CHAPTER 8

Long-Run Costs
and Output Decisions
Appendix: External Economies and Diseconomies and the
Long-Run Industry Supply Curve

Prepared by: Fernando Quijano

and Yvonn Quijano

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair
 Short-Run Conditions
and Long-Run Directions
C H A P T E R 8: Long-Run Costs and Output Decisions

• Profit is the difference between total

revenue and total economic cost.

• Total economic cost includes a

normal rate of return, or the rate that
is just sufficient to keep current
investors interested in the industry.

• Breaking even is a situation in

which a firm earns exactly a normal
rate of return.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 38
 Maximizing Profits
C H A P T E R 8: Long-Run Costs and Output Decisions

Blue Velvet Car Wash Weekly Costs

TOTAL VARIABLE COSTS TOTAL COSTS
TOTAL FIXED COSTS (TFC) (TVC) (800 WASHES) (TC = TFC + TVC) $ 3,600
1. Normal return to 1. Labor $1,000 Total revenue (TR)
investors $ 1,000 2. Materials 600 at P = $5 (800 x $5) $ 4,000
2. Other fixed costs $1,600 Profit (TR  TC) $ 400
(maintenance contract,
insurance, etc.) 1,000
$ 2,000

• Revenue is sufficient to cover both fixed costs of

$2,000 and variable costs of $1,600, leaving a
positive economic profit of $400 per week.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 3 of 38
 Firm Earning Positive
Profits in the Short Run
C H A P T E R 8: Long-Run Costs and Output Decisions

• To maximize profit, the firm sets the level of output

where marginal revenue equals marginal cost.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 4 of 38
 Firm Earning Positive
Profits in the Short Run
C H A P T E R 8: Long-Run Costs and Output Decisions

• Profit is the difference between total revenue and

total cost.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 5 of 38
 Minimizing Losses
C H A P T E R 8: Long-Run Costs and Output Decisions

• Operating profit (or loss) or net

operating revenue equals 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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 6 of 38
 Minimizing Losses
C H A P T E R 8: Long-Run Costs and Output Decisions

• Operating profit (or loss) or net

operating revenue equals total
revenue minus total variable cost
(TR – TVC).
• 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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 7 of 38
 Minimizing Losses
C H A P T E R 8: Long-Run Costs and Output Decisions

• When price equals $3.50, revenue is sufficient to

cover total variable cost but not total cost.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 8 of 38
 Minimizing Losses
C H A P T E R 8: Long-Run Costs and Output Decisions

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 $ 2,000 Fixed costs $ 2,000

Variable costs + 0 Variable costs + 1,600
Total costs $ 2,000 Total costs $ 3,600

Profit/loss (TR  TC)  $ 2,000 Operating profit/loss (TR  TVC) $ 800

Total profit/loss (TR  TC)  $ 1,200

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 9 of 38
 Minimizing Losses
C H A P T E R 8: Long-Run Costs and Output Decisions

• As long as price is sufficient to cover average variable costs,

the firm stands to gain by operating instead of shutting down.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 10 of 38
 Minimizing Losses
C H A P T E R 8: Long-Run Costs and Output Decisions

• The difference between ATC and AVC equals AFC.

Then, AFC  q = TFC.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 11 of 38
 Shutting Down to Minimize Loss
C H A P T E R 8: Long-Run Costs and Output Decisions

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 $ 2,000 Fixed costs $ 2,000

Variable costs + 0 Variable costs + 1,600
Total costs $ 2,000 Total costs $ 3,600

Profit/loss (TR  TC)  $ 2,000 Operating profit/loss (TR  TVC)  $ 400

Total profit/loss (TR  TC)  $ 2,400

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 12 of 38
 Short-Run Supply Curve
of a Perfectly Competitive Firm
C H A P T E R 8: Long-Run Costs and Output Decisions

• The shut-down 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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 13 of 38
 Short-Run Supply Curve
of a Perfectly Competitive Firm
C H A P T E R 8: Long-Run Costs and Output Decisions

• 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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 14 of 38
 The Short-Run Industry Supply Curve
C H A P T E R 8: Long-Run Costs and Output Decisions

• 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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 15 of 38
 Profits, Losses, and Perfectly Competitive
Firm Decisions in the Long and Short Run
C H A P T E R 8: Long-Run Costs and Output Decisions

SHORT-RUN SHORT-RUN LONG-RUN

CONDITION DECISION 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

• In the short-run, firms have to decide how

much to produce in the current scale of plant.
• In the long-run, firms have to choose among
many potential scales of plant.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 16 of 38
 Long-Run Costs: Economies and
Diseconomies of Scale
C H A P T E R 8: Long-Run Costs and Output Decisions

• Increasing returns to
scale, or economies of
scale, refers to an
increase in a firm’s scale
of production, which
leads to lower average
costs per unit produced.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 17 of 38
 Weekly Costs Showing
Economies of Scale in Egg Production
C H A P T E R 8: Long-Run Costs and Output Decisions

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
Average cost $.019 per egg

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 18 of 38
 A Firm Exhibiting Economies of Scale
C H A P T E R 8: Long-Run Costs and Output Decisions

• The long run average cost curve of a firm

exhibiting economies of scale is downward-
sloping.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 19 of 38
 The Long-Run Average Cost Curve
C H A P T E R 8: Long-Run Costs and Output Decisions

