Chapter 8

1. Chapter 8 Costs and Output Decisions in the Long Run

2. Output supply decisions are less constrained in the long run. • The firm has no fixed factors of production; all inputs are variable. • Firms are free to enter or exit the industry.

3. Profits can fall into three different categories: • Normal profits: The firm is earning just enough to cover opportunity costs. Economic profits are zero and the firm is “breaking even.” • Economic profits: The firm is earning more than enough to cover opportunity costs. • Economic losses: The firm is not earning enough to cover opportunity costs.

4. Example-P>ATC profit Price per unit P MC ATC D=MR $5 $4 AVC 800 Q Q

5. Example-P>ATC • Profit=TR-TC • TR=p*q=5*800=4000 • TC=TFC+TVC=2000+1600=3600 • (Table 9.1) • Profit=1500-1260=$400 • ATC=TC/q=3600/800=$4

6. Example-P<ATC Price per unit P loss S1 MC ATC D=MR $5 S2 $4 AVC $3.5 $3 D 700 Q Q

7. Example-P<ATC • Profit=TR-TC • TR=p*q=3*700=2100 • TFC=2000, TVC=1450 • TC= TFC+ TVC=2000+1450=3450 • ATC=TC/q=2450/700=3.5 • Profit=2100-3450=-$1350 • it’s economic loss • Will you operate at price=3?

8. Example-P<ATC • Shut down • TR=0 • TC=TFC+TVC=2000+0=2000 • Profit/loss=TR-TC=0-2000=-2000 • Operate • TR=2100 • TC=TFC+TVC=2000+1450=3450 • Profit/loss=TR-TC=2100-3450=-1350 • By operating, the firm reduces its losses from $2000 to $1350.

9. Example Shut-down point –P=min AVC Shut-down point Price per unit MC ATC AVC Market price Q

10. Shut-down point • If price falls below AVC, producing at MC=MR will generate losses greater than fixed costs. • P = minimum AVC is called the firm’s shutdown point. • Even in the short run, the firm minimizes its losses by producing no output. • In the short run, the firm must still pay its fixed costs.

11. P=ATC • When P=ATC, Blue Velvet earns a normal profit. Profit =0

12. What is the Firm’s Supply Curve? • MR=MC=p • We let the price (equal to MR) vary, and we trace the MC curve. • This gives us the firm’s supply. We can then add up firm supplies to get industry supply. Price per unit MC ATC AVC Q

13. Long-Run Directions • If firms in an industry are earning economic profits, expect that industry to expand. • If firms in an industry are earning economic losses, expect that industry to contract. • If firms in an industry are earning normal profits, expect no net entry or exit.

14. Production in the long run • The long run is a period of production where ALL INPUTAS are VARICABLE INPUTS. • The firm is free to vary everything about production including plant size. • This implies that costs will ALWAYS be minimized for any level of output. • Recall the example from previous chapter:

15. Example – producing 100 diapers w/ alternative technologies There are 5 different technologies to choose from, raging from using a lot of labor to a lot of capital. Which technology is cheapest? It depends on input prices.

16. Example – producing 100 diapers w/ alternative technologies Currently C is the best choice. If labor price increase to $5, in short run with technology C, a firm must gear those higher costs. But in the long run, the firm can shift to technology E and lower costs. This is how we can say that in the long run costs are always minimized for any level of output.

17. Costs in the long run • Long run costs are the minimum cost of producing any given output when all inputs are variable. • What will be the shape of long run costs curves, especially long run average cost (LRAC)? What determines the shape of the curve? • In the short run it was diminishing marginal returns that affected the shape of the average cost curves. • Diminishing marginal returns only occurs with a fixed input in production. There are non in the long run. • Since a firm can vary all inputs. Including the plant size (call scale of operations), it must be how costs react to increasing the scale of operations (plant size).

18. Costs in the long run-increasing returns to scale • LRAC could decline as the scale of operations (plant size) are increased.this is called increasing returns to scale or economies of scale. • It means as inputs double, output would more than double. • Why would economies of scale exist? • This occurs because of increases in specialization, productivity, (which lower costs) being able to buy materials at lower prices. Etc.

19. Example • Suppose that a cattle ranch is a square such as the following: 5 Area=25 5 • The ranch then decides to expand and double the amount of fencing. • What happens to the grazing area of the cattle?

20. Example • The ranch then decides to expand and double the amount of fencing. 10 5 Area=25 10 5 • The area quadruples!!!

21. 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

22. How do we represent economies of scale with long run average costs?

23. SRAC costs • SRAC1 is the original ATC curve. • SRAC curve is for one particular plant size. If the plant size changes then the SRAC curve changes. • If economies of scale exist then average costs will fall as the plant size gets larger. SRAC1 SRAC2 SRAC3 SRAC4 Total product

24. LRAC curve costs • The long run average cost curve is a series of SRAC curves below their points of intersections. This reflects the LOWEST COSTS at all level of output. • The LRAC curve is a “planning curve”. • The firm can choose a particular plant size in the long run to minimize costs for the level of output. SRMC1 SRAC1 SRMC2 SRMC3 SRMC4 SRAC2 SRAC3 SRAC4 LRAC Total product

25. Minimum efficient scale costs • The lowest level of output associated with the minimum average cost in the long run is called the minimum efficient scale. SRMC1 SRAC1 SRMC2 SRMC3 SRMC4 SRAC2 SRAC3 SRAC4 LRAC Total product

26. Minimum efficient scale costs • After minimum efficient scale is reached, economies of scale are exhausted. Firms enter into constant returns to scale. SRAC4 LRAC Total product

27. Costs in the long run-Constant Returns to Scale • An increase in scale of operation leads to no change in average costs per unit produced • When the firm doubles the use of inputs, it will double output. • Duplicate the one that we have! • Another building. • Same number of workers, same types of machines. • Duplicate output.

28. Constant Returns to Scale costs • One sure sign hat constant returns to scale exist in an industry is to observe whether small firms and large firms exit and compete with one another • Being big or small matters litter because average cost are the same for both of them. A larger firm SRAC4 LRAC Total product

29. Costs in the long run- Decreasing Returns to Scale, or Diseconomies of Scale • An increase in scale of operation leads to higher average costs per unit produced • Eventually,some resource may become scarce, then costs rise. • Problems of managing a large firm. • Difficulties in coordinating work activities, communicating directives to the right persons, and the problem of monitoring personal effectively.

30. Diminishing return to scale costs Diminishing return to scale Optimal plant size LRAC Total product

31. Minimum LRAC • Optimal plan size occurs at minimum LRAC. • The optimal (lowest cost) plant size is always in the constant returns to scale section of the LRAC curve. • For such a firm, it’s LRAC=SRAC=MC

32. Long-Run Adjustments to Equilibrium • An industry is not in equilibrium if firms have an incentive to enter or exit in the long run. • When firms earn normal profits, there is no incentive for firms to enter or exit.

33. Expansion to Equilibrium - Initial Conditions $ $ SRMC1 P SRAC1 q q

34. Expansion to Equilibrium $ $ S1 S2 SRMC1 P SRAC1 SRMC SRAC q q

35. So, what do we have? • In the short run and in the long run: P = MR = MC • In the SR, profits may be positive, negative or zero. • In the LR, due to entry or exit, profits = 0. • In the LR, we have minimized the cost of providing the good, given that people WILL produce it.

36. Review question • Calculate profit. • Shut down point. • LRAC • Increasing returns to scale • Constant returns to scale • Decreasing returns to scale • Apply the knowledge.