Long Run Costs and Output Decisions Ch-9

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 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.) 1,600 Profit (TR - TC) 400 2,000 If Blue Velvet washes 800 cars each week, it takes in revenues of $4,000 at a given price of $5 for each wash 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.

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 = 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 Operating profit (or loss) or net operating revenue = 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.

Minimizing Losses 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) $ Total Revenue ($3 x 800) 2,400 Fixed costs Variable costs Total costs + $ $ 2,000 0 2,000 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 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 CASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $1.50 Total Revenue (q = 0) $ Total revenue ($1.50 x 800) 1,200 Fixed costs Variable costs Total costs + $ $ 2,000 0 2,000 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

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 SHORT-RUN CONDITION SHORT-RUN DECISION LONG-RUN DECISION Profits TR > TC P = MC: operate Expand: new firms enter Losses 1. With operating profit Contract: firms exit (TR  TVC) (losses < fixed costs) 2. With operating losses Shut down: (TR < TVC) 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.

Long-Run Costs: Economies and Diseconomies of Scale In the long run, the shape of the long run average cost curve depends on how costs vary with the scale of operation Increasing returns to scale/ 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 / Diseconomies of 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. Since the increasing, constant and decreasing returns to scale are found within the firm, they are called internal economies of scale

Increasing Returns to Scale/ Economies of scale Technically speaking, returns to scale refer to the relationship between input and output; in an increasing returns to scale, a given percentage increase in input leads to a larger percentage increase in output Hence, with fixed input prices, increasing returns to scale also mean that as output rises, average cost of production falls. Sources of economies of scale: Technology Size of the firm-e.g.-buying inputs in bulk and getting huge discounts

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 $.074 per egg CHICKEN LITTLE EGG FARMS INC. Labor $ 5,128 4,115 2,431 Land and capital costs 19,230 $30,904 1,600,000 eggs $.019 per egg

Long Run Average Cost Curve (LRAC) LRAC curve shows different scales on which a firm can choose to operate Hence it traces out the position of all its short run curves , each corresponding to a different scale Hence LRAC is the ‘envelope’ of a series of short run curves; it wraps around the set of all possible short run curves Each point on the LRAC represents the minimum cost at which the associated output can be produced

The Long-Run Average Cost Curve The long run average cost curve of a firm exhibiting economies of scale is downward-sloping.

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 The industry will not be in long run equilibrium if firms have an incentive to enter or exit an industry When firms are earning economic profits or suffering losses,i.e, the industry is not in equilibrium and hence the firms will change their, behavior.

Short-Run Profits: Expansion to equilibrium Firms expand in the long-run when increasing returns to scale are available.

Short-Run Profits: Expansion to equilibrium Prices will be driven down to the minimum point on the LRAC curve.

Short-Run Profits: Expansion to Equilibrium In the above case, since scale economies existed, hence the firms will expand their output till all scale economies are exhausted The existence of positive profits will also attract new entrants to an industry. Because of the above two factors, 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. Each firm will choose a scale of plant that produces its product at minimum of LRAC- Competition drives firms to use most efficient technology in the short run and most efficient scale of plant in the long run.

Short-Run Profits: Expansion to Equilibrium Hence in the long run, equilibrium price is equal to LRAC, SRMC, and SRAC and profits are equal to zero P*= SRMC=SRAC=LRAC, Where P* is the equilibrium price in long run

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 With losses , the long run picture changes. Firms will exit the industry. 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. At this point, individual firms are operating at the most efficient scale of plant; at the minimum point of LRAC

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.