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© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
CHAPTERCHAPTER 88
Prepared by: Fernando QuijanoPrepared by: Fernando Quijano
and Yvonn Quijanoand Yvonn Quijano
Costs and Output Decisions inCosts and Output Decisions in
the Long Runthe Long Run

The Concept of ProfitThe Concept of Profit
• ProfitProfit is the difference between total revenueis the difference between total revenue
and total cost.and total cost.
• The economic concept of profit takes intoThe economic concept of profit takes into
account the opportunity cost of capital.account the opportunity cost of capital.
• Total economic cost includes a normal rate ofTotal economic cost includes a normal rate of
return. Areturn. A normal rate of returnnormal rate of return is the rate that isis the rate that is
just sufficient to keep current investors interestedjust sufficient to keep current investors interested
in the industry.in the industry.
• Breaking evenBreaking even is a situation in which a firm isis a situation in which a firm is
earning exactly a normal rate of return.earning exactly a normal rate of return.

Blue Velvet Car Wash Weekly CostsBlue Velvet Car Wash Weekly Costs
Maximizing Profit–An ExampleMaximizing Profit–An Example
• If Blue Velvet washes 800 cars each week, itIf Blue Velvet washes 800 cars each week, it
takes in revenues of $4,000.takes in revenues of $4,000.
• This revenue is sufficient to cover both fixed costsThis revenue is sufficient to cover both fixed costs
of $2,000 and variable costs of $1,600, leaving aof $2,000 and variable costs of $1,600, leaving a
positive economic profit of $400 per week.positive economic profit of $400 per week.
TOTAL FIXED COSTS (TOTAL FIXED COSTS (TFCTFC))
TOTAL VARIABLE COSTSTOTAL VARIABLE COSTS
((TVCTVC) (800 WASHES)) (800 WASHES)
TOTAL COSTSTOTAL COSTS
((TCTC == TFCTFC ++ TVCTVC)) $$ 3,6003,600
1.1. Normal return toNormal return to
investorsinvestors $$ 1,0001,000
1.1.
2.2.
LaborLabor
MaterialsMaterials
$$1,0001,000
600600
Total revenue (Total revenue (TRTR))
atat PP = $5 (800 x $5)= $5 (800 x $5) $$ 4,0004,000
2.2. Other fixed costsOther fixed costs
(maintenance contract,(maintenance contract,
insurance, etc.)insurance, etc.) 1,0001,000
$$1,6001,600 Profit (Profit (TRTR −− TCTC)) $$ 400400
$$ 2,0002,000

Firm Earning Positive Profits in theFirm Earning Positive Profits in the
Short RunShort Run
• To maximize profit, the firm sets the level of outputTo maximize profit, the firm sets the level of output
where marginal revenue equals marginal cost.where marginal revenue equals marginal cost.

Firm Earning Positive Profits in theFirm Earning Positive Profits in the
Short RunShort Run
• Profit is the difference between total revenue andProfit is the difference between total revenue and
total cost.total cost.

Minimizing LossesMinimizing Losses
• Operating profit (or loss)Operating profit (or loss) oror netnet
operating revenueoperating revenue equals total revenueequals total revenue
minus total variable cost (TR – TVC).minus total variable cost (TR – TVC).
• If revenues exceed variable costs, operatingIf revenues exceed variable costs, operating
profit is positive and can be used to offset fixedprofit is positive and can be used to offset fixed
costs and reduce losses, and it will pay the firmcosts and reduce losses, and it will pay the firm
to keep operating.to keep operating.

• If revenues are smaller than variable costs, theIf revenues are smaller than variable costs, the
firm suffers operating losses that push totalfirm suffers operating losses that push total
losses above fixed costs. In this case, the firmlosses above fixed costs. In this case, the firm
can minimize its losses by shutting down.can minimize its losses by shutting down.
• Operating profit (or loss)Operating profit (or loss) oror netnet
operating revenueoperating revenue equals total revenueequals total revenue
minus total variable cost (TR – TVC).minus total variable cost (TR – TVC).

