Long-Run Costs and Output Decisions

Transcription

1 Chapter 9 Long-Run Costs and Prepared by: Fernando & Yvonn Quijano 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

2 Long-Run Costs and 9 Chapter Outline 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 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 36

3 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 equal to fixed costs Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 36

4 SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS breaking even The situation in which a firm is earning exactly a normal rate of return. 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, Normal return to investors $ 1, Labor Materials $ 1, Total revenue (TR) at P = $5 (800 x $5) $ 4, Other fixed costs (maintenance contract, insurance, etc.) 1,000 $ 2,000 $ 1,600 Profit (TR TC) $ Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 36

5 SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS Graphic Presentation FIGURE 9.1 Firm Earning Positive Profits in the Short Run 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 36

6 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 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 36

7 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 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, Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 36

8 SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS Graphic Presentation FIGURE 9.2 Firm Suffering Losses but Showing an Operating Profit in the Short Run 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 36

9 SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS 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: ATC = AFC + AVC or AFC = ATC AVC = $4.10 $3.10 = $1.00 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 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 36

10 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 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 profitmaximizing level of output. At all prices below it, optimal short-run output is zero Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 36

11 SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS 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. 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) Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 36

12 SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS FIGURE 9.3 Short-Run Supply Curve of a Perfectly Competitive Firm 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 36

13 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 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 36

14 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 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 36

15 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 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 36

16 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 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 36

17 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 Average cost 1,600,000 eggs $.019 per egg 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 36

18 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 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 36

19 LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE FIGURE 9.5 A Firm Exhibiting Economies of Scale 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 36

20 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 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 36

21 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 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 36

22 LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF SCALE It is important to note that economic efficiency requires taking advantage of economies of scale (if they exist) and avoiding diseconomies of scale. optimal scale of plant The scale of plant that minimizes average cost Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 36

23 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 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 36

24 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) operating profit (or loss) or net operating revenue optimal scale of plant short-run industry supply curve shut-down point 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 36