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

Long-Run Costs and Output Decisions We begin our discussion of the long run by looking at firms in three short-run circumstances: firms earning economic profits, firms suffering economic losses but continuing to operate to reduce or minimize those losses, and 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.

Short-Run Conditions and Long-Run Directions Maximizing Profits Example: The Blue Velvet Car Wash 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.) 1,600 Profit (TR - TC) 400 2,000

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

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

Short-Run Conditions and Long-Run Directions Minimizing Losses 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) $ 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

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

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

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

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 Contract: firms exit (TR  TVC) (losses < fixed costs) 2. With operating losses Shut down: (TR < TVC) losses = fixed costs

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.

Long-Run Costs: Economies and Diseconomies of Scale Increasing Returns to 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. Labor $ 5,128 4,115 2,431 Land and capital costs 19,230 $30,904 1,600,000 eggs $0.019 per egg

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.

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.

Long-Run Costs: Economies and Diseconomies of Scale Decreasing Returns to Scale optimal scale of plant The scale of plant that minimizes average cost.  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.

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.

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

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.

Long-Run Adjustments to Short-Run Conditions Short-Run Losses: Contraction to Equilibrium 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.

The Long-Run Average Cost Curve: Flat or U-Shaped? Long-Run Adjustments to Short-Run Conditions 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,

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