Transcript Principles of Economics, Case and Fair,9e

CHAPTER 9 Long-Run Costs and Output Decisions
PowerPoint Lectures for
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of
Microeconomics, 9e
; ;
By
Karl E. Case,
Ray C. Fair &
Sharon M. Oster
Principles of Microeconomics 9e by Case, Fair and Oster
1 of 33
CHAPTER 9 Long-Run Costs and Output Decisions
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
2 of 33
PART II THE MARKET SYSTEM
9
CHAPTER 9 Long-Run Costs and Output Decisions
Long-Run Costs and
Output Decisions
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Prepared by:
Fernando & Yvonn Quijano
Principles of Microeconomics 9e by Case, Fair and Oster
3 of 33
PART II THE MARKET SYSTEM
CHAPTER 9 Long-Run Costs and Output Decisions
Long-Run Costs and
Output Decisions
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
9
CHAPTER OUTLINE
Short-Run Conditions and LongRun Directions
Maximizing Profits
Minimizing Losses
The Short-Run Industry Supply Curve
Long-Run Directions: A Review
Long-Run Costs: Economies and
Diseconomies of Scale
Increasing Returns to Scale
Constant Returns to Scale
Decreasing Returns to Scale
Long-Run Adjustments
to Short-Run Conditions
Short-Run Profits: Expansion to Equilibrium
Short-Run Losses: Contraction to
Equilibrium
The Long-Run Adjustment Mechanism:
Investment Flows toward Profit
Opportunities
Output Markets: A Final Word
Appendix: External Economies and
Diseconomies and the Long-Run Industry
Supply Curve
Principles of Microeconomics 9e by Case, Fair and Oster
4 of 33
Long-Run Costs and Output Decisions
CHAPTER 9 Long-Run Costs and Output Decisions
We begin our discussion of the long run by looking at firms in
three short-run circumstances:
(1) firms earning economic profits,
(2) firms suffering economic losses but continuing to operate to
reduce or minimize those losses, and
(3) firms that decide to shut down and bear losses just equal to
fixed costs.
breaking even The situation in which a
firm is earning exactly a normal rate of
return.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
5 of 33
Short-Run Conditions and Long-Run Directions
CHAPTER 9 Long-Run Costs and Output Decisions
Maximizing Profits
Example: The Blue Velvet Car Wash
TABLE 9.1 Blue Velvet Car Wash Weekly Costs
Total Variable Costs
(TVC) (800 Washes)
Total Fixed Costs (TFC)
1. Normal return to investors
2. Other fixed costs
(maintenance contract,
insurance, etc.)
$ 1,000
1. Labor
2. Materials
Total Costs
(TC = TFC + TVC)
$ 3,600
$ 1,000
600
Total revenue (TR)
at P = $5 (800 x $5)
$ 4,000
$ 1,600
Profit (TR - TC)
$
400
1,000
$ 2,000
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
6 of 33
Short-Run Conditions and Long-Run Directions
CHAPTER 9 Long-Run Costs and Output Decisions
Maximizing Profits
 FIGURE 9.1 Firm Earning Positive Profits in the Short Run
A profit-maximizing perfectly competitive firm will produce up to the point where P* = MC.
Profits are the difference between total revenue and total costs. At q* = 300, total revenue is
$5 × 300 = $1,500, total cost is $4.20 × 300 = $1,260, and total profit = $1,500 - $1,260 =
$240.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
7 of 33
Short-Run Conditions and Long-Run Directions
CHAPTER 9 Long-Run Costs and Output Decisions
Minimizing Losses
operating profit (or loss) or net
operating revenue 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.
■ 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.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
8 of 33
Short-Run Conditions and Long-Run Directions
Minimizing Losses
CHAPTER 9 Long-Run Costs and Output Decisions
Producing at a Loss to Offset Fixed Costs: The Blue Velvet Revisited
TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost
CASE 1: Shut Down
Total Revenue
(q = 0)
$
CASE 2: Operate at Price = $3
0
Total Revenue ($3 x 800)
Fixed costs
Variable costs
Total costs
$ 2,000
+
0
$ 2,000
Fixed costs
Variable costs
Total costs
Profit/loss (TR
- TC)
- $ 2,000
Operating profit/loss (TR - TVC)
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Total profit/loss (TR - TC)
$ 2,400
$ 2,000
+ 1,600
$ 3,600
$
800
- $ 1,200
Principles of Microeconomics 9e by Case, Fair and Oster
9 of 33
Short-Run Conditions and Long-Run Directions
CHAPTER 9 Long-Run Costs and Output Decisions
Minimizing Losses
 FIGURE 9.1 Firm Suffering Losses but Showing an Operating Profit in the Short Run
When price is sufficient to cover average variable costs, firms suffering short-run
losses will continue operating instead of shutting down.
