Transcript document

Chapter 8
Costs and Output Decisions in the
Long Run
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.
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.
Example-P>ATC
P
Price per unit
profit
MC
ATC
D=MR
$5
$4
AVC
800
Q
Q
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
Example-P<ATC
P
Price per unit
S1
S2
D
loss
MC
ATC
D=MR
$5
$4
$3.5
$3
Q
AVC
700
Q
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?
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.
Example Shut-down point –
P=min AVC
Price per unit
Shut-down point
MC
ATC
AVC
Market price
Q
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.
P=ATC
• When P=ATC, Blue Velvet earns a normal
profit. Profit =0
What is the Firm’s Supply Curve?
Price per unit
MC
ATC
AVC
Q
• 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.
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.
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:
Example – producing 100 diapers
w/ alternative technologies
Technology
Units of capital Units of labor
A
B
C
D
E
2
3
4
6
10
10
6
4
3
2
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.
Example – producing 100 diapers w/
alternative technologies
Technology Units of
capital
Units of
labor
P(L)=$1
P(k)=$1
P(L)=$1
P(k)=$1
A
2
10
$12
$52
B
3
6
$9
$33
C
4
4
$8
$24
D
6
3
$9
$21
E
10
2
$12
$20
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.
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).
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.
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?
Example
• The ranch then decides to expand and double the
amount of fencing. 10
5
Area=25
• The area quadruples!!!
5
10
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
How do we represent economies
of scale with long run average
costs?
SRAC
• 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.
costs
SRAC1
SRAC2
SRAC3
SRAC4
Total product
LRAC curve
• 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.
costs
SRMC1
SRAC1
SRMC2
SRMC3
SRAC2
SRAC3
SRMC4
SRAC4
LRAC
Total product
Minimum efficient scale
• The lowest level of output associated
with the minimum average cost in the
long run is called the minimum
efficient scale.
costs
SRMC1
SRAC1
SRMC2
SRMC3
SRAC2
SRAC3
SRMC4
SRAC4
LRAC
Total product
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
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.
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.
SRAC4
A larger
firm
LRAC
Total product
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.
Diminishing return to scale
costs
Diminishing
return to scale
Optimal plant size
LRAC
Total product
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
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.
Expansion to Equilibrium - Initial
Conditions
$
$
SRMC1
P
SRAC1
q
q
Expansion to Equilibrium
$
$
S1
S2
SRMC1
P
SRAC1
SRMC
SRAC
q
q
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.
Review question
• Calculate profit.
• Shut down point.
• LRAC
– Increasing returns to scale
– Constant returns to scale
– Decreasing returns to scale
• Apply the knowledge.