Powerpoint Lectures For Principles of Microeconomics, 9E by Karl E. Case, Ray C. Fair & Sharon M. Oster

PowerPoint Lectures for
CHAPTER 9 Long-Run Costs and Output Decisions
Principles of
Microeconomics, 9e
; ; By
Karl E. Case,
Ray C. Fair &
Sharon M. Oster
© 2009 Prentice Hall Business Publishing Principles of Economics 9e by Case, Fair and Oster 1 of 45
PART II THE MARKET SYSTEM
Long-Run Costs and

9
Output Decisions
Tania El Kallab
PART II THE MARKET SYSTEM
Long-Run Costs and

9
Output Decisions CHAPTER OUTLINE
Short-Run Conditions and Long-
Run Directions
Maximizing Profits
Minimizing Losses
The Short-Run Industry Supply Curve
Long-Run Directions: A Review
Long-Run Costs: Economies and
Diseconomies of Scale
Increasing Returns to Scale
Constant Returns to Scale
Decreasing Returns to Scale
Long-Run Adjustments
to Short-Run Conditions
Short-Run Profits: Expansion to Equilibrium
Short-Run Losses: Contraction to
Equilibrium
The Long-Run Adjustment Mechanism:
Investment Flows toward Profit
Opportunities
Output Markets: A Final Word
Appendix: External Economies and
Diseconomies and the Long-Run Industry
Supply Curve
Long-Run Costs and Output Decisions
We begin our discussion of the long run by looking at firms in

three short-run circumstances:
(1) firms earning economic profits,
(2) firms suffering economic losses but continuing to operate to

reduce or minimize those losses, and
(3) firms that decide to shut down and bear losses just equal to
fixed costs.
breaking even The situation in which a

firm is earning exactly a normal rate of
return.
Short-Run Conditions and Long-Run Directions
Maximizing Profits
Example: The Blue Velvet Car Wash
TABLE 9.1 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 investors $ 1,000 1. Labor $ 1,000 Total revenue (TR)

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
Refer to the figure. Given the market
price and cost conditions
described in the graphs, which of
the four firms earns a normal rate
of return?
a. A
b. B
c. C
d. D
e. All of the firms above earn a
normal rate of return because they
produce the level of output for
which MR = MC.
Refer to the figure. Given the market
price and cost conditions
described in the graphs, which of
the four firms earns a normal rate
of return?
a. A
b. B
c. C
d. D
e. All of the firms above earn a
normal rate of return because they
produce the level of output for
which MR = MC.
Maximizing Profits
 FIGURE 9.1 Firm Earning Positive Profits in the Short Run

A profit-maximizing perfectly competitive firm will produce up to the point where P* = MC.
Profits are the difference between total revenue and total costs. At q* = 300, total revenue
is $5 × 300 = $1,500, total cost is $4.20 × 300 = $1,260, and total profit = $1,500  $1,260
= $240.
Use the graph in the upper-left corner as a reference. When the firm
produces 600 units of output, which area, A, B, or C, corresponds to
the firm’s profit?
a. A
b. B
c. C
d. None of above.
Profit is not an
area but a distance.
Use the graph in the upper-left corner as a reference. When the firm
produces 600 units of output, which area, A, B, or C, corresponds to
the firm’s profit?
a. A
b. B
c. C
d. None of above.
Profit is not an
area but a distance.
Minimizing Losses
operating profit (or loss) or net

operating revenue 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
Producing at a Loss to Offset Fixed Costs: The Blue Velvet Revisited

TABLE 9.2 A Firm Will Operate If Total Revenue Covers Total Variable Cost
CASE 1: Shut Down CASE 2: Operate at Price = $3
Total Revenue $ 0 Total Revenue ($3 x 800) $ 2,400

(q = 0)
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  $ 2,000 Operating profit/loss (TR  TVC) $ 800

 TC)
Total profit/loss (TR  TC)  $ 1,200
Minimizing Losses
 FIGURE 9.1 Firm Suffering Losses but Showing an Operating Profit in the Short Run
When price is sufficient to cover average variable costs, firms suffering short-run
losses will continue operating instead of shutting down.
Total revenues (P* × q*) cover variable costs, leaving an operating profit of $90 to
cover part of fixed costs and reduce losses to $135.
Whether or not a firm decides to produce or shut down in the short run
depends solely on whether revenues from operating are sufficient
to cover:
a. Fixed costs.
b. Variable costs.
c. Total costs.
d. Normal profit.
Whether or not a firm decides to produce or shut down in the short run
depends solely on whether revenues from operating are sufficient
to cover:
a. Fixed costs.
b. Variable costs.
c. Total costs.
d. Normal profit.
Minimizing Losses
Shutting Down to Minimize Loss