A Firm Will Operate If Total Revenue Covers Total Variable CostA Firm Will Operate If Total Revenue Covers Total Variable Cost
CASE 1: SHUT DOWNCASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $3CASE 2: OPERATE AT PRICE = $3
Total Revenue (Total Revenue (qq = 0)= 0) $$ 00 Total Revenue ($3 x 800)Total Revenue ($3 x 800) $$ 2,4002,400
Fixed costsFixed costs
Variable costsVariable costs
Total costsTotal costs
++
$$
$$
2,0002,000
00
2,0002,000
++
$$
$$
2,0002,000
1,6001,600
3,6003,600
Profit/loss (Profit/loss (TRTR −− TCTC)) −− $$ 2,0002,000 Operating profit/loss (Operating profit/loss (TRTR −− TVCTVC)) $$ 800800
Total profit/loss (Total profit/loss (TRTR −− TCTC)) −− $$ 1,2001,200

• When price equals $3.50, revenue is sufficient toWhen price equals $3.50, revenue is sufficient to
cover total variable cost but not total cost.cover total variable cost but not total cost.

• As long as price (which is equal to average revenue perAs long as price (which is equal to average revenue per
unit) is sufficient to cover average variable costs, the firmunit) is sufficient to cover average variable costs, the firm
stands to gain by operating instead of shutting down.stands to gain by operating instead of shutting down.

• The difference betweenThe difference between ATCATC andand AVCAVC equalsequals
AFCAFC. Then,. Then, AFCAFC  qq == TFCTFC (the brown area).(the brown area).

• The blue area equals losses.The blue area equals losses.
• The green area equals operating profit.The green area equals operating profit.

A Firm Will Shut Down If Total Revenue Is Less Than Total VariableA Firm Will Shut Down If Total Revenue Is Less Than Total Variable
CostCost
Shutting Down to Minimize LossShutting Down to Minimize Loss
CASE 1: SHUT DOWNCASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $1.50CASE 2: OPERATE AT PRICE = $1.50
Total Revenue (Total Revenue (qq = 0)= 0) $$ 00 Total revenue ($1.50 x 800)Total revenue ($1.50 x 800) $$ 1,2001,200
++
$$
$$
2,0002,000
00
2,0002,000
++
$$
$$
2,0002,000
1,6001,600
3,6003,600
Profit/loss (Profit/loss (TRTR −− TCTC)) −− $$ 2,0002,000 Operating profit/loss (Operating profit/loss (TRTR −− TVCTVC)) −− $$ 400400
Total profit/loss (Total profit/loss (TRTR −− TCTC)) −− $$ 2,4002,400

Short-Run Supply Curve of a PerfectlyShort-Run Supply Curve of a Perfectly
Competitive FirmCompetitive Firm
• The short-runThe short-run
supply curve of asupply curve of a
competitive firm iscompetitive firm is
the part of itsthe part of its
marginal cost curvemarginal cost curve
that lies above itsthat lies above its
average variableaverage variable
cost curve.cost curve.

The Short-Run Industry Supply CurveThe Short-Run Industry Supply Curve
• The industry supply curve in the short-run is theThe industry supply curve in the short-run is the
horizontal sum of the marginal cost curves (abovehorizontal sum of the marginal cost curves (above AVCAVC))
of all the firms in an industry.of all the firms in an industry.

Profits, Losses, and Perfectly CompetitiveProfits, Losses, and Perfectly Competitive
Firm Decisions in the Long and Short RunFirm Decisions in the Long and Short Run
SHORT-RUNSHORT-RUN
CONDITIONCONDITION
SHORT-RUNSHORT-RUN
DECISIONDECISION
LONG-RUNLONG-RUN
DECISIONDECISION
ProfitsProfits TR > TCTR > TC P = MC: operateP = MC: operate Expand: new firms enterExpand: new firms enter
LossesLosses 1. With operating profit1. With operating profit P = MC: operateP = MC: operate Contract: firms exitContract: firms exit
((TRTR ≥≥ TVCTVC)) (losses < fixed costs)(losses < fixed costs)
2. With operating losses2. With operating losses Shut down:Shut down: Contract: firms exitContract: firms exit
((TRTR << TVCTVC)) losses = fixed costslosses = fixed costs
• In the short-run, firms have to decide how much toIn the short-run, firms have to decide how much to
produce in the current scale of plant.produce in the current scale of plant.
• In the long-run, firms have to choose among manyIn the long-run, firms have to choose among many
potential scales of plant.potential scales of plant.

Long-Run Costs: Economies andLong-Run Costs: Economies and
Diseconomies of ScaleDiseconomies of Scale
• Increasing returns to scaleIncreasing returns to scale, or, or
economies of scale,economies of scale, refers to anrefers to an
increase in a firm’s scale ofincrease in a firm’s scale of
production, which leads toproduction, which leads to lowerlower
average costs per unit produced.average costs per unit produced.

