© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 8 Prepared...

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

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Prepared by: Fernando Prepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano

Costs and Output Decisions in Costs and Output Decisions in the Long Runthe Long Run


The Concept of ProfitThe Concept of Profit

• ProfitProfit is the difference between total revenue is the difference between total revenue and total cost.and total cost.

• The economic concept of profit takes into The economic concept of profit takes into account the opportunity cost of capital.account the opportunity cost of capital.

• Total economic cost includes a normal rate of Total economic cost includes a normal rate of return. A return. A normal rate of returnnormal rate of return is the rate that is is the rate that is just sufficient to keep current investors interested just sufficient to keep current investors interested in the industry.in the industry.

• Breaking evenBreaking even is a situation in which a firm is is a situation in which a firm is earning exactly a normal rate of return.earning exactly a normal rate of return.


Blue Velvet Car Wash Weekly CostsBlue Velvet Car Wash Weekly Costs

Maximizing Profit–An ExampleMaximizing Profit–An Example

• If Blue Velvet washes 800 cars each week, it If Blue Velvet washes 800 cars each week, it takes in revenues of $4,000.takes in revenues of $4,000.

• This revenue is sufficient to cover both fixed costs This revenue is sufficient to cover both fixed costs of $2,000 and variable costs of $1,600, leaving a of $2,000 and variable costs of $1,600, leaving a positive economic profit of $400 per week.positive economic profit of $400 per week.

TOTAL FIXED COSTS (TOTAL FIXED COSTS (TFCTFC))TOTAL VARIABLE COSTSTOTAL VARIABLE COSTS((TVCTVC) (800 WASHES)) (800 WASHES)

TOTAL COSTSTOTAL COSTS((TCTC = = TFCTFC + + TVCTVC)) $$ 3,6003,600

1.1. Normal return to Normal return to investorsinvestors $$ 1,0001,000

1.1.2.2.

LaborLaborMaterialsMaterials

$$1,0001,000600600

Total revenue (Total revenue (TRTR)) at at PP = $5 (800 x $5) = $5 (800 x $5) $$ 4,0004,000

2.2. Other fixed costs Other fixed costs (maintenance contract, (maintenance contract, insurance, etc.)insurance, etc.) 1,0001,000

$$1,6001,600 Profit (Profit (TRTR TCTC)) $$ 400400

$$ 2,0002,000


Firm Earning Positive Profits in the Firm Earning Positive Profits in the Short RunShort Run

• To maximize profit, the firm sets the level of output To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.where marginal revenue equals marginal cost.


Firm Earning Positive Profits in the Firm Earning Positive Profits in the Short RunShort Run

• Profit is the difference between total revenue and Profit is the difference between total revenue and total cost.total cost.


Minimizing LossesMinimizing Losses

• Operating profit (or loss)Operating profit (or loss) or or net net operating revenueoperating revenue equals total revenue equals total revenue minus total variable cost (TR – TVC).minus total variable cost (TR – TVC).

• If revenues exceed variable costs, operating If revenues exceed variable costs, operating profit is positive and can be used to offset fixed profit is positive and can be used to offset fixed costs and reduce losses, and it will pay the firm costs and reduce losses, and it will pay the firm to keep operating.to keep operating.



• If revenues are smaller than variable costs, the If revenues are smaller than variable costs, the firm suffers operating losses that push total firm suffers operating losses that push total losses above fixed costs. In this case, the firm losses above fixed costs. In this case, the firm can minimize its losses by shutting down.can minimize its losses by shutting down.

• Operating profit (or loss)Operating profit (or loss) or or net net operating revenueoperating revenue equals total revenue equals total revenue minus total variable cost (TR – TVC).minus total variable cost (TR – TVC).


A Firm Will Operate If Total Revenue Covers Total Variable CostA Firm Will Operate If Total Revenue Covers Total Variable Cost


CASE 1: SHUT DOWNCASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $3CASE 2: OPERATE AT PRICE = $3

Total Revenue (Total Revenue (qq = 0) = 0) $$ 00 Total Revenue ($3 x 800)Total Revenue ($3 x 800) $$ 2,4002,400

Fixed costsFixed costsVariable costsVariable costsTotal costsTotal costs

++$$

$$

2,0002,00000

2,0002,000


++$$

$$

2,0002,0001,6001,6003,6003,600

Profit/loss (Profit/loss (TRTR TCTC)) $$ 2,0002,000 Operating profit/loss (Operating profit/loss (TRTR TVCTVC)) $$ 800800

Total profit/loss (Total profit/loss (TRTR TCTC)) $$ 1,2001,200



• When price equals $3.50, revenue is sufficient to When price equals $3.50, revenue is sufficient to cover total variable cost but not total cost. cover total variable cost but not total cost.