TABLE 9.3 A Firm Will Shut Down If Total Revenue Is Less Than Total Variable Cost
Case 1: Shut Down CASE 2: Operate at Price = $1.50
Total Revenue (q = 0) $ 0 Total revenue ($1.50 x 800) $ 1,200
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) $ 400

Total profit/loss (TR  TC)  $ 2,400
Minimizing Losses
 FIGURE 9.1 Firm Suffering

Losses but Showing an
Operating Profit in the Short
Run
At prices below average

variable cost, it pays a
firm to shut down rather
than continue operating.
Thus, 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.
shut-down point 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.
Refer to the figure below. Which of the firms below chooses to produce
output at a loss?
a. A
b. C
c. Both A and C.
d. A, C, and D.
Refer to the figure below. Which of the firms below chooses to produce
output at a loss?
a. A
b. C
c. Both A and C.
d. A, C, and D.
The Short-Run Industry Supply Curve

short-run industry supply curve The sum of the marginal
cost curves (above AVC) of all the firms in an industry.
 FIGURE 9.4 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
A profit-maximizing perfectly competitive firm will produce up to the point where P* = If there are
only three firms in the industry, the industry supply curve is simply the sum of all the products
supplied by the three firms at each price. For example, at $6, firm 1 supplies 100 units, firm 2
supplies 200 units, and firm 3 supplies 150 units, for a total industry supply of 450.
Long-Run Directions: A Review

TABLE 9.4 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and
Short Run
Short-Run Condition Short-Run Decision Long-Run 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
Long-Run Costs: Economies and Diseconomies of Scale
increasing returns to scale, or economies of

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

scale of production has no effect on costs per unit
produced.
decreasing returns to scale, or diseconomies of

scale An increase in a firm’s scale of production
leads to higher costs per unit produced.
Increasing Returns to Scale
Example: Economies of Scale in Egg Production

TABLE 9.5 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 17
production
$177
Total output 2,400 eggs
Average cost $0.074 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 $0.019 per egg
long-run average cost curve (LRAC) A graph that shows the
different scales on which a firm can choose to operate in the long run.
 FIGURE 9.5 A Firm Exhibiting Economies of Scale

The long-run average cost curve of a firm shows the different scales on which the firm can
choose to operate in the long run. Each scale of operation defines a different short run. Here we
see a firm exhibiting economies of scale; moving from scale 1 to scale 3 reduces average cost.
Constant Returns to Scale

Technically, the term constant returns means that

the quantitative relationship between input and
output stays constant, or the same, when output is
increased.
Constant returns to scale mean that the firm’s long-

run average cost curve remains flat.
Refer to the figure below. The firm in question exhibits economies of scale:
a. Along the decreasing portion of the long-run average cost curve

(LRAC), up until Q0.
b. Along the increasing portion of the long-run average cost curve (LRAC),
after Q0.
c. At Q0, where LRAC is minimum.
d. Anywhere along the LRAC, as long as increasing the scale of
operations does not affect cost per unit.
Refer to the figure below. The firm in question exhibits economies of scale:
a. Along the decreasing portion of the long-run average cost curve

(LRAC), up until Q0.
b. Along the increasing portion of the long-run average cost curve (LRAC),
after Q0.
c. At Q0, where LRAC is minimum.
d. Anywhere along the LRAC, as long as increasing the scale of
operations does not affect cost per unit.
Decreasing Returns to Scale

optimal scale of plant

The scale of plant that
minimizes average cost.
 FIGURE 9.6 A Firm Exhibiting Economies and Diseconomies of Scale

Economies of scale push this firm’s average costs down to q*. Beyond q*, the firm
experiences diseconomies of scale; q* is the level of production at lowest average cost,
using optimal scale.
Blood bank merger ‘good’

for Manatee
Bradenton Herald.com
“Northwest needed to be aligned

with a larger organization to
achieve economy of scale,” said
J.B. Gaskins, Florida Blood
Services vice president. “That
economy of scale is good for the
whole network, including Manatee
County.”
Long-Run Adjustments to Short-Run Conditions

 FIGURE 9.7 Firms Expand in the Long Run When Increasing Returns to Scale Are Available
When economies of scale can be realized, firms have an incentive to expand. Thus, firms
will be pushed by competition to produce at their optimal scales. Price will be driven to the
minimum point on the LRAC curve.