• Constant returns to scaleConstant returns to scale refers torefers to
an increase in a firm’s scale ofan increase in a firm’s scale of
production, which hasproduction, which has no effectno effect onon

• Decreasing returns to scaleDecreasing returns to scale refersrefers
to an increase in a firm’s scale ofto an increase in a firm’s scale of
production, which leads toproduction, which leads to higherhigher

The Long-Run Average Cost CurveThe Long-Run Average Cost Curve
• TheThe long-run average costlong-run average cost
curve (LRAC)curve (LRAC) is a graph thatis a graph that
shows the different scales onshows the different scales on
which a firm can choose towhich a firm can choose to
operate in the long-run. Eachoperate in the long-run. Each
scale of operation defines ascale of operation defines a
different short-run.different short-run.

The Long-Run Average Cost CurveThe Long-Run Average Cost Curve
• The long run average cost curve of a firmThe long run average cost curve of a firm
exhibiting economies of scale is downward-exhibiting economies of scale is downward-
sloping.sloping.

Weekly Costs Showing Economies ofWeekly Costs Showing Economies of
Scale in Egg ProductionScale in Egg Production
JONES FARMJONES FARM TOTAL WEEKLY COSTSTOTAL WEEKLY COSTS
15 hours of labor (implicit value $8 per hour)15 hours of labor (implicit value $8 per hour) $120$120
Feed, other variable costsFeed, other variable costs 2525
Transport costsTransport costs 1515
Land and capital costs attributable to egg productionLand and capital costs attributable to egg production 1717
$177$177
Total outputTotal output 2,400 eggs2,400 eggs
Average costAverage cost $.074 per egg$.074 per egg
CHICKEN LITTLE EGG FARMS INC.CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTSTOTAL WEEKLY COSTS
LaborLabor $ 5,128$ 5,128
Feed, other variable costsFeed, other variable costs 4,1154,115
Transport costsTransport costs 2,4312,431
Land and capital costsLand and capital costs 19,23019,230
$30,904$30,904
Total outputTotal output 1,600,000 eggs1,600,000 eggs
Average costAverage cost $.019 per egg$.019 per egg

A Firm Exhibiting Economies andA Firm Exhibiting Economies and
• The long-run average cost curve of a firmThe long-run average cost curve of a firm
that eventually exhibits diseconomies ofthat eventually exhibits diseconomies of
scale becomes upward-sloping.scale becomes upward-sloping.

Optimal Scale of PlantOptimal Scale of Plant
• The optimal scale of plant is the scale thatThe optimal scale of plant is the scale that
minimizes average cost.minimizes average cost.

Long-Run Adjustments toLong-Run Adjustments to
Short-Run ConditionsShort-Run Conditions
• Firms expand in the long-run whenFirms expand in the long-run when
increasing returns to scale are available.increasing returns to scale are available.

Long-Run Adjustments toLong-Run Adjustments to
Short-Run ConditionsShort-Run Conditions
• Prices will be driven down to the minimumPrices will be driven down to the minimum
point on the LRAC curve.point on the LRAC curve.

Short-Run Profits:Short-Run Profits:
Expansion to EquilibriumExpansion to Equilibrium
• The existence of positive profits will attractThe existence of positive profits will attract
new entrants to an industry.new entrants to an industry.
• As capital flows into the industry, the supplyAs capital flows into the industry, the supply
curve shifts to the right, and price falls.curve shifts to the right, and price falls.
• Firms will continue to expand as long asFirms will continue to expand as long as
there are economies of scale to be realized,there are economies of scale to be realized,
and new firms will continue to enter as longand new firms will continue to enter as long
as positive profits are being earned.as positive profits are being earned.

Short-Run Losses:Short-Run Losses:
Contraction to EquilibriumContraction to Equilibrium
• When firms in an industry suffer losses,When firms in an industry suffer losses,
there is an incentive for them to exit.there is an incentive for them to exit.

• As firms exit, the supply curve shifts fromAs firms exit, the supply curve shifts from
SS toto S’S’, driving price up to, driving price up to P*.P*.

• The industry eventually returns to long-runThe industry eventually returns to long-run
equilibrium and losses are eliminated.equilibrium and losses are eliminated.

Short-Run Profits:Short-Run Profits:
• As long as losses are being sustained in anAs long as losses are being sustained in an
industry, firms will shut down and leave theindustry, firms will shut down and leave the
industry, thus reducing supply.industry, thus reducing supply.
• As this happens, price rises.As this happens, price rises.
• This gradual price rise reduces losses for firmsThis gradual price rise reduces losses for firms
remaining in the industry until those losses areremaining in the industry until those losses are
ultimately eliminated.ultimately eliminated.

