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PowerPoint Lectures for Principles of Economics,
9e By Karl E. Case, Ray C. Fair Sharon M.
Oster

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(No Transcript)
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Long-Run Costs and Output Decisions
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Prepared by
Fernando Yvonn Quijano
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Long-Run Costs and Output Decisions
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CHAPTER OUTLINE
Short-Run Conditions and Long- Run
Directions Maximizing ProfitsMinimizing
LossesThe Short-Run Industry Supply
CurveLong-Run Directions A Review Long-Run
Costs Economies and Diseconomies of
Scale Increasing Returns to ScaleConstant
Returns to ScaleDecreasing Returns to
Scale Long-Run Adjustmentsto Short-Run
Conditions Short-Run Profits Expansion to
EquilibriumShort-Run Losses Contraction to
EquilibriumThe Long-Run Adjustment Mechanism
Investment Flows toward Profit Opportunities Outpu
t 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
• 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.
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Short-Run Conditions and Long-Run Directions
Maximizing Profits
Example The Blue Velvet Car Wash
TABLE 9.1 Blue Velvet Car Wash Weekly Costs TABLE 9.1 Blue Velvet Car Wash Weekly Costs TABLE 9.1 Blue Velvet Car Wash Weekly Costs TABLE 9.1 Blue Velvet Car Wash Weekly Costs TABLE 9.1 Blue Velvet Car Wash Weekly Costs TABLE 9.1 Blue Velvet Car Wash Weekly Costs TABLE 9.1 Blue Velvet Car Wash Weekly Costs TABLE 9.1 Blue Velvet Car Wash Weekly Costs TABLE 9.1 Blue Velvet Car Wash Weekly Costs TABLE 9.1 Blue Velvet Car Wash Weekly Costs TABLE 9.1 Blue Velvet Car Wash Weekly Costs TABLE 9.1 Blue Velvet Car Wash Weekly Costs TABLE 9.1 Blue Velvet Car Wash Weekly Costs
Total Fixed Costs (TFC) Total Fixed Costs (TFC) Total Fixed Costs (TFC) Total Fixed Costs (TFC) Total Variable Costs(TVC) (800 Washes) Total Variable Costs(TVC) (800 Washes) Total Variable Costs(TVC) (800 Washes) Total Variable Costs(TVC) (800 Washes) Total Variable Costs(TVC) (800 Washes) Total Costs(TC TFC TVC) Total Costs(TC TFC TVC) 3,600

1. Normal return to investors 1,000 1.2. LaborMaterials 1,000600 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
2,000

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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.
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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).
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
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 TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost
CASE 1 Shut Down CASE 1 Shut Down CASE 1 Shut Down CASE 1 Shut Down CASE 1 Shut Down CASE 1 Shut Down CASE 2 Operate at Price 3 CASE 2 Operate at Price 3 CASE 2 Operate at Price 3 CASE 2 Operate at Price 3

Total Revenue (q 0) 0 Total Revenue (3 x 800) Total Revenue (3 x 800) 2,400
Fixed costsVariable costsTotal costs 2,00002,000 Fixed costsVariable costsTotal costs Fixed costsVariable costsTotal costs 2,0001,6003,600
Profit/loss (TR - TC) - 2,000 Operating profit/loss (TR - TVC) Operating profit/loss (TR - TVC) 800
Total profit/loss (TR - TC) Total profit/loss (TR - TC) - 1,200

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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.
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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 TABLE 9.3 A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost TABLE 9.3 A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost TABLE 9.3 A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost TABLE 9.3 A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost TABLE 9.3 A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost TABLE 9.3 A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost TABLE 9.3 A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost TABLE 9.3 A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost TABLE 9.3 A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost
Case 1 Shut Down Case 1 Shut Down Case 1 Shut Down Case 1 Shut Down Case 1 Shut Down CASE 2 Operate at Price 1.50 CASE 2 Operate at Price 1.50 CASE 2 Operate at Price 1.50 CASE 2 Operate at Price 1.50

Total Revenue (q 0) 0 Total revenue (1.50 x 800) 1,200
Fixed costsVariable costsTotal costs 2,00002,000 Fixed costsVariable costsTotal costs 2,0001,6003,600
Profit/loss (TR - TC) - 2,000 Operating profit/loss (TR - TVC) - 400
Total profit/loss (TR - TC) - 2,400