Total revenues (P* × q*) cover variable costs, leaving an operating profit of $90 to
cover part of fixed costs and reduce losses to $135.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
10 of 33
Short-Run Conditions and Long-Run Directions
Minimizing Losses
CHAPTER 9 Long-Run Costs and Output Decisions
Shutting Down to Minimize Loss
TABLE 9.3 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
$
Fixed costs
Variable costs
Total costs
Operating profit/loss (TR - TVC)
Fixed costs
Variable costs
Total costs
+
$
2,000
0
2,000
Profit/loss (TR - TC):
- $
2,000
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Total revenue ($1.50 x 800)
Total profit/loss (TR - TC)
$ 1,200
+
$ 2,000
1,600
$ 3,600
400
-$
- $ 2,400
Principles of Microeconomics 9e by Case, Fair and Oster
11 of 33
Short-Run Conditions and Long-Run Directions
Minimizing Losses
CHAPTER 9 Long-Run Costs and Output Decisions
 FIGURE 9.1 Firm
Suffering Losses but
Showing an Operating Profit
in the Short Run
At prices below average
variable cost, it pays a
firm to shut down rather
than continue operating.
Thus, 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.
shut-down point 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.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
12 of 33
Short-Run Conditions and Long-Run Directions
The Short-Run Industry Supply Curve
CHAPTER 9 Long-Run Costs and Output Decisions
short-run industry supply curve The sum of the marginal
cost curves (above AVC) of all the firms in an industry.
 FIGURE 9.4 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
A profit-maximizing perfectly competitive firm will produce up to the point where P* = If there are
only three firms in the industry, the industry supply curve is simply the sum of all the products
supplied by the three firms at each price. For example, at $6, firm 1 supplies 100 units, firm 2
supplies 200 units, and firm 3 supplies 150 units, for a total industry supply of 450.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
13 of 33
Short-Run Conditions and Long-Run Directions
CHAPTER 9 Long-Run Costs and Output Decisions
Long-Run Directions: A Review
TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and
Short Run
Short-Run Condition
Profits
Losses
TR > TC
1. With operating profit
(TR  TVC)
2. With operating losses
(TR < TVC)
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Short-Run Decision
Long-Run Decision
P = MC: operate
Expand: new firms enter
P = MC: operate
Contract: firms exit
(losses < fixed costs)
Shut down:
Contract: firms exit
losses = fixed costs
Principles of Microeconomics 9e by Case, Fair and Oster
14 of 33
CHAPTER 9 Long-Run Costs and Output Decisions
Long-Run Costs: Economies and Diseconomies of Scale
increasing returns to scale, or economies of
scale An increase in a firm’s scale of production
leads to lower costs per unit produced.
constant returns to scale An increase in a firm’s
scale of production has no effect on costs per unit
produced.
decreasing returns to scale, or diseconomies of
scale An increase in a firm’s scale of production
leads to higher costs per unit produced.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
15 of 33
Long-Run Costs: Economies and Diseconomies of Scale
Increasing Returns to Scale
Example: Economies of Scale in Egg Production
CHAPTER 9 Long-Run Costs and Output Decisions
TABLE 9.5 Weekly Costs Showing Economies of Scale in Egg Production
Jones Farm
Total Weekly Costs
15 hours of labor (implicit value $8 per hour)
Feed, other variable costs
Transport costs
Land and capital costs attributable to egg production
Total output
Average cost
Chicken Little Egg Farms Inc.
Labor
Feed, other variable costs
Transport costs
Land and capital costs
$120
25
15
17
$177
2,400 eggs
$0.074 per egg
Total Weekly Costs
$ 5,128
4,115
2,431
19,230
$30,904
Total output
1,600,000 eggs
Average cost
$0.019 per egg
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
16 of 33
Long-Run Costs: Economies and Diseconomies of Scale
CHAPTER 9 Long-Run Costs and Output Decisions
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.
 FIGURE 9.5 A Firm Exhibiting Economies of Scale
The long-run average cost curve of a firm shows the different scales on which the firm can
choose to operate in the long run. Each scale of operation defines a different short run. Here we
see a firm exhibiting economies of scale; moving from scale 1 to scale 3 reduces average cost.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
17 of 33
Long-Run Costs: Economies and Diseconomies of Scale
CHAPTER 9 Long-Run Costs and Output Decisions
Constant Returns to Scale
Technically, the term constant returns means that
the quantitative relationship between input and
output stays constant, or the same, when output is
increased.