Long-Run Equilibrium in PerfectlyLong-Run Equilibrium in Perfectly
Competitive Output MarketsCompetitive Output Markets
• Whether we begin with an industry in whichWhether we begin with an industry in which
firms are earning profits or suffering losses,firms are earning profits or suffering losses,
the final long-run competitive equilibriumthe final long-run competitive equilibrium
condition is the same.condition is the same.
• In the long-run, equilibrium price (In the long-run, equilibrium price (PP*) is equal*) is equal
to long-run average cost, short-run marginalto long-run average cost, short-run marginal
cost, and short-run average cost. Profits arecost, and short-run average cost. Profits are
driven to zero.driven to zero.

The Long-Run Adjustment MechanismThe Long-Run Adjustment Mechanism
• The central idea in our discussion of entry,The central idea in our discussion of entry,
exit, expansion, and contraction is this:exit, expansion, and contraction is this:
• In efficient markets, investment capital flowsIn efficient markets, investment capital flows
toward profit opportunities.toward profit opportunities.
• The actual process is complex and varies fromThe actual process is complex and varies from
industry to industry.industry to industry.

• The central idea in our discussion of entry,The central idea in our discussion of entry,
exit, expansion, and contraction is this:exit, expansion, and contraction is this:
The Long-Run Adjustment MechanismThe Long-Run Adjustment Mechanism
• Investment—in the form of new firms andInvestment—in the form of new firms and
expanding old firms—will over time tend to favorexpanding old firms—will over time tend to favor
those industries in which profits are being made,those industries in which profits are being made,
and over time industries in which firms areand over time industries in which firms are
suffering losses will gradually contract fromsuffering losses will gradually contract from
disinvestment.disinvestment.

Internal Versus ExternalInternal Versus External
Economies of ScaleEconomies of Scale
• Economies of scale that are foundEconomies of scale that are found
within the individual firm are calledwithin the individual firm are called
internal economies of scale.internal economies of scale.
• External economies of scaleExternal economies of scale
describe economies or diseconomiesdescribe economies or diseconomies
of scale on an industry-wide basis.of scale on an industry-wide basis.

The Long-Run Industry Supply CurveThe Long-Run Industry Supply Curve
• TheThe long-run industry supply curvelong-run industry supply curve
(LRIS)(LRIS) traces output over time as thetraces output over time as the
industry expands.industry expands.
• When an industry enjoys externalWhen an industry enjoys external
economies, its long-run supply curveeconomies, its long-run supply curve
slopes down. Such an industry isslopes down. Such an industry is
called acalled a decreasing-cost industry.decreasing-cost industry.

A Decreasing-Cost Industry:A Decreasing-Cost Industry:
External EconomiesExternal Economies
• In a decreasing cost industry, costs decline as aIn a decreasing cost industry, costs decline as a
result of industry expansion, and the LRIS isresult of industry expansion, and the LRIS is
downward-sloping.downward-sloping.

An Increasing-Cost Industry:An Increasing-Cost Industry:
External DiseconomiesExternal Diseconomies
• In an increasing cost industry, costs rise as aIn an increasing cost industry, costs rise as a
result of industry expansion, and the LRIS isresult of industry expansion, and the LRIS is
upward-sloping.upward-sloping.

Construction Activity and the Price of LumberConstruction Activity and the Price of Lumber
Products, 1991 - 1994Products, 1991 - 1994
An Increasing-Cost Industry: ExternalAn Increasing-Cost Industry: External
DiseconomiesDiseconomies
YEARYEAR
MONTHLYMONTHLY
AVERAGE, NEWAVERAGE, NEW
HOUSINGHOUSING
PERMITSPERMITS
PERCENTAGEPERCENTAGE
INCREASEINCREASE
OVER THEOVER THE
PREVIOUSPREVIOUS
YEARYEAR
CHANGE IN THECHANGE IN THE
PRICE OFPRICE OF
LUMBERLUMBER
PRODUCTSPRODUCTS
CHANGE INCHANGE IN
CONSUMERCONSUMER
PRICESPRICES
19911991 79,50079,500 -- -- --
19921992 92,16792,167 ++ 15.915.9 ++ 14.714.7 ++ 3.03.0
19931993 100,917100,917 ++ 9.59.5 ++ 24.624.6 ++ 3.03.0
19941994 111,000111,000 ++ 10.010.0 NANA ++ 2.12.1
Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21;Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21;
Statistical Abstract of the United StatesStatistical Abstract of the United States, 1994, Tables 754, 755., 1994, Tables 754, 755.

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