• The long-run average cost

curve (LRAC) is a graph that
shows the different scales on
which a firm can choose to
operate in the long-run. Each
scale of operation defines a
different short-run.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 20 of 38
 Constant Returns to Scale
C H A P T E R 8: Long-Run Costs and Output Decisions

• Constant returns to
scale refers to an
increase in a firm’s scale
of production, which has
no effect on average
costs per unit produced.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 21 of 38
 Decreasing Returns to Scale
C H A P T E R 8: Long-Run Costs and Output Decisions

• Decreasing returns to
scale, or diseconomies
of scale, refers to an
increase in a firm’s scale
of production, which
leads to higher average
costs per unit produced.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 22 of 38
 A Firm Exhibiting Economies
and Diseconomies of Scale
C H A P T E R 8: Long-Run Costs and Output Decisions

• The LRAC curve of a firm that eventually

exhibits diseconomies of scale becomes
upward-sloping.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 23 of 38
 Optimal Scale of Plant
C H A P T E R 8: Long-Run Costs and Output Decisions

• The optimal scale of plant is the scale

that minimizes average cost.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 24 of 38
 Long-Run Adjustments
to Short-Run Conditions
C H A P T E R 8: Long-Run Costs and Output Decisions

• Firms expand in the long-run when

increasing returns to scale are available.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 25 of 38
 Short-Run Profits:
Expansion to Equilibrium
C H A P T E R 8: Long-Run Costs and Output Decisions

• Firms expand in the long run when

increasing returns to scale are available.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 26 of 38
 Short-Run Losses:
Contraction to Equilibrium
C H A P T E R 8: Long-Run Costs and Output Decisions

• When firms in an industry suffer losses,

there is an incentive for them to exit.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 27 of 38
 Short-Run Losses:
Contraction to Equilibrium
C H A P T E R 8: Long-Run Costs and Output Decisions

• As firms exit, the supply curve shifts from S

to S’, driving price up to P*.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 28 of 38
 Short-Run Losses:
Contraction to Equilibrium
C H A P T E R 8: Long-Run Costs and Output Decisions

• The industry eventually returns to long-run

equilibrium and losses are eliminated.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 29 of 38
 Long-Run Competitive Equilibrium
C H A P T E R 8: Long-Run Costs and Output Decisions

• 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

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 30 of 38
 The Long-Run Adjustment Mechanism:
Investment Flows Toward Profit Opportunities
C H A P T E R 8: Long-Run Costs and Output Decisions

• The central idea in our discussion of

entry, exit, expansion, and
contraction is this:
• In efficient markets, investment capital
flows toward profit opportunities.
• The actual process is complex and
varies from industry to industry.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 31 of 38
 Long-Run Adjustment Mechanism:
Investment Flows Toward Profit Opportunities
C H A P T E R 8: Long-Run Costs and Output Decisions

• The central idea in our discussion of

entry, exit, expansion, and
contraction is this:
• 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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 32 of 38
 Review Terms and Concepts
C H A P T E R 8: Long-Run Costs and Output Decisions

breaking even operating profit (or loss) or net operating

revenue
constant return to scales
optimal scale of plant
decreasing returns to scale, or disec
onomies of scale short-run industry supply curve

increasing returns to scale, or econo shut-down point

mies of scale
long-run competitive equilibrium:
long-run average cost curve (LRAC) P = SRMC = SRAC = LRAC

long-run competitive equilibrium

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 33 of 38
 Appendix: External Economies and Diseconomies
and the Long-Run Industry Supply Curve
C H A P T E R 8: Long-Run Costs and Output Decisions

• Economies of scale that are found

within the individual firm are called
internal economies of scale.

• External economies of scale

describe economies or diseconomies
of scale on an industry-wide basis.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 34 of 38
 Appendix: External Economies and Diseconomies
and the Long-Run Industry Supply Curve
C H A P T E R 8: Long-Run Costs and Output Decisions

• The long-run industry supply

curve (LRIS) traces output over time
as the industry expands.

• When an industry enjoys external

economies, its long-run supply curve
slopes down. Such an industry is
called a decreasing-cost industry.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 35 of 38
 Appendix: External Economies and Diseconomies
and the Long-Run Industry Supply Curve
C H A P T E R 8: Long-Run Costs and Output Decisions

Construction Activity and the Price of Lumber

Products, 1991 - 1994
PERCENTAGE PERCENTAGE
MONTHLY INCREASE CHANGE IN THE PERCENTAGE
AVERAGE, NEW OVER THE PRICE OF CHANGE IN
HOUSING PREVIOUS LUMBER CONSUMER
YEAR PERMITS YEAR PRODUCTS PRICES
1991 79,500 - - -

1992 92,167 + 15.9 + 14.7 + 3.0

1993 100,917 + 9.5 + 24.6 + 3.0

1994 111,000 + 10.0 NA + 2.1

Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21;
Statistical Abstract of the United States, 1994, Tables 754, 755.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 36 of 38
 Appendix: External Economies and Diseconomies
and the Long-Run Industry Supply Curve
C H A P T E R 8: Long-Run Costs and Output Decisions

• In a decreasing cost industry, costs decline

as a result of industry expansion, and the
LRIS is downward-sloping.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 37 of 38
 Appendix: External Economies and Diseconomies
and the Long-Run Industry Supply Curve
C H A P T E R 8: Long-Run Costs and Output Decisions

• In an increasing cost industry, costs rise as

a result of industry expansion, and the LRIS
is upward-sloping.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 38 of 38