Long-Run Costs and Output Decisions

C HAPTE R 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
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.
Firm Earning Positive
Profits in the Short Run
• To maximize profit, the firm sets the level of output

where marginal revenue equals marginal cost.
Firm Earning Positive
Profits in the Short Run
• Profit is the positive difference between total revenue

(TR) and total cost (TC).
Minimizing Losses
• 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.
Minimizing Losses
• 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.
Minimizing Losses
• When price equals $3.50, revenue is sufficient to

cover total variable cost but not total cost.
Minimizing Losses
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 - $ 800

TVC)
Total profit/loss (TR - TC) - $ 1,200
Minimizing Losses
• As long as price is sufficient to cover average variable costs,

the firm stands to gain by operating instead of shutting down.
Minimizing Losses
• The difference between ATC and AVC equals AFC.

Then, AFC  q = TFC.
Shutting Down to Minimize Loss
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 - -$ 400
TVC)
Total profit/loss (TR - TC) - $ 2,400
Short-Run Supply Curve
of a Perfectly Competitive Firm
• 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.
Short-Run Supply Curve
of a Perfectly Competitive Firm
• 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.
The Short-Run Industry Supply Curve
• 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.
Profits, Losses, and Perfectly Competitive
Firm Decisions in the Long and Short Run
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.
Long-Run Costs: Economies and
Diseconomies of Scale
• 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.
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
Average cost $.019 per egg
A Firm Exhibiting Economies of Scale
• The long run average cost curve of a firm

exhibiting economies of scale is downward-
sloping.
The Long-Run Average Cost Curve
• 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.
Constant Returns to Scale
• 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.
Decreasing Returns to Scale
• 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.
A Firm Exhibiting Economies
and Diseconomies of Scale
• The LRAC curve of a firm that eventually

exhibits diseconomies of scale becomes
upward-sloping.
Optimal Scale of Plant
• The optimal scale of plant is the scale

that minimizes average cost.
Long-Run Adjustments
to Short-Run Conditions
• Firms expand in the long-run when

increasing returns to scale are available.
Short-Run Profits:
Expansion to Equilibrium
• Firms expand in the long run when

increasing returns to scale are available.
Short-Run Losses:
Contraction to Equilibrium
• When firms in an industry suffer losses,

there is an incentive for them to exit.
Short-Run Losses:
• As firms exit, the supply curve shifts from

S to S’, driving price up to P*.
Short-Run Losses:
• The industry eventually returns to long-

run equilibrium and losses are eliminated.
Long-Run Competitive 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

The Long-Run Adjustment Mechanism:
Investment Flows Toward Profit Opportunities
• 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.
Long-Run Adjustment Mechanism:
Investment Flows Toward Profit Opportunities
• 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.
Review Terms and Concepts
breaking even operating profit (or loss) or net

constant return to scales operating revenue
decreasing returns to scale, or optimal scale of plant

diseconomies of scale short-run industry supply curve
increasing returns to scale, or shut-down point
economies of scale
long-run competitive equilibrium:
long-run average cost curve P = SRMC = SRAC =
(LRAC) LRAC
long-run competitive equilibrium
Appendix: External Economies and Diseconomies
and the Long-Run Industry Supply Curve
• 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.
• 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.
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.
• In a decreasing cost industry, costs decline

as a result of industry expansion, and the
LRIS is downward-sloping.
• In an increasing cost industry, costs rise as

a result of industry expansion, and the
LRIS is upward-sloping.

Long-Run Costs and Output Decisions

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C HAPTE R 8

Prepared by: Fernando Quijano

• Profit is the difference between total

Blue Velvet Car Wash Weekly Costs

• Revenue is sufficient to cover both fixed costs of

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

• Profit is the positive difference between total revenue

• Operating profit (or loss) or net

• Operating profit (or loss) or net

• When price equals $3.50, revenue is sufficient to

A Firm Will Operate If Total Revenue Covers Total Variable Cost

Fixed costs $ 2,000 Fixed costs $ 2,000

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

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

• The difference between ATC and AVC equals AFC.

• The shut-down point is

• The short-run supply

• The industry supply curve in the short-run is the

SHORT-RUN SHORT-RUN LONG-RUN

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

• Increasing returns to scale, or

JONES FARM TOTAL WEEKLY COSTS

• The long run average cost curve of a firm

• The long-run average cost

• Constant returns to scale refers

• Decreasing returns to scale, or

• The LRAC curve of a firm that eventually

• The optimal scale of plant is the scale

• Firms expand in the long-run when

• Firms expand in the long run when

• When firms in an industry suffer losses,

• As firms exit, the supply curve shifts from

• The industry eventually returns to long-

• In the long run, equilibrium price

P*  SRMC  SRAC  LRAC

• The central idea in our discussion of

• The central idea in our discussion of entry, exit,

breaking even operating profit (or loss) or net

decreasing returns to scale, or optimal scale of plant

• Economies of scale that are found within

• The long-run industry supply curve

Construction Activity and the Price of Lumber

• In a decreasing cost industry, costs decline

• In an increasing cost industry, costs rise as

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