Download Chapter 9 Long Run Cost and Output (CFO)

Long-Run Costs and
Output Decisions
9
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
U-Shaped Long-Run Average Costs
Long-Run Adjustments to Short-Run Conditions
Short-Run Profits: Moves In and Out of 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
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Regardless of the structure of the Market (i.e., Market Structure):
1. Firm’s choose their output level (quantity supplied) so as to maximize
their profits
Profits = Total Revenues (price x quantity supplied) x Total Costs (which
depend on quantity supplied
2. In Perfectly Competitive Markets:
• Market price is not determined by firm’s output decision, but is
whatever clears the entire market (so it faces a horizontal demand
curve)
• Firm can only control it’s costs – so looks for the least (minimum)
cost way to produce the output
• Firm can maximize profits by finding the level of output where the
last unit produced is just equal to the market price
• Since all marginal costs are increasing (i.e., total costs are
increasing at an increasing rate) -> makes a profit on all prior
units
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Short-run versus the Long-run in PC Markets
In the long-run:
1. All firms earn a Zero economic profit
• But do earn a (+) accounting profit
• Earn a “normal rate of return” (same rate as other
firms) for the industry they are in
• Otherwise new firms would enter the industry if they
earned a + economic profit
• Increase in supply would drive price back towards
zero economic profit
2. In the short-run
• can earn either positive or negative economic profit
• Positive econ profit - > new firms enter the market -> price
changes to drive price back to zero econ profit
• Negative econ profit -> existing firms exit the market (e.g.
recession) until price changes and drives economic profits
up to zero
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Short-Run Conditions and Long-Run Directions
breaking even The situation in which a firm is earning exactly a normal rate of
return.
Maximizing Profits
Example: The Blue Velvet Car Wash: earning a (+) economic
profit
TABLE 9.1 Blue Velvet Car Wash Weekly Costs
TVC
Total Variable Cost
(800 Washes)
TFC
Total Fixed Cost
1. Normal return to
investors
2. Other fixed costs
(maintenance
contract)
$1,000
1. Labor
2. Soap
$1,000
600
$1,600
TC
Total Cost
(800 Washes)
TC = TFC + TVC
= $2,000 + $1,600
= $3,600
TR
Total Revenue
(P = $5)
TR = $5 × 800
= $4,000
Profit = TR  TC
= $400
1,000
$2,000
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Cars Washed
Fixed Cost
Tot Costs
ATC
0
$2,000.00
$0.00
$2,000.00
800
$2,000.00
$1,600.00
$3,600.00
Price
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Variable
Tot Rev
Profit
AFC
#DIV/0!
#DIV/0!
$4.50
$2.50
Rev-Var
5
4000
$400.00
$2,400.00
4.5
3600
$0.00
$2,000.00
4
3200
-$400.00
$1,600.00
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A PC Firm Earning an Economic Profit (shhort-run)
 FIGURE 9.1 Firm Earning a Positive Profit in the Short Run
A profit-maximizing perfectly competitive firm will produce up to the point where P* = MC.
Profit is the difference between total revenue and total cost.
At q* = 800, total revenue is $5 × 800 = $4,000, total cost is $4.50 × 800 = $3,600, and profit = $4,000 
$3,600 = $400.
Because average total cost is derived by dividing total cost by q, we can get back to total cost by
multiplying average total cost by q.
TC and so
TC = ATC × q.
ATC 
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q
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 FIGURE 9.2 Short-Run Supply Curve of a Perfectly Competitive Firm
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.
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Long-Run Directions: A Review
TABLE 9.2 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and
Short Run
Short-Run Condition
Profits
Losses
TR > TC
1. TR  TVC
Short-Run Decision
Long-Run Decision
P = MC: operate
Expand: new firms enter
P = MC: operate
Contract: firms exit
(loss < total fixed cost)
2. TR < TVC
Shut down:
Contract: firms exit
loss = total fixed cost
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Long-Run Adjustments to Short-Run Conditions
Starting at Equilibrium
 FIGURE 9.6 Equilibrium for an Industry with U-shaped Cost Curves
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Final Equilibrium Depends on Industry’s Cost Structure
Average ATC in short ATC in short
Total
run with
run with
Cost small factory medium factory
ATC in short
run with
large factory
ATC in long run
$12,000
10,000
Economies
of scale
0
Constant returns to scale
1,000
1,200
Diseconomies
of scale
Quantity of Cars per Day
Because fixed costs are variable in the long run, the average-total-cost curve in the
short run differs from the average-total-cost curve in the long run.
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The Long-Run Industry Supply Curve
long-run industry supply curve (LRIS) A curve 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.
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.
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 Short-run Industry Response to an Increase in Demand – no entry yet
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New Equilibrium with Higher Demand – with entry and constantreturns to scale
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 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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 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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Average total cost in the short and long runs
Average ATC in short ATC in short
Total
run with
run with
Cost small factory medium factory
ATC in short
run with
large factory
ATC in long run
$12,000
10,000
Economies
of scale
0
Constant returns to scale
1,000
1,200
Diseconomies
of scale
Quantity of Cars per Day
Because fixed costs are variable in the long run, the average-total-cost curve in the
short run differs from the average-total-cost curve in the long run.
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