Copyright 2002, Pearson Education Canada1 Costs and Output Decisions in the Long Run Chapter 9

Copyright 2002, Pearson Education Canada2 Supply Decisions in the Long Run zOutput (supply) decisions in the long run are less constrained than in the short run for two reasons: yThere is no fixed factor of production that confines production to a given scale yFirms are free to enter and exit in order to seek profits or avoid losses

Copyright 2002, Pearson Education Canada3 Breaking Even zBreaking even refers to the situation in which a firm is earning exactly a normal profit rate. z Economic profits are zero: TR - TC = 0

Copyright 2002, Pearson Education Canada4 Firm Earning Economic Profits in the Short Run (Figure 9.1) The firm produces at the point where MC = price and manages to make a profit of TR - TC or $ $1260 = $240.

Copyright 2002, Pearson Education Canada5 Minimizing Losses zOperating profit (or loss) or net operating revenue is total revenue minus total variable cost (TR - TVC). zFirms suffering losses fall into two categories: yThose that find it advantageous to shut down operations immediately and suffer losses equal to fixed costs yThose that continue to operate in the short run to minimize losses

Copyright 2002, Pearson Education Canada6 A Firm Will Operate If Total Revenue Covers Total Variable Cost (Table 9.2)

Copyright 2002, Pearson Education Canada7 Firm Suffering Economic Losses But Showing an Operating Profit in the Short Run (Figure 9.2)

Copyright 2002, Pearson Education Canada8 Shutdown Point zThe shutdown 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.

Copyright 2002, Pearson Education Canada9 Short-Run Supply Curve of a Perfectly Competitive Firm (Figure 9.3) zThe short-run supply curve of a competitive firm is that portion of its marginal cost curve that lies above its average variable cost curve.

Copyright 2002, Pearson Education Canada10 Short-Run Industry Supply Curve (Figure 9.4) zThe short run industry supply curve is the horizontal sum of the marginal cost curves (above AVC) of all the firms in an industry.

Copyright 2002, Pearson Education Canada11 Long-Run Costs: Economies and Diseconomies of Scale zIncreasing returns to scale or economies of scale are occur when an increase in a firm’s scale in production leads to lower average costs per unit produced. zConstant returns to scale occur when an increase in a firm’s scale of production has no effect on average costs per unit produced. zDecreasing returns to scale or diseconomies of scale occur when an increase in a firm’s scale of production leads to higher average costs per unit produced.

Copyright 2002, Pearson Education Canada12 Long-Run Average Cost Curve (Figure 9.5) zThe long-run average cost curve is a graph that shows the different scales on which a firm can choose to operate in the long run. In the graph below the firm exhibits economies of scale.

Copyright 2002, Pearson Education Canada13 A Firm Exhibiting Economies and Diseconomies of Scale (Figure 9.6) zBeyond q* the firm experience diseconomies of scale, and therefore q* is the level of production at lowest average cost, using optimal scale of plant.

Copyright 2002, Pearson Education Canada14 Long-Run Adjustments to Short-Run Conditions zFirms 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 economic profits are being earned. zIn the long run, equilibrium price (P*) is equal to long-run average cost, short-run average cost, and short-run marginal cost. Economic profits are driven to zero.

Copyright 2002, Pearson Education Canada15 Firms Expand Along in the Long Run When Increasing Returns to Scale Are Available (Figure 9.7) zFirms will be pushed by competition to produce at their optimal scales and the price will be driven to the minimum point on the LRAC curve. Profits will be driven to zero.

Copyright 2002, Pearson Education Canada16 Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses (Figure 9.8) zAs long as losses are being sustained in an industry, firms will shut down and leave the industry. The shift in supply and the gradual price rise reduce losses until profits are zero again.

Copyright 2002, Pearson Education Canada17 Long-run Competitive Equilibrium zLong-run competitive equilibrium exists when: P = SRMC = SRAC = LRAC and economic profit is equal to zero.

Copyright 2002, Pearson Education Canada18 Investment Flows Toward Profit Opportunities zIn competitive markets, investment capital flows toward profit opportunities. The actual process is complex and varies from industry to industry. zInvestment, in the form of new firms and expanding old firms, will, over time, tend to favour those industries in which profits are being made. zAt the same time, industries in which firms are suffering losses will gradually contract from disinvestment.

Copyright 2002, Pearson Education Canada19 Review Terms & Concepts zbreaking even zconstant returns to scale zdecreasing returns to scale (diseconomies of scale) zincreasing returns to scale (economies of scale) zlong-run average cost (LRAC) zlong-run competitive equilibrium zoperating profit (or loss) zoptimal scale of plant zshort-run industry supply curve zshut down point