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C H A P T E R
C H A P T E R
C H A P T E R 8
© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Long-Run Costsand Output Decisions
Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve
Prepared by: Fernando QuijanoPrepared by: Fernando Quijanoand Yvonn Quijanoand Yvonn Quijano
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
2 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Short-Run Conditionsand Long-Run Directions
• Profit is the difference between total revenue and total economic cost.
• Total economic cost includes a normal rate of return, or the rate that is just sufficient to keep current investors interested in the industry.
• Breaking even is a situation in which a firm earns exactly a normal rate of return.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
3 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Maximizing Profits
• Revenue is sufficient to cover both fixed costs of $2,000 and variable costs of $1,600, leaving a positive economic profit of $400 per week.
Blue Velvet Car Wash Weekly CostsTOTAL COSTS(TC = TFC + TVC)
2,000$
400$Profit (TR − TC)1,600$
1,000
Other fixed costs (maintenance contract, insurance, etc.)
2.
4,000$Total revenue (TR)
at P = $5 (800 x $5)1,000
600$Labor
Materials1.2.1,000$
Normal return to investors
1.3,600$
TOTAL VARIABLE COSTS(TVC) (800 WASHES)TOTAL FIXED COSTS (TFC)
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Run Costs and Output Decisions
4 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Firm Earning Positive Profits in the Short Run
• To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
5 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Firm Earning Positive Profits in the Short Run
• Profit is the difference between total revenue and total cost.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
6 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
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.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
7 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Minimizing Losses
• 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.
• Operating profit (or loss) or net operating revenue equals total revenue minus total variable cost (TR – TVC).
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
8 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Minimizing Losses
• When price equals $3.50, revenue is sufficient to cover total variable cost but not total cost.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
9 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Minimizing Losses
A Firm Will Operate If Total Revenue Covers Total Variable Cost
1,200$−Total profit/loss (TR − TC)800$Operating profit/loss (TR − TVC)2,000$−Profit/loss (TR − TC)
2,0001,6003,600
$
$+
Fixed costsVariable costsTotal costs
2,0000
2,000
$
$+
Fixed costsVariable costsTotal costs
2,400$Total Revenue ($3 x 800)0$Total Revenue (q = 0)
CASE 2: OPERATE AT PRICE = $3CASE 1: SHUT DOWN
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
10 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Minimizing Losses
• As long as price is sufficient to cover average variable costs, the firm stands to gain by operating instead of shutting down.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
11 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Minimizing Losses
• The difference between ATC and AVC equals AFC. Then, AFC q = TFC.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
12 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Shutting Down to Minimize Loss
A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost
2,400$−Total profit/loss (TR − TC)400$−Operating profit/loss (TR − TVC)2,000$−Profit/loss (TR − TC)
2,0001,6003,600
$
$+
Fixed costsVariable costsTotal costs
2,0000
2,000
$
$+
Fixed costsVariable costsTotal costs
1,200$Total revenue ($1.50 x 800)0$Total Revenue (q = 0)CASE 2: OPERATE AT PRICE = $1.50CASE 1: SHUT DOWN
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
13 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
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.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
14 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
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.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
15 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
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.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
16 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short Run
losses = fixed costs(TR < TVC)Contract: firms exitShut down:2. With operating losses
(losses < fixed costs)(TR ≥ TVC)Contract: firms exitP = MC: operate1. With operating profitLosses
Expand: new firms enterP = MC: operateTR > TCProfits
LONG-RUNDECISION
SHORT-RUNDECISION
SHORT-RUNCONDITION
• 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.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
17 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Long-Run Costs: Economies andDiseconomies 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.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
18 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Weekly Costs Showing Economies of Scale in Egg Production
$.019 per eggAverage cost1,600,000 eggsTotal output
$30,90419,230Land and capital costs
2,431Transport costs4,115Feed, other variable costs
$ 5,128Labor
TOTAL WEEKLY COSTSCHICKEN LITTLE EGG FARMS INC.
