Long-Run Costs and Output Decisions Jalil Choudhury
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LONG-RUN COSTS AND OUTPUT DECISIONS
We begin our discussion of the long run by looking at firms in three short-run circumstances: firms earning economic profits, firms suffering economic losses but continuing to operate to reduce or minimize those losses, l osses, and firms that decide to shut down and bear losses ust e!ual to fi"ed costs#
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SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS MINIMIZING LOSSES operating profit (or lo! or net operating re"en#e 'otal re(enue minus total (ariable cost
)TR − TVC *#
+f re(enues e"ceed (ariable costs, operating profit is positi(e and can be used to offset fi"ed costs and reduce losses, and it will pay the firm to keep operating# +f re(enues are smaller than (ariable costs, the firm suffers operating losses that push total losses abo(e fi"ed costs# +n this case, the firm can minimize its losses by shutting down# &
SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
/emember that a(erage total cost is e!ual to a(erage fi"ed cost plus a(erage (ariable cost# 'his means that at e(ery le(el of output, a(erage fi"ed cost is the difference between a(erage total and a(erage (ariable cost: ATC AFC AVC or AFC = ATC
− AVC = 3%#14 − 3$#14 31#44
0s long as price )which is e!ual to a(erage re(enue per unit* is sufficient to co(er a(erage (ariable costs, the firm stands to gain by operating instead of shutting down# .
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SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
0ny time that price )a(erage re(enue* is below the minimum point on the a(erage (ariable cost cur(e, total re(enue will be less than total (ariable cost, and operating profit will be negati(e6that is, there will be a loss on operation# +n other words, when price is below all points on the a(erage (ariable cost cur(e, the firm will suffer operating losses at any possible output le(el the firm could choose# When this is the case, the firm will stop producing and bear losses e!ual to fi"ed costs# 'his is why the bottom of the a(erage (ariable cost cur(e is called the shut-down point#
0t all prices abo(e it, the marginal cost cur(e shows the profitma"imizing le(el of output# 0t all prices below it, optimal short-run output is zero# 14
SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS
$#t-%o&n point 'he lowest point on the
a(erage (ariable cost cur(e# When price falls below the minimum point on 07C, total re(enue is insufficient to co(er (ariable costs and the firm will shut down and bear losses e!ual to fi"ed costs#
'he short-run supply cur(e of a competiti(e firm is that portion of its marginal cost cur(e that lies abo(e its a(erage (ariable cost cur(e 11
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SHORT-RUN CONDITIONS AND LONG-RUN DIRECTIONS' A REIE)
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LONG-RUN COSTS' ECONOMIES AND DISECONOMIES O* SCALE
in+reaing ret#rn to +ale, or e+onoie of +ale 0n increase in a firm8s scale of production
leads to lower costs per unit produced#
+ontant ret#rn to +ale 0n increase in a firm8s
scale of production has no effect on costs per unit produced#
%e+reaing ret#rn to +ale, or %ie+onoie of +ale 0n increase in a firm8s scale of production
leads to higher costs per unit produced# 1&
LONG-RUN COSTS' ECONOMIES AND DISECONOMIES O* SCALE INCREASING RETURNS TO SCALE T$e So#r+e of E+onoie of S+ale
9ost of the economies of scale that immediately come to mind are technological in nature#
ome economies of scale result not from technology but from sheer size#
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LONG-RUN COSTS' ECONOMIES AND DISECONOMIES O* SCALE Grap$i+ Preentation long-r#n a"erage +ot +#r"e ( LRAC ! 0
graph that shows the different scales on which a firm can choose to operate in the long run#
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LONG-RUN COSTS' ECONOMIES AND DISECONOMIES O* SCALE
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LONG-RUN COSTS' ECONOMIES AND DISECONOMIES O* SCALE CONSTANT RETURNS TO SCALE
'echnically, the term constant returns means that the !uantitati(e relationship between input and output stays constant, or the same, when output is increased#
Constant returns to scale mean that the firm8s longrun a(erage cost cur(e remains flat#
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LONG-RUN COSTS' ECONOMIES AND DISECONOMIES O* SCALE
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LONG-RUN COSTS' ECONOMIES AND DISECONOMIES O* SCALE 0ll short-run a(erage cost cur(es are ;-shaped, because we assume a fi"ed scale of plant that constrains production and dri(es marginal cost upward as a result of diminishing returns# +n the long run, we make no such assumption< instead, we assume that scale of plant can be changed# +t is important to note that economic efficiency re!uires taking ad(antage of economies of scale )if they e"ist* and a(oiding diseconomies of scale# optial +ale of plant 'he scale of plant that minimizes a(erage cost#
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LONG-RUN AD.USTMENTS TO SHORT-RUN CONDITIONS
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LONG-RUN AD.USTMENTS TO SHORT-RUN CONDITIONS
=irms will continue to e"pand as long as there are economies of scale to be realized, and new firms will continue to enter as long as positi(e profits are being earned# +n the long run, e!uilibrium price )>?* is e!ual to long-run a(erage cost, short-run marginal cost, and short-run a(erage cost# >rofits are dri(en to zero: P/ 0 SRMC 0 SRAC 0 LRAC
where /9C denotes short-run marginal cost, /0C denotes shortrun a(erage cost, and @/0C denotes long-run a(erage cost# Ao other price is an e!uilibrium price# 0ny price abo(e >? means that there are profits to be made in the industry, and new firms will continue to enter# 0ny price below >? means that firms are suffering losses, and firms will e"it the industry# Bnly at >? will profits be ust e!ual to zero, and only at >? will the industry be in e!uilibrium# 2$
LONG-RUN AD.USTMENTS TO SHORT-RUN CONDITIONS
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LONG-RUN AD.USTMENTS TO SHORT-RUN CONDITIONS 0s long as losses are being sustained in an industry, firms will shut down and lea(e the industry, thus reducing supply6 shifting the supply cur(e to the left# 0s this happens, price rises# 'his gradual price rise reduces losses for firms remaining in the industry until those losses are ultimately eliminated# Whether we begin with an industry in which firms are earning profits or suffering losses, the final long-run competiti(e e!uilibrium condition is the same:
P/ 0 SRMC 0 SRAC 0 LRAC
and profits are zero# 0t this point, indi(idual firms are operating at the most efficient scale of plant6that is, at the minimum point on their @/0C cur(e#
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LONG-RUN AD.USTMENTS TO SHORT-RUN CONDITIONS
long-r#n +opetiti"e e1#ili2ri# When
P
SRMC SRAC LRAC and profits are zero#
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