Slide MGT101 Slide09
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Fernando & Yvonn
Quijano
9
Chapter
Long-Run Costs
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© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 36
Chapter Outline
9
Long-Run Costs
and Output Decisions
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
Long-Run Adjustments to Short-Run Conditions
Short-Run Profits: Expansion to Equilibrium Short-Run Losses: Contraction to 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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LONG-RUN COSTS AND OUTPUT DECISIONS
We begin our discussion of the long run by looking at firms
in three short-run circumstances:
(1)
firms earning economic profits,
(2)
firms suffering economic losses but continuing to
operate to reduce or minimize those losses, and
(3)
firms that decide to shut down and bear losses just
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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.
Example: The Blue Velvet Car Wash
MAXIMIZING PROFITS
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.) 1,000
$ 1,600 Profit (TR TC) $ 400
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
Graphic Presentation
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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).
In general,
■
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.
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
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)
$
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)
$
800
Total profit/loss (TR TC)
$ 1,200
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
Graphic Presentation
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
ATC
=
AFC
+
AVC
or
AFC = ATC AVC =
$4.10 $3.10 = $1.00
Remember that average total cost is equal to average
fixed cost plus average variable cost. This means that
at every level of output, average fixed cost is the
difference between average total and average variable
cost:
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.
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
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)
$
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)
$
400
Total profit/loss (TR TC)
$ 2,400
Any time that price (average revenue) is below the minimum point on the average variable
cost curve, total revenue will be less than total variable cost, and operating profit will be
negative
—
that is, there will be a loss on operation. In other words, when price is below all
points on the average variable cost curve, the firm will suffer operating losses at any possible
output level the firm could choose. When this is the case, the firm will stop producing and
bear losses equal to fixed costs. This is why the bottom of the average variable cost curve is
called the shut-down point. At all prices above it, the marginal cost curve shows the
profit-maximizing level of output. At all prices below it, optimal short-run output is zero.
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
The short-run supply curve of a competitive firm is that portion of its marginal cost
curve that lies above its average variable cost curve (Figure 9.3).
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.
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
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
short-run industry supply curve The
sum of the marginal cost curves (above
AVC) of all the firms in an industry.
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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
P = MC: operate
Contract: firms exit
(TR TVC)
(losses < fixed costs)
2. With operating losses
Shut down:
Contract: firms exit
(TR < TVC)
losses = fixed costs
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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.
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
INCREASING RETURNS TO SCALE
The Sources of Economies of Scale
Most of the economies of scale that immediately
come to mind are technological in nature.
Some economies of scale result not from technology
but from sheer size.
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF 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
$.074 per egg
CHICKEN LITTLE EGG FARMS INC.
TOTAL WEEKLY COSTS
Labor
$ 5,128
Feed, other variable costs
4,115
Transport costs
2,431
Land and capital costs
19,230
$30,904
Total output
1,600,000 eggs
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
Graphic Presentation
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.
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
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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.
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
DECREASING RETURNS TO SCALE
FIGURE 9.6
A Firm Exhibiting Economies and Diseconomies of Scale
All short-run average cost curves are U-shaped, because we assume a fixed scale of plant
that constrains production and drives marginal cost upward as a result of diminishing
returns. In the long run, we make no such assumption; instead, we assume that scale of
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
optimal scale of plant The scale of plant
that minimizes average cost.
It is important to note that economic efficiency requires
taking advantage of economies of scale (if they exist)
and avoiding diseconomies of scale.
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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS
THE LONG-RUN ADJUSTMENT MECHANISM:
INVESTMENT FLOWS TOWARD PROFIT
OPPORTUNITIES
In efficient markets, investment capital flows toward profit opportunities.
The actual process is complex and varies from industry to industry.
When firms in an industry are making
positive profits, capital is likely to flow
into that industry. Entrepreneurs start
new firms, and firms producing entirely
different products may join the
competition. The success of Ben and
Jerry’s has inspired a slew of imitators
to compete in the ice cream industry.
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breaking even
constant returns to scale
decreasing returns to scale,
or diseconomies of scale
increasing returns to scale,
or economies of scale
long-run average cost curve
(LRAC)
REVIEW TERMS AND CONCEPTS
operating profit (or loss) or net
operating revenue
optimal scale of plant
short-run industry supply curve
shut-down point
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
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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
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© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 36
LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
DECREASING RETURNS TO SCALE
FIGURE 9.6 A Firm Exhibiting Economies and Diseconomies of Scale
All short-run average cost curves are U-shaped, because we assume a fixed scale of plant that constrains production and drives marginal cost upward as a result of diminishing returns. In the long run, we make no such assumption; instead, we assume that scale of plant can be changed.
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LONG-RUN COSTS: ECONOMIES
AND DISECONOMIES OF SCALE
optimal scale of plant
The scale of plant
that minimizes average cost.
It is important to note that economic efficiency requires taking advantage of economies of scale (if they exist) and avoiding diseconomies of scale.
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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS
THE LONG-RUN ADJUSTMENT MECHANISM:
INVESTMENT FLOWS TOWARD PROFIT
OPPORTUNITIES
In efficient markets, investment capital flows toward profit opportunities. The actual process is complex and varies from industry to industry.
When firms in an industry are making positive profits, capital is likely to flow into that industry. Entrepreneurs start new firms, and firms producing entirely different products may join the
competition. The success of Ben and
Jerry’s has inspired a slew of imitators
(6)
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breaking even
constant returns to scale decreasing returns to scale,
or diseconomies of scale increasing returns to scale,
or economies of scale
long-run average cost curve (LRAC)
REVIEW TERMS AND CONCEPTS
operating profit (or loss) or net operating revenue
optimal scale of plant
short-run industry supply curve shut-down point