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
Any price above P* means that there are profits to be made in the
industry, and new firms will continue to enter. Any price below P*
means that firms are suffering losses, and firms will exit the
industry. Only at P* will profits be just equal to zero, and only at P*
will the industry be in equilibrium.
Short-Run Losses: Contraction to Equilibrium

 FIGURE 9.8 Long-Run Contraction and Exit in an Industry Suffering Short-Run Losses
When firms in an industry suffer losses, there is an incentive for them to exit.
As firms exit, the supply curve shifts from S0 to S1, driving price up to P*. As price rises,
losses are gradually eliminated and the industry returns to equilibrium.
Short-Run Losses: Contraction to Equilibrium

Whether we begin with an industry in which firms are earning

profits or suffering losses, the final long-run competitive equilibrium
condition is the same:
P* = SRMC = SRAC = LRAC
and profits are zero. At this point, individual firms are operating at
the most efficient scale of plant—that is, at the minimum point on
their LRAC curve.
Refer to the figure below. Which level of output does the firm produce under
long-run, perfectly competitive conditions?
a. q1.
b. Either q* or q1.
c. q*.
d. In the long run, the firm may produce any level of output, so both q* and
q1 are possible.
Refer to the figure below. Which level of output does the firm produce under
long-run, perfectly competitive conditions?
a. q1.
b. Either q* or q1.
c. q*.
d. In the long run, the firm may produce any level of output, so both q* and
q1 are possible.
The Long-Run Average Cost Curve:

Flat or U-Shaped?
The structure of the industry in the long run will depend on
whether existing firms expand faster than new firms enter.
There is an element of randomness in the way industries
expand. Most industries contain some large firms and
some small firms,
The Long-Run Adjustment Mechanism: Investment Flows Toward

Profit Opportunities
The entry and exit of firms in response to profit opportunities usually

involve the financial capital market. In capital markets, people are
constantly looking for profits.When firms in an industry do well, capital
is likely to flow into that industry in a variety of forms.
long-run competitive equilibrium When P =

SRMC = SRAC = LRAC and profits are zero.
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.
The Long-Run Adjustment Mechanism: Investment Flows Toward

Profit Opportunities
Why Are Hot Dogs So

Expensive in Central
Park?
In New York, you need a
license to operate a hot dog
cart, and a license to operate
in the park costs more. Since
hot dogs are $.50 more in the
park, the added cost of a
license each year must be roughly $.50 per hot dog sold. In
fact, in New York City, licenses to sell hot dogs in the park
are auctioned off for many thousands of dollars, while
licenses to operate outside the park cost only about $1,000.
Output Markets: A Final Word
In the last four chapters, we have been building a model of a

simple market system under the assumption of perfect
competition.
You have now seen what lies behind the demand curves and
supply curves in competitive output markets. The next two
chapters take up competitive input markets and complete the
picture.
REVIEW TERMS AND CONCEPTS
breaking even long-run competitive equilibrium

constant returns to scale operating profit (or loss) or net
decreasing returns to scale, operating revenue
or diseconomies of scale optimal scale of plant
increasing returns to scale, or short-run industry supply curve
economies of scale shut-down point
long-run average cost curve long-run competitive equilibrium,
(LRAC) P = SRMC = SRAC = LRAC
APPENDIX
EXTERNAL ECONOMIES AND DISECONOMIES AND THE LONG-

RUN INDUSTRY SUPPLY CURVE
When long-run average costs

decrease as a result of industry
growth, we say that there are
external economies.
When average costs increase as a

result of industry growth, we say that
there are external diseconomies.
APPENDIX
EXTERNAL ECONOMIES AND DISECONOMIES AND THE LONG-

RUN INDUSTRY SUPPLY CURVE
Example of an expanding industry facing external diseconomies of scale
TABLE 9A.1 Construction of New Housing and Construction Materials Costs, 2000–2005
Construction Consumer Prices

