs and Output Decisions The Long-Run Adjustment Mechanism: Investment Flows Toward Profit Opportunities • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 31

C H A P T E R 8: Long-Run Costs and Output Decisions Long-Run Adjustment Mechanism: Investment Flows Toward Profit Opportunities • The central idea in our discussion of entry, exit, expansion, and contraction is this: • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 32

C H A P T E R 8: Long-Run Costs and Output Decisions Review Terms and Concepts breaking even operating profit (or loss) or net operating revenue constant return to scales decreasing returns to scale, or diseconomies of scale increasing returns to scale, or economies of scale optimal scale of plant short-run industry supply curve shut-down point long-run average cost curve (LRAC) long-run competitive equilibrium: P = SRMC = SRAC = LRAC long-run competitive equilibrium © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 33

C H A P T E R 8: Long-Run Costs and Output Decisions Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 34

C H A P T E R 8: Long-Run Costs and Output Decisions Appendix: External Economies and Diseconomies and 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 35

C H A P T E R 8: Long-Run Costs and Output Decisions Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve Construction Activity and the Price of Lumber Products, 1991 - 1994 YEAR MONTHLY AVERAGE, NEW HOUSING PERMITS PERCENTAGE INCREASE OVER THE PREVIOUS YEAR PERCENTAGE CHANGE IN THE PRICE OF LUMBER PRODUCTS 1991 79, 500 - - - 1992 92, 167 + 15. 9 + 14. 7 + 3. 0 1993 100, 917 + 9. 5 + 24. 6 + 3. 0 1994 111, 000 + 10. 0 NA + 2. 1 PERCENTAGE CHANGE IN CONSUMER PRICES Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21; Statistical Abstract of the United States, 1994, Tables 754, 755. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 36

C H A P T E R 8: Long-Run Costs and Output Decisions Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve • In a decreasing cost industry, costs decline as a result of industry expansion, and the LRIS is downward-sloping. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 37

C H A P T E R 8: Long-Run Costs and Output Decisions Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve • In an increasing cost industry, costs rise as a result of industry expansion, and the LRIS is upward-sloping. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 38