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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.
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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.
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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 TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run 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 gt TC P MC operate Expand new firms enter
Losses 1. With operating profit P MC operate Contract firms exit
(TR ? TVC) (losses lt fixed costs)
2. With operating losses Shut down Contract firms exit
(TR lt 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 firms scale of
production leads to lower costs per unit produced.
constant returns to scale An increase in a
firms scale of production has no effect on costs
per unit produced.
decreasing returns to scale, or diseconomies of
scale An increase in a firms 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
Example Economies of Scale in Egg Production
TABLE 9.5 Weekly Costs Showing Economies of Scale in Egg Production TABLE 9.5 Weekly Costs Showing Economies of Scale in Egg Production TABLE 9.5 Weekly Costs Showing Economies of Scale in Egg Production TABLE 9.5 Weekly Costs Showing Economies of Scale in Egg Production
Jones Farm Jones Farm Total Weekly Costs Total Weekly Costs
15 hours of labor (implicit value 8 per hour) 15 hours of labor (implicit value 8 per hour) 120
Feed, other variable costs Feed, other variable costs 25
Transport costs Transport costs 15
Land and capital costs attributable to egg production Land and capital costs attributable to egg production 17
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Total output 2,400 eggs
Average cost 0.074 per egg
Chicken Little Egg Farms Inc. Chicken Little Egg Farms Inc. Total Weekly Costs Total Weekly Costs
Labor Labor 5,128
Feed, other variable costs Feed, other variable costs 4,115
Transport costs Transport costs 2,431
Land and capital costs Land and capital costs 19,230
30,904
Total output 1,600,000 eggs
Average cost 0.019 per egg
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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.
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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 firms long-run average cost curve
remains flat.
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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 firms 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.
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Long-Run Costs Economies and Diseconomies of
Scale
Blood bank merger good for Manatee Bradenton
Herald.com
Northwest needed to be aligned with a larger
organization to achieve economy of scale, said
J.B. Gaskins, Florida Blood Services vice
president. That economy of scale is good for the
whole network, including Manatee County.
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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.
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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.
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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.
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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 plantthat is, at the minimum point on their
LRAC curve.
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The Long-Run Average Cost CurveFlat 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,
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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.
Investmentin the form of new firms and expanding
old firmswill 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.
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Long-Run Adjustments to Short-Run Conditions
Why Are Hot Dogs So Expensive in Central Park?
The Long-Run Adjustment Mechanism Investment
Flows Toward Profit Opportunities
In New York, you need alicense to operate a hot
dogcart, and a license to operatein the park
costs more. Sincehot dogs are .50 more in
thepark, the added cost of alicense each year
must be roughly .50 per hot dog sold. In fact,
in New York City, licenses to sell hot dogs in
the park are auctioned off for many thousands of
dollars, while licenses to operate outside the
park cost only about 1,000.
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Output Markets A Final Word
In the last four chapters, we have been building
a model of a simple market system under the
assumption of perfect competition. You have now
seen what lies behind the demand curves and
supply curves in competitive output markets. The
next two chapters take up competitive input
markets and complete the picture.
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REVIEW TERMS AND CONCEPTS
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)
long-run competitive equilibrium operating profit
(or loss) or net operating revenue optimal scale
of plant short-run industry supply
curve shut-down point long-run competitive
equilibrium, P SRMC SRAC LRAC
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A P P E N D I X
EXTERNAL ECONOMIES AND DISECONOMIES AND THE
LONG-RUN INDUSTRY SUPPLY CURVE
When long-run average costs decrease as a result
of industry growth, we say that there are
external economies.
When average costs increase as a result of
industry growth, we say that there are external
diseconomies.
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A P P E N D I X
EXTERNAL ECONOMIES AND DISECONOMIES AND THE
LONG-RUN INDUSTRY SUPPLY CURVE
Example of an expanding industry facing external
diseconomies of scale
TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 20002005 TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 20002005 TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 20002005 TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 20002005 TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 20002005 TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 20002005
Year House Prices Change Over the Previous Year Housing Starts(Thousands) Housing Starts Change Over The Previous Year Construction Materials Prices Change Over The Previous Year Consumer Prices Change Over The Previous Year

2000 - 1,573 - - -
2001 7.5 1,661 5.6 0 2.8
2002 7.5 1,710 2.9 1.5 1.5
2003 7.9 1,853 8.4 1.6 2.3
2004 12.0 1,949 5.2 8.3 2.7
2005 13.0 2,053 5.3 5.4 2.5
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A P P E N D I X
THE LONG-RUN INDUSTRY SUPPLY CURVE
long-run industry supply curve (LRIS) A graph
that traces out price and total output over time
as an industry expands.
decreasing-cost industry An industry that
realizes external economiesthat is, average
costs decrease as the industry grows. The
long-run supply curve for such an industry has a
negative 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.
increasing-cost industry An industry that
encounters external diseconomiesthat is, average
costs increase as the industry grows. The
long-run supply curve for such an industry has a
positive slope.
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Appendix
A P P E N D I X
THE LONG-RUN INDUSTRY SUPPLY CURVE
? 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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Appendix
A P P E N D I X
THE LONG-RUN INDUSTRY SUPPLY CURVE
? 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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REVIEW TERMS AND CONCEPTS

• constant-cost industry
• decreasing-cost industry
• external economies and diseconomies
• increasing-cost industry
• long-run industry supply curve (LRIS)