AP Microeconomics

Warm Up: When can a business expand?

Are businesses guaranteed continued profits when they expand? Explain.

Long Run & short run are different mainly because… Short Run = fixed capacity (cap. gds)

therefore costs will increase; no entry or exit.

Long Run = ALL inputs are variable; with expansion costs can go up, go down, stay the same.

Short Run Review:

We know that the shapes of short-run cost curves are u-shaped as a result of the assumption that they are affected by a fixed factor of production. Costs go down in the beginning, but because of the fixed scale of operations they will reach a low point and then increase at every point after that.

Side-by-Side Graphs

Since this firm is making a profit, it can reinvest that profit and expand production!! The Volume of competition in perfect competition pushes all firms to expand when possible!

Market

Cost & Rev ($)

OutputQuantity

Price ($)

FirmS

D

P* P MR

MC

ATC

AVC

QQ

Eco Profit

Profit in SR = Expand to LR

Long-run cost curves contain no such assumption. Firms in the long-run can either triple production or exit an industry altogether. As a result, their long-run average cost curve is made up of several short-run average cost curves at various scales of production.

Like this:

Cost & Rev ($)

Output

SRMC1

SRAC1P*

Output Quantity 1

Since this firm is making a profit, it can expand its production. One of three things can happen:

1. Get More Efficient (costs ↓)

2. Get Less Efficient (costs ↑)

3. No change in efficiency

Like this:

Cost & Rev ($)

Output

SRMC1

SRAC1P*

Output Quantity 1

SRMC2

SRAC2

Output Quantity 2

There’s an important reason we are now using the SRMC=SRAC point to identify all subsequent firm outputs.

SRMC3

SRAC3

Output Quantity 3

SRMC4

SRAC4

Output Quantity 4

Like this:

Cost & Rev ($)

Output

SRMC1

SRAC1P*

Output Quantity 1

SRMC2

SRAC2

Output Quantity 2

SRMC3

SRAC3

Output Quantity 3

SRMC4

SRAC4

Output Quantity 4

SRMC = SRAC represents break even, as long as price is above this point a firm is making profits and can expand.

Like this:

Cost & Rev ($)

Output

SRAC1

Output Quantity 1

SRAC2

Output Quantity 2

SRAC3

Output Quantity 3

SRAC4

Output Quantity 4

LRAC

Long Run Average Costs

The Long Run ATC (LRAC): “envelopes” all of the SRAC curves; its shape depends on how costs vary with differing scales of operations.

Increasing Returns to Scale

An increase in a firm’s scale of production leads to lower average costs per unit produced.

[bigger is better]Ex) automobile manufacturing,

public transportation bus, airline industry.

Constant Returns to Scale

An increase in a firm’s scale of production has no effect on average costs per unit produced.

Decreasing Returns to Scale

An increase in a firm’s scale of production leads to higher average costs per unit produced.Ex) bureaucratic inefficiencies, top-

heavy management, sometimes union drive industries.

The low point of a firm’s LRAC:U

nit

Co

sts

Output

Long-run ATC

Economiesof scale

The low point of a firm’s LRAC:U

nit

Co

sts

Output

Long-run ATC

Economiesof scale

Constant returnsto scale

The low point of a firm’s LRAC:U

nit

Co

sts

Output

Long-run ATC

Economiesof scale

Diseconomiesof scale

Constant returnsto scale

(decreasing costs as production increases)

(constant - unchanging costs as production increases)

(increasing costs as production increases)

The low point of a firm’s LRAC:

Is called Optimum Scale: The scale of plant that minimizes average

cost. Once a firm has expanded beyond this

point, it should scale back production or exit the industry.