Principles of Microeconomics

Thirteenth Edition

Chapter 9
Long-Run Costs
and Output
Decisions

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Chapter Outline and Learning
Objectives (1 of 2)
9.1 Short-Run Conditions and Long-Run Directions
9.2 Long-Run Costs: Economies and Diseconomies of
Scale.

9.3 Long-Run Adjustments to Short-Run Conditions

– Describe long-run adjustments for short-run profits and losses.

• Appendix: External Economies and Diseconomies and

the Long-Run Industry Supply Curve

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Chapter 9 Long-Run Costs and
Output Decisions
• Output decisions in the long run are less
constrained than in the short run:
– Firms can choose their scale of plant and
change any or all of its inputs.
– Firms are free to enter and leave the industry.
• Managers simultaneously make short-run and
long-run decisions, making the best of the current
constraints while planning for the future.

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Short-Run Conditions and Long-Run
Directions
• We begin our discussion of the long run by looking at firms
in 3 short-run circumstances:
– Firms that earn economic profits
– Firms that suffer economic losses but continue
to operate to reduce or minimize those losses
– 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. (P=ATC)

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Maximizing Profits (1 of 2)
Example: The Blue Velvet Car Wash
Table 9.1 Blue Velvet Car Wash Weekly Costs
TFC TVC TVC TC TR
Total Fixed Total Variable Total Variable Cost Total Cost Total Revenue
Cost Cost (800 (800 Washes) (800 Washes) (P = $5)
Washes)
1. Normal $1,000 1. Labor $1,000 TC = TFC + TVC TR = $5 × 800
return to 2. Soap 600 = $2,000 + =$4,000
investors $1,600
= $3,600
2. Other fixed 1,000 $1,600 Profit = TR − TC
costs = $400
(maintenance
contract)
$2,000

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Maximizing Profits (2 of 2)
Graphic Presentation
• A profit-maximizing perfectly competitive firm will produce up to
the point where P * MC.
• Profit is the difference between total revenue and total cost.
• Because average total cost is derived by dividing total cost by q,
we can get back to total cost by multiplying average total cost by
q.

TC
ATC 
q
and so
TC  ATC  q.
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Figure 9.1 Firm Earning a Positive
Profit in the Short Run

At q* = 800, total revenue is $5 × 800 = $4,000, total cost is

$4.50 × 800 = $3,600, and profit is $4,000 − $3,600 = $400.
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Minimizing Losses (1 of 2)
• If TR > TVC, the excess revenue can be
used to offset fixed costs and reduce
losses, and it will pay the firm to keep
operating.
• Operating profit = TR – TVC
• If TR < TVC, the firm that operates will
suffer losses in excess of fixed costs. In this
case, the firm can minimize its losses by
shutting down.
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Minimizing Losses (2 of 2)
Producing at a Loss to Offset Fixed Costs
• shutdown 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.

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Figure 9.2 Short-Run Supply Curve of
a Perfectly Competitive Firm

• 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.
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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.

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Figure 9.3 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

• 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 each firm supplies 150 units, for a total industry
supply of 450.
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Long-Run Directions: A Review
Table 9.2 Profits, Losses, and Perfectly Competitive
Firm Decisions in the Long and Short Run
Short-Run Short-Run Decision Long-Run
Condition Decision
Profits TR > TC P = MC: operate Expand: new
firms enter

Losses 1. TR TVC P = MC: operate Contract: firms

(loss < total fixed exit
cost)
2. TR < TVC Shut down: Contract: firms
loss = total fixed cost exit

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Long-Run Costs: Economies and
Diseconomies of Scale
• long-run average cost curve (LRAC) Shows the way
per-unit costs change with output in the long run.
1. increasing returns to scale or economies of
scale ‫ وفورات الحجم‬An increase in a firm’s scale of
production leads to lower costs per unit produced.
2. constant returns to scale An increase in a firm’s
scale of production has no effect on costs per unit
produced.
3. decreasing returns to scale or diseconomies
of scale ‫ تبذيرات‬An increase in a firm’s scale of
production leads to higher costs per unit produced.
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Increasing Returns to Scale
The Sources of Economies of Scale
• Some economies of scale result not from
technology but from 1 (firm-level efficiencies and
2 ) bargaining power that can come with size.
• Economies of scale have come from advantages
of larger firm size rather than gains from plant
size.
• minimum efficient scale (MES) The smallest
size at which the long-run average cost curve is at
its minimum.
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Figure 9.4 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.
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Economics In Practice (1 of 4)
Economies of Scale in the Search Business

Online search is a scale-driven

business: The search behavior of
one user can be used to improve
the search of future users.
Google—the top search engine—
has more than three times the
searches of Microsoft’s Bing but
employs only about twice as many
engineers and spends less per
search on its data centers.
CRITICAL THINKING
1. Google was an early pioneer in the search business. How did that
early lead interact with the fact of scale economies in Google’s favor?
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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 means that
the firm’s long-run average cost curve
remains flat.
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Diseconomies of Scale
• When average cost increases with scale of production, a
firm faces decreasing returns to scale, or diseconomies of
scale.

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Economics In Practice (2 of 4)
Diseconomies of Scale in Secondary School
Education
The number of school districts in the United
States reduced from 100,000 in the 1940s to
just over 10,000 by the late 1990s.
Schools searched for scale economies by
expanding the number of students with the
same amounts of fixed costs, such as the
costs for a gym or library.
More recently, there was recognition that
larger schools increased bureaucracy, which
increased school costs and potentially
reduces school quality.

CRITICAL THINKING

1. If you were only concerned about the cost side of education, where do you think you
would find the biggest opportunities for cost saving with size?

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U-Shaped Long-Run Average Costs
• optimal scale of plant The scale
of plant that minimizes long-run
average cost.

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Figure 9.5 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 long-run average costs, using optimal scale.
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Long-Run Adjustments to Short-Run
Conditions
Short-Run Profits: Moves In and Out of Equilibrium
• Suppose demand increases when the industry is in long-
run equilibrium. What will happen?

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Figure 9.6 Equilibrium for an Industry
with U-Shaped Cost Curves

• The individual firm on the right is producing 2,000 units, and we also know that
the industry consists of 100 firms.
• All firms are identical, and all are producing at the uniquely best output level of
2,000 units.
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Figure 9.7 Industry Response to an
Increase in Demand

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Figure 9.8 New Equilibrium with Higher
Demand

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Short-Run Profits: Moves In and Out
of Equilibrium
• In equilibrium, each firm has:

SRMC SRAC  LRAC

• Firms make no excess profits so that:

P SRMC SRAC  LRAC

and there are enough firms so that supply equals demand.

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The Long-Run Adjustment Mechanism:
Investment Flows toward Profit
Opportunities (1 of 2)
• 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.

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The Long-Run Adjustment Mechanism:
Investment Flows toward Profit
Opportunities (2 of 2)
• 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.
• Also, over time, industries in which
firms are suffering losses will gradually
contract from disinvestment.
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Economics In Practice (4 of 4)
Why Are Hot Dogs So Expensive in Central
Park?
Licenses to sell hot dogs in New York
City’s Central Park are auctioned off for
thousands of dollars, while licenses to
operate in more remote parts