• As long as price (which is equal to average revenue per As long as price (which is equal to average revenue per unit) is sufficient to cover average variable costs, the firm unit) is sufficient to cover average variable costs, the firm stands to gain by operating instead of shutting down.stands to gain by operating instead of shutting down.



• The difference between The difference between ATCATC and and AVCAVC equals equals AFCAFC. Then, . Then, AFCAFC qq = = TFCTFC (the brown area). (the brown area).



• The blue area equals losses.The blue area equals losses.

• The green area equals operating profit.The green area equals operating profit.


A Firm Will Shut Down If Total Revenue Is Less Than Total Variable A Firm Will Shut Down If Total Revenue Is Less Than Total Variable CostCost

Shutting Down to Minimize LossShutting Down to Minimize Loss

CASE 1: SHUT DOWNCASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $1.50CASE 2: OPERATE AT PRICE = $1.50

Total Revenue (Total Revenue (qq = 0) = 0) $$ 00 Total revenue ($1.50 x 800)Total revenue ($1.50 x 800) $$ 1,2001,200


++$$

$$

2,0002,00000

2,0002,000


++$$

$$

2,0002,0001,6001,6003,6003,600

Profit/loss (Profit/loss (TRTR TCTC)) $$ 2,0002,000 Operating profit/loss (Operating profit/loss (TRTR TVCTVC)) $$ 400400

Total profit/loss (Total profit/loss (TRTR TCTC)) $$ 2,4002,400


Short-Run Supply Curve of a Perfectly Short-Run Supply Curve of a Perfectly Competitive FirmCompetitive Firm

• The short-run The short-run supply curve of a supply curve of a competitive firm is competitive firm is the part of its the part of its marginal cost curve marginal cost curve that lies above its that lies above its average variable average variable cost curve.cost curve.


The Short-Run Industry Supply CurveThe Short-Run Industry Supply Curve

• The industry supply curve in the short-run is the The industry supply curve in the short-run is the horizontal sum of the marginal cost curves (above horizontal sum of the marginal cost curves (above AVCAVC) ) of all the firms in an industry.of all the firms in an industry.


Profits, Losses, and Perfectly Competitive Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and Short RunFirm Decisions in the Long and Short Run

SHORT-RUNSHORT-RUNCONDITIONCONDITION

SHORT-RUNSHORT-RUNDECISIONDECISION

LONG-RUNLONG-RUNDECISIONDECISION

ProfitsProfits TR > TCTR > TC P = MC: operateP = MC: operate Expand: new firms enterExpand: new firms enter

LossesLosses 1. With operating profit1. With operating profit P = MC: operateP = MC: operate Contract: firms exitContract: firms exit

((TRTR TVCTVC)) (losses < fixed costs)(losses < fixed costs)

2. With operating losses2. With operating losses Shut down:Shut down: Contract: firms exitContract: firms exit

((TRTR < < TVCTVC)) losses = fixed costslosses = fixed costs

• In the short-run, firms have to decide how much to In the short-run, firms have to decide how much to produce in the current scale of plant.produce in the current scale of plant.

• In the long-run, firms have to choose among many In the long-run, firms have to choose among many potential scales of plant.potential scales of plant.


Long-Run Costs: Economies and Long-Run Costs: Economies and Diseconomies of ScaleDiseconomies of Scale

• Increasing returns to scaleIncreasing returns to scale, or , or economies of scale,economies of scale, refers to an refers to an increase in a firm’s scale of increase in a firm’s scale of production, which leads to production, which leads to lowerlower average costs per unit produced.average costs per unit produced.



• Constant returns to scaleConstant returns to scale refers to refers to an increase in a firm’s scale of an increase in a firm’s scale of production, which has production, which has no effectno effect on on average costs per unit produced.average costs per unit produced.



• Decreasing returns to scaleDecreasing returns to scale refers refers to an increase in a firm’s scale of to an increase in a firm’s scale of production, which leads to production, which leads to higherhigher average costs per unit produced.average costs per unit produced.