$.074 per eggAverage cost2,400 eggsTotal output
$17717Land and capital costs attributable to egg production15Transport costs25Feed, other variable costs
$12015 hours of labor (implicit value $8 per hour)
TOTAL WEEKLY COSTSJONES FARM
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C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
19 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
A Firm Exhibiting Economies of Scale
• The long run average cost curve of a firm exhibiting economies of scale is downward-sloping.
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C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
20 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
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.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
21 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
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.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
22 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
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.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
23 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
A Firm Exhibiting Economiesand Diseconomies of Scale
• The LRAC curve of a firm that eventually exhibits diseconomies of scale becomes upward-sloping.
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C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
24 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Optimal Scale of Plant
• The optimal scale of plant is the scale that minimizes average cost.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
25 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Long-Run Adjustmentsto Short-Run Conditions
• Firms expand in the long-run when increasing returns to scale are available.
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26 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Short-Run Profits:Expansion to Equilibrium
• Firms expand in the long run when increasing returns to scale are available.
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27 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Short-Run Losses:Contraction to Equilibrium
• When firms in an industry suffer losses, there is an incentive for them to exit.
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28 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Short-Run Losses:Contraction to Equilibrium
• As firms exit, the supply curve shifts from Sto S’, driving price up to P*.
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29 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Short-Run Losses:Contraction to Equilibrium
• The industry eventually returns to long-run equilibrium and losses are eliminated.
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30 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Long-Run Competitive 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= = =
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31 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
The Long-Run Adjustment Mechanism:Investment Flows Toward Profit Opportunities
• The central idea in our discussion of entry, exit, expansion, and contraction is this:
• In efficient markets, investment capital flows toward profit opportunities.
• The actual process is complex and varies from industry to industry.
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C H A P T E R 8: Long
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Run Costs and Output Decisions
32 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
• The central idea in our discussion of entry, exit, expansion, and contraction is this:
Long-Run Adjustment Mechanism:Investment Flows Toward Profit Opportunities
• 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.
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C H A P T E R 8: Long
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33 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Review Terms and Concepts
operating profit (or loss) or net operating operating profit (or loss) or net operating revenuerevenue
optimal scale of plantoptimal scale of plant
shortshort--run industry supply curverun industry supply curve
shutshut--down pointdown point
longlong--run competitive equilibrium: run competitive equilibrium: P = SRMC = SRAC = LRACP = SRMC = SRAC = LRAC
breaking evenbreaking even
constant return to scalesconstant return to scales
decreasing returns to scale, or decreasing returns to scale, or diseconomies of scalediseconomies of scale
increasing returns to scale, or increasing returns to scale, or economies of scaleeconomies of scale
longlong--run average cost curve (LRAC)run average cost curve (LRAC)
longlong--run competitive equilibriumrun competitive equilibrium
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
34 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve
• Economies of scale that are found within the individual firm are called internal economies of scale.
• External economies of scaledescribe economies or diseconomies of scale on an industry-wide basis.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
35 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve
• The long-run industry supply curve (LRIS) traces output over time as the industry expands.
• When an industry enjoys external economies, its long-run supply curve slopes down. Such an industry is called a decreasing-cost industry.
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C H A P T E R 8: Long
C H A P T E R 8: Long -- Run Costs and Output Decisions
Run Costs and Output Decisions
36 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve
Construction Activity and the Price of Lumber Products, 1991 - 1994
Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21; Statistical Abstract of the United States, 1994, Tables 754, 755.
2.1+NA10.0+111,0001994
3.0+24.6+9.5+100,9171993
3.0+14.7+15.9+92,1671992
---79,5001991
PERCENTAGE CHANGE IN CONSUMER
PRICES
PERCENTAGE CHANGE IN THE
PRICE OF LUMBER
PRODUCTS
PERCENTAGE INCREASE OVER THE PREVIOUS
YEAR
MONTHLY AVERAGE, NEW
HOUSING PERMITSYEAR
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Run Costs and Output Decisions
37 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve
• In a decreasing cost industry, costs decline as a result of industry expansion, and the LRIS is downward-sloping.
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38 of 38© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve
• In an increasing cost industry, costs rise as a result of industry expansion, and the LRIS is upward-sloping.
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