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Long-Run Costs

and Output Decisions


Jalil Choudhury

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, and
firms that decide to shut down and bear losses
just equal to fixed costs.
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
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.
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS

Remember that average total cost is equal to average


fixed cost plus average variable cost. This means that at
every level of output, average fixed cost is the difference
between average total and average variable cost:
ATC = AFC + AVC
or
AFC = ATC AVC = $4.10 $3.10 = $1.00

As long as price (which is equal to average revenue


per unit) is sufficient to cover average variable costs,
the firm stands to gain by operating instead of shutting
down.
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS

Any time that price (average revenue) is below the minimum point
on the average variable cost curve, total revenue will be less than
total variable cost, and operating profit will be negativethat is,
there will be a loss on operation.
In other words, when price is below all points on the average
variable cost curve, the firm will suffer operating losses at any
possible output level the firm could choose.
When this is the case, the firm will stop producing and bear losses
equal to fixed costs.
This is why the bottom of the average variable cost curve is called
the shut-down point.
At all prices above it, the marginal cost curve shows the profitmaximizing level of output.
At all prices below it, optimal short-run output is zero.
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS
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.

The

short-run supply curve of a competitive


firm is that portion of its marginal cost curve
that lies above its average variable cost curve
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SHORT-RUN CONDITIONS
AND LONG-RUN DIRECTIONS: A REVIEW

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LONG-RUN COSTS: ECONOMIES


AND DISECONOMIES OF SCALE

increasing returns to scale, or economies of


scale An increase in a firms scale of production
leads to lower costs per unit produced.

constant returns to scale An increase in a firms


scale of production has no effect on costs per unit
produced.

decreasing returns to scale, or diseconomies of


scale An increase in a firms scale of production
leads to higher costs per unit produced.
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LONG-RUN COSTS: ECONOMIES


AND DISECONOMIES OF SCALE
INCREASING RETURNS TO SCALE
The Sources of Economies of Scale

Most of the economies of scale that immediately


come to mind are technological in nature.

Some economies of scale result not from technology


but from sheer size.

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LONG-RUN COSTS: ECONOMIES


AND DISECONOMIES OF SCALE
Graphic Presentation
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.

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LONG-RUN COSTS: ECONOMIES


AND DISECONOMIES OF SCALE

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LONG-RUN COSTS: ECONOMIES


AND DISECONOMIES OF SCALE
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 firms longrun average cost curve remains flat.

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LONG-RUN COSTS: ECONOMIES


AND DISECONOMIES OF SCALE

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LONG-RUN COSTS: ECONOMIES


AND DISECONOMIES OF SCALE

All short-run average cost curves are U-shaped,


because we assume a fixed scale of plant that
constrains production and drives marginal cost upward
as a result of diminishing returns.
In the long run, we make no such assumption; instead,
we assume that scale of plant can be changed.
It is important to note that economic efficiency requires
taking advantage of economies of scale (if they exist)
and avoiding diseconomies of scale.
optimal scale of plant The scale of plant that
minimizes average cost.
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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS

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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS

Firms will continue to expand as long as there are economies of scale


to be realized, and new firms will continue to enter as long as positive
profits are being earned.
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
where SRMC denotes short-run marginal cost, SRAC denotes shortrun average cost, and LRAC denotes long-run average cost.
No other price is an equilibrium price.
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.
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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS

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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS

As long as losses are being sustained in an industry, firms


will shut down and leave the industry, thus reducing supply
shifting the supply curve to the left.
As this happens, price rises.
This 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 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 plantthat is, at the minimum point on their
LRAC curve.
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LONG-RUN ADJUSTMENTS
TO SHORT-RUN CONDITIONS
long-run

competitive equilibrium When P


= SRMC = SRAC = LRAC and profits are
zero.

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