The Long-Run Average Cost CurveThe Long-Run Average Cost Curve

• The The long-run average cost long-run average cost curve (LRAC)curve (LRAC) is a graph that is a graph that shows the different scales on shows the different scales on which a firm can choose to which a firm can choose to operate in the long-run. Each operate in the long-run. Each scale of operation defines a scale of operation defines a different short-run.different short-run.


The Long-Run Average Cost CurveThe Long-Run Average Cost Curve

• The long run average cost curve of a firm exhibiting The long run average cost curve of a firm exhibiting economies of scale is downward-sloping.economies of scale is downward-sloping.


Weekly Costs Showing Economies of Weekly Costs Showing Economies of Scale in Egg ProductionScale in Egg Production

JONES FARMJONES FARM TOTAL WEEKLY COSTSTOTAL WEEKLY COSTS

15 hours of labor (implicit value $8 per hour)15 hours of labor (implicit value $8 per hour) $120$120Feed, other variable costsFeed, other variable costs 2525Transport costsTransport costs 1515Land and capital costs attributable to egg productionLand and capital costs attributable to egg production 1717

$177$177Total outputTotal output 2,400 eggs2,400 eggsAverage costAverage cost $.074 per egg$.074 per egg

CHICKEN LITTLE EGG FARMS INC.CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTSTOTAL WEEKLY COSTS

LaborLabor $ 5,128$ 5,128Feed, other variable costsFeed, other variable costs 4,1154,115Transport costsTransport costs 2,4312,431Land and capital costsLand and capital costs 19,23019,230

$30,904$30,904Total outputTotal output 1,600,000 eggs1,600,000 eggsAverage costAverage cost $.019 per egg$.019 per egg


A Firm Exhibiting Economies and A Firm Exhibiting Economies and Diseconomies of ScaleDiseconomies of Scale

• The long-run average cost curve of a firm The long-run average cost curve of a firm that eventually exhibits diseconomies of that eventually exhibits diseconomies of scale becomes upward-sloping.scale becomes upward-sloping.


Optimal Scale of PlantOptimal Scale of Plant

• The optimal scale of plant is the scale that The optimal scale of plant is the scale that minimizes average cost.minimizes average cost.


Long-Run Adjustments toLong-Run Adjustments toShort-Run ConditionsShort-Run Conditions

• Firms expand in the long-run when Firms expand in the long-run when increasing returns to scale are available.increasing returns to scale are available.


Long-Run Adjustments toLong-Run Adjustments toShort-Run ConditionsShort-Run Conditions

• Prices will be driven down to the minimum Prices will be driven down to the minimum point on the LRAC curve.point on the LRAC curve.


Short-Run Profits:Short-Run Profits:Expansion to EquilibriumExpansion to Equilibrium

• The existence of positive profits will attract The existence of positive profits will attract new entrants to an industry.new entrants to an industry.

• As capital flows into the industry, the supply As capital flows into the industry, the supply curve shifts to the right, and price falls.curve shifts to the right, and price falls.

• Firms will continue to expand as long as Firms will continue to expand as long as there are economies of scale to be realized, there are economies of scale to be realized, and new firms will continue to enter as long and new firms will continue to enter as long as positive profits are being earned.as positive profits are being earned.


Short-Run Losses:Short-Run Losses:Contraction to EquilibriumContraction to Equilibrium

• When firms in an industry suffer losses, When firms in an industry suffer losses, there is an incentive for them to exit.there is an incentive for them to exit.



• As firms exit, the supply curve shifts from As firms exit, the supply curve shifts from SS to to S’S’, driving price up to , driving price up to P*.P*.



• The industry eventually returns to long-run The industry eventually returns to long-run equilibrium and losses are eliminated.equilibrium and losses are eliminated.


Short-Run Profits:Short-Run Profits:Contraction to EquilibriumContraction to Equilibrium

• As long as losses are being sustained in an As long as losses are being sustained in an industry, firms will shut down and leave the industry, firms will shut down and leave the industry, thus reducing supply.industry, thus reducing supply.

• As this happens, price rises.As this happens, price rises.

• This gradual price rise reduces losses for firms This gradual price rise reduces losses for firms remaining in the industry until those losses are remaining in the industry until those losses are ultimately eliminated.ultimately eliminated.


