Long-Run Costs and Output Decisions

CHAPTER 8
Long-Run Costs
and Output Decisions
© 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
• In the long-run
1. The firm has no fixed factor of

production.
2. Firms are free to enter and exit

industries.
• Normal rate of return is a rate that

is just sufficient to keep investors
satisfied.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 38
Short-Run Conditions
and Long-Run Directions
• For any firm one of three conditions

hold at any given moment:
1) The firm is making positive profits
2) The firm is suffering losses
3) The firm is just breaking even.
• Breaking even, or earning a zero

profit is a situation in which a firm
earns exactly a normal rate of return.
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
• Profit is the difference between total revenue and

total cost.
Minimizing Losses
• There are two types of firms that suffer

from losses
1) Those which shut down immediately
and bear losses equal to fixed costs.
2) Those that continue their operations in
the short-run to minimize losses.
• The decision to shut down depends on
whether revenues from operating are
sufficient to cover variable costs.
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  TVC) $ 800

Total profit/loss (TR  TC)  $ 1,200
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.
• 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
• The difference between ATC and AVC equals AFC.

Then, AFC  q = TFC.
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 versus Short Run Costs
• Short-run cost curves are U-shaped. This

follows from fixed factor of production. As
output increases beyond a certain point, the
fixed factor causes diminishing returns to
variable factors and thus increasing marginal
cost.
• The shape of firm’s long-run average cost
curve depends on how costs vary with scale
of operation. For some firms, increased scale
reduces costs. For others, increased scale
leads to inefficiency and waste.
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. (Automobile
production, a bus carrying
100 people versus 100
people driving 100 cars)
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
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.
A Firm Exhibiting Economies of Scale
• The long run average cost curve of a firm

exhibiting economies of scale is downward-
sloping.
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
• All SRAC curves are U-shaped since there is a fixed scale of plant that
constrains production and drives marginal cost as a result of diminishing
marginal returns. In the long run scale of plant can be changed and the
shape of the LRAC curve depends on how costs vary with scale.
Optimal Scale of Plant
• The optimal scale of plant is the scale

that minimizes average cost.

Long-Run Costs and Output Decisions

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CHAPTER 8

1. The firm has no fixed factor of

2. Firms are free to enter and exit

• Normal rate of return is a rate that

• For any firm one of three conditions

1) The firm is making positive profits

2) The firm is suffering losses

3) The firm is just breaking even.

• Breaking even, or earning a zero

Blue Velvet Car Wash Weekly Costs

• Revenue is sufficient to cover both fixed costs of

• Profit is the difference between total revenue and

• There are two types of firms that suffer

A Firm Will Operate If Total Revenue Covers Total Variable

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

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

• Operating profit (or loss) or net

• 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

SHORT-RUN SHORT-RUN LONG-RUN

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

• Short-run cost curves are U-shaped. This

JONES FARM TOTAL WEEKLY COSTS

CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTS

• The long-run average cost

• The long run average cost curve of a firm

• The LRAC curve of a firm that eventually

• The optimal scale of plant is the scale

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