Constant returns to scale mean that the firm’s longrun average cost curve remains flat.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
18 of 33
Long-Run Costs: Economies and Diseconomies of Scale
CHAPTER 9 Long-Run Costs and Output Decisions
Decreasing Returns to Scale
optimal scale of plant
The scale of plant that
minimizes average cost.
 FIGURE 9.6 A Firm Exhibiting Economies and Diseconomies of Scale
Economies of scale push this firm’s average costs down to q*. Beyond q*, the firm
experiences diseconomies of scale; q* is the level of production at lowest average cost,
using optimal scale.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
19 of 33
CHAPTER 9 Long-Run Costs and Output Decisions
Long-Run Costs: Economies and Diseconomies of Scale
Blood bank merger ‘good’
for Manatee
Bradenton Herald.com
“Northwest needed to be aligned
with a larger organization to
achieve economy of scale,” said
J.B. Gaskins, Florida Blood
Services vice president. “That
economy of scale is good for the
whole network, including Manatee
County.”
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
20 of 33
Long-Run Adjustments to Short-Run Conditions
CHAPTER 9 Long-Run Costs and Output Decisions
Short-Run Profits: Expansion to Equilibrium
 FIGURE 9.7 Firms Expand in the Long Run When Increasing Returns to Scale Are Available
When economies of scale can be realized, firms have an incentive to expand. Thus, firms
will be pushed by competition to produce at their optimal scales. Price will be driven to the
minimum point on the LRAC curve.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
21 of 33
Long-Run Adjustments to Short-Run Conditions
CHAPTER 9 Long-Run Costs and Output Decisions
Short-Run Profits: Expansion to 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
Any price above P* means that there are profits to be made in the
industry, and new firms will continue to enter. Any price below P*
means that firms are suffering losses, and firms will exit the
industry. Only at P* will profits be just equal to zero, and only at P*
will the industry be in equilibrium.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
22 of 33
Long-Run Adjustments to Short-Run Conditions
CHAPTER 9 Long-Run Costs and Output Decisions
Short-Run Losses: Contraction to Equilibrium
 FIGURE 9.8 Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses
When firms in an industry suffer losses, there is an incentive for them to exit.
As firms exit, the supply curve shifts from S0 to S1, driving price up to P*. As price rises,
losses are gradually eliminated and the industry returns to equilibrium.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
23 of 33
Long-Run Adjustments to Short-Run Conditions
CHAPTER 9 Long-Run Costs and Output Decisions
Short-Run Losses: Contraction to Equilibrium
Whether we begin with an industry in which firms are earning
profits or suffering losses, the final long-run competitive
equilibrium condition is the same:
P* = SRMC = SRAC = LRAC
and profits are zero. At this point, individual firms are operating at
the most efficient scale of plant—that is, at the minimum point on
their LRAC curve.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
24 of 33
CHAPTER 9 Long-Run Costs and Output Decisions
Long-Run Adjustments to Short-Run Conditions
The Long-Run Average Cost Curve:
Flat or U-Shaped?
The structure of the industry in the long run will depend on
whether existing firms expand faster than new firms enter.
There is an element of randomness in the way industries
expand. Most industries contain some large firms and
some small firms,
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
25 of 33
Long-Run Adjustments to Short-Run Conditions
CHAPTER 9 Long-Run Costs and Output Decisions
The Long-Run Adjustment Mechanism: Investment Flows Toward
Profit Opportunities
The entry and exit of firms in response to profit opportunities usually
involve the financial capital market. In capital markets, people are
constantly looking for profits.When firms in an industry do well, capital
is likely to flow into that industry in a variety of forms.
long-run competitive equilibrium When P =
SRMC = SRAC = LRAC and profits are zero.
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.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
26 of 33
Long-Run Adjustments to Short-Run Conditions
CHAPTER 9 Long-Run Costs and Output Decisions
The Long-Run Adjustment Mechanism: Investment Flows Toward
Profit Opportunities
Why Are Hot Dogs So
Expensive in Central
Park?
In New York, you need a
license to operate a hot dog
cart, and a license to operate
in the park costs more. Since
hot dogs are $.50 more in the
park, the added cost of a
license each year must be roughly $.50 per hot dog sold. In
fact, in New York City, licenses to sell hot dogs in the park are
auctioned off for many thousands of dollars, while licenses to
operate outside the park cost only about $1,000.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
27 of 33
CHAPTER 9 Long-Run Costs and Output Decisions
Output Markets: A Final Word
In the last four chapters, we have been building a model of a
simple market system under the assumption of perfect
competition.
You have now seen what lies behind the demand curves and
supply curves in competitive output markets. The next two
chapters take up competitive input markets and complete the
picture.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
28 of 33
CHAPTER 9 Long-Run Costs and Output Decisions
REVIEW TERMS AND CONCEPTS
breaking even
constant returns to scale
decreasing returns to scale,
or diseconomies of scale
increasing returns to scale, or
economies of scale
long-run average cost curve
(LRAC)
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
long-run competitive equilibrium
operating profit (or loss) or net
operating revenue
optimal scale of plant
short-run industry supply curve
shut-down point
long-run competitive equilibrium,
P = SRMC = SRAC = LRAC
Principles of Microeconomics 9e by Case, Fair and Oster
29 of 33
APPENDIX
CHAPTER 9 Long-Run Costs and Output Decisions
EXTERNAL ECONOMIES AND DISECONOMIES AND THE LONGRUN INDUSTRY SUPPLY CURVE
When long-run average costs
decrease as a result of industry
growth, we say that there are
external economies.
When average costs increase as a
result of industry growth, we say that
there are external diseconomies.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
30 of 33
APPENDIX
CHAPTER 9 Long-Run Costs and Output Decisions
EXTERNAL ECONOMIES AND DISECONOMIES AND THE LONGRUN INDUSTRY SUPPLY CURVE
Example of an expanding industry facing external diseconomies of scale
TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 2000–2005
Year
House Prices %
Change Over the
Previous Year
Housing Starts
(Thousands)
Housing Starts
% Change Over
The Previous Year
Construction
Materials Prices %
Change Over The
Previous Year
2000
-
1,573
-
-
-
2001
7.5
1,661
5.6%
0%
2.8%
2002
7.5
1,710
2.9%
1.5%
1.5%
2003
7.9
1,853
8.4%
1.6%
2.3%
2004
12.0
1,949
5.2%
8.3%
2.7%
2005
13.0
2,053
5.3%
5.4%
2.5%
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Consumer Prices
% Change Over
The Previous
Year
Principles of Microeconomics 9e by Case, Fair and Oster
31 of 33
APPENDIX
THE LONG-RUN INDUSTRY SUPPLY CURVE
CHAPTER 9 Long-Run Costs and Output Decisions
long-run industry supply curve (LRIS) A graph that traces
out price and total output over time as an industry expands.
decreasing-cost industry An industry that realizes external
economies—that is, average costs decrease as the industry
grows. The long-run supply curve for such an industry has a
negative slope.
constant-cost industry An industry that
shows no economies or diseconomies of
scale as the industry grows. Such industries have flat, or
horizontal, long-run supply curves.
increasing-cost industry An industry that encounters
external diseconomies—that is, average costs increase as the
industry grows. The long-run supply curve for such an industry
has a positive slope.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
32 of 33
APPENDIX
Appendix
CHAPTER 9 Long-Run Costs and Output Decisions
THE LONG-RUN INDUSTRY SUPPLY CURVE
 FIGURE 9A.1 A Decreasing-Cost Industry: External Economies
In a decreasing-cost industry, average cost declines as the industry expands. As demand
expands from D0 to D1, price rises from P0 to P1.
As new firms enter and existing firms expand, supply shifts from S0 to S1, driving price
down. If costs decline as a result of the expansion to LRAC2, the final price will be below
P0 at P2.
The long-run industry supply curve (LRIS) slopes downward in a decreasing-cost industry.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
33 of 33
APPENDIX
Appendix
CHAPTER 9 Long-Run Costs and Output Decisions
THE LONG-RUN INDUSTRY SUPPLY CURVE
 FIGURE 9A.2 An Increasing-Cost Industry: External Diseconomies
In an increasing-cost industry, average cost increases as the industry expands. As demand
shifts from D0 to D1, price rises from P0 to P1.
As new firms enter and existing firms expand output, supply shifts from S0 to S1, driving
price down. If long-run average costs rise, as a result, to LRAC2, the final price will be P2.
The long-run industry supply curve (LRIS) slopes up in an increasing-cost industry.
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
34 of 33
CHAPTER 9 Long-Run Costs and Output Decisions
REVIEW TERMS AND CONCEPTS
constant-cost industry
decreasing-cost industry
external economies and diseconomies
increasing-cost industry
long-run industry supply curve (LRIS)
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Microeconomics 9e by Case, Fair and Oster
35 of 33