Long-Run Equilibrium in Perfectly Long-Run Equilibrium in Perfectly Competitive Output MarketsCompetitive Output Markets

• Whether we begin with an industry in which Whether we begin with an industry in which firms are earning profits or suffering losses, firms are earning profits or suffering losses, the final long-run competitive equilibrium the final long-run competitive equilibrium condition is the same.condition is the same.

• In the long-run, equilibrium price (In the long-run, equilibrium price (PP*) is equal *) is equal to long-run average cost, short-run marginal to long-run average cost, short-run marginal cost, and short-run average cost. Profits are cost, and short-run average cost. Profits are driven to zero.driven to zero.


The Long-Run Adjustment MechanismThe Long-Run Adjustment Mechanism

• The central idea in our discussion of entry, The central idea in our discussion of entry, exit, expansion, and contraction is this:exit, expansion, and contraction is this:

• In efficient markets, investment capital flows In efficient markets, investment capital flows toward profit opportunities.toward profit opportunities.

• The actual process is complex and varies from The actual process is complex and varies from industry to industry.industry to industry.


• The central idea in our discussion of entry, The central idea in our discussion of entry, exit, expansion, and contraction is this:exit, expansion, and contraction is this:

The Long-Run Adjustment MechanismThe Long-Run Adjustment Mechanism

• Investment—in the form of new firms and Investment—in the form of new firms and expanding old firms—will over time tend to favor expanding old firms—will over time tend to favor those industries in which profits are being made, those industries in which profits are being made, and over time industries in which firms are and over time industries in which firms are suffering losses will gradually contract from suffering losses will gradually contract from disinvestment.disinvestment.


Internal Versus ExternalInternal Versus ExternalEconomies of ScaleEconomies of Scale

• Economies of scale that are found Economies of scale that are found within the individual firm are called within the individual firm are called internal economies of scale.internal economies of scale.

• External economies of scaleExternal economies of scale describe economies or diseconomies describe economies or diseconomies of scale on an industry-wide basis.of scale on an industry-wide basis.


The Long-Run Industry Supply CurveThe Long-Run Industry Supply Curve

• The The long-run industry supply curve long-run industry supply curve (LRIS)(LRIS) traces output over time as the traces output over time as the industry expands.industry expands.

• When an industry enjoys external When an industry enjoys external economies, its long-run supply curve economies, its long-run supply curve slopes down. Such an industry is slopes down. Such an industry is called a called a decreasing-cost industry.decreasing-cost industry.


A Decreasing-Cost Industry:A Decreasing-Cost Industry:External EconomiesExternal Economies

• In a decreasing cost industry, costs decline as a In a decreasing cost industry, costs decline as a result of industry expansion, and the LRIS is result of industry expansion, and the LRIS is downward-sloping.downward-sloping.


An Increasing-Cost Industry:An Increasing-Cost Industry:External DiseconomiesExternal Diseconomies

• In an increasing cost industry, costs rise as a In an increasing cost industry, costs rise as a result of industry expansion, and the LRIS is result of industry expansion, and the LRIS is upward-sloping.upward-sloping.


Construction Activity and the Price of Lumber Construction Activity and the Price of Lumber Products, 1991 - 1994Products, 1991 - 1994

An Increasing-Cost Industry: External An Increasing-Cost Industry: External DiseconomiesDiseconomies

YEARYEAR

MONTHLY MONTHLY AVERAGE, NEWAVERAGE, NEW

HOUSING HOUSING PERMITSPERMITS

PERCENTAGE PERCENTAGE INCREASE INCREASE OVER THE OVER THE PREVIOUS PREVIOUS

YEARYEAR

PERCENTAGE PERCENTAGE CHANGE IN THE CHANGE IN THE

PRICE OF PRICE OF LUMBER LUMBER

PRODUCTSPRODUCTS

PERCENTAGE PERCENTAGE CHANGE IN CHANGE IN CONSUMER CONSUMER

PRICESPRICES

19911991 79,50079,500 -- -- --

19921992 92,16792,167 ++ 15.915.9 ++ 14.714.7 ++ 3.03.0

19931993 100,917100,917 ++ 9.59.5 ++ 24.624.6 ++ 3.03.0

19941994 111,000111,000 ++ 10.010.0 NANA ++ 2.12.1

Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21; Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21; Statistical Abstract of the United StatesStatistical Abstract of the United States , 1994, Tables 754, 755., 1994, Tables 754, 755.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 8 Prepared...

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Transcript of © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 8 Prepared...