House Prices % Housing Starts Materials Prices % % Change Over
Change Over the Housing Starts % Change Over Change Over The The Previous
Year Previous Year (Thousands) The Previous Year Previous Year Year
2000  1,573   
2001 7.5 1,661 5.6% 0% 2.8%
2002 7.5 1,710 2.9% 1.5% 1.5%
2003 7.9 1,853 8.4% 1.6% 2.3%
2004 12.0 1,949 5.2% 8.3% 2.7%
2005 13.0 2,053 5.3% 5.4% 2.5%
APPENDIX
THE LONG-RUN INDUSTRY SUPPLY CURVE
long-run industry supply curve (LRIS) A graph that traces

out price and total output over time as an industry expands.
decreasing-cost industry An industry that realizes external

economies—that is, average costs decrease as the industry

grows. The long-run supply curve for such an industry has a
negative slope.
constant-cost industry An industry that

shows no economies or diseconomies of
scale as the industry grows. Such industries have flat, or
horizontal, long-run supply curves.
increasing-cost industry An industry that encounters

external diseconomies—that is, average costs increase as the
industry grows. The long-run supply curve for such an industry
has a positive slope.
APPENDIX
Appendix
 FIGURE 9A.1 A Decreasing-Cost Industry: External Economies

In a decreasing-cost industry, average cost declines as the industry expands. As demand
expands from D0 to D1, price rises from P0 to P1.
As new firms enter and existing firms expand, supply shifts from S0 to S1, driving price
down. If costs decline as a result of the expansion to LRAC2, the final price will be below
P0 at P2.
The long-run industry supply curve (LRIS) slopes downward in a decreasing-cost industry.
APPENDIX
Appendix
 FIGURE 9A.2 An Increasing-Cost Industry: External Diseconomies

In an increasing-cost industry, average cost increases as the industry expands. As
demand shifts from D0 to D1, price rises from P0 to P1.
As new firms enter and existing firms expand output, supply shifts from S0 to S1, driving
price down. If long-run average costs rise, as a result, to LRAC2, the final price will be P2.
The long-run industry supply curve (LRIS) slopes up in an increasing-cost industry.
REVIEW TERMS AND CONCEPTS
constant-cost industry
decreasing-cost industry
external economies and diseconomies
increasing-cost industry
long-run industry supply curve (LRIS)

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CHAPTER 9 Long-Run Costs and Output Decisions

Long-Run Costs and

Long-Run Costs and

We begin our discussion of the long run by looking at firms in

(1) firms earning economic profits,

(2) firms suffering economic losses but continuing to operate to

breaking even The situation in which a

Example: The Blue Velvet Car Wash

TABLE 9.1 Blue Velvet Car Wash Weekly Costs

1. Normal return to investors $ 1,000 1. Labor $ 1,000 Total revenue (TR)

2. Other fixed costs $ 1,600 Profit (TR  TC) $ 400

 FIGURE 9.1 Firm Earning Positive Profits in the Short Run

operating profit (or loss) or net

■ If revenues exceed variable costs, operating profit

Producing at a Loss to Offset Fixed Costs: The Blue Velvet Revisited

Total Revenue $ 0 Total Revenue ($3 x 800) $ 2,400

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

Shutting Down to Minimize Loss

Total Revenue (q = 0) $ 0 Total revenue ($1.50 x 800) $ 1,200

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

Profit/loss (TR  TC):  $ 2,000 Operating profit/loss (TR  TVC) $ 400

 FIGURE 9.1 Firm Suffering

At prices below average

shut-down point The lowest point on the average variable cost

The Short-Run Industry Supply Curve

Long-Run Directions: A Review

increasing returns to scale, or economies of

constant returns to scale An increase in a firm’s

decreasing returns to scale, or diseconomies of

Increasing Returns to Scale

Example: Economies of Scale in Egg Production

Jones Farm Total Weekly Costs

 FIGURE 9.5 A Firm Exhibiting Economies of Scale

Constant Returns to Scale

Technically, the term constant returns means that

Constant returns to scale mean that the firm’s long-

a. Along the decreasing portion of the long-run average cost curve

a. Along the decreasing portion of the long-run average cost curve

Decreasing Returns to Scale

optimal scale of plant

 FIGURE 9.6 A Firm Exhibiting Economies and Diseconomies of Scale

Blood bank merger ‘good’

“Northwest needed to be aligned

Short-Run Profits: Expansion to Equilibrium

Short-Run Profits: Expansion to Equilibrium

In the long run, equilibrium price (P*) is equal to long-run average

P* = SRMC = SRAC = LRAC

Short-Run Losses: Contraction to Equilibrium

Short-Run Losses: Contraction to Equilibrium

Whether we begin with an industry in which firms are earning

P* = SRMC = SRAC = LRAC

The Long-Run Average Cost Curve:

The Long-Run Adjustment Mechanism: Investment Flows Toward

The entry and exit of firms in response to profit opportunities usually

long-run competitive equilibrium When P =

Investment—in the form of new firms and expanding old firms—will

The Long-Run Adjustment Mechanism: Investment Flows Toward

Why Are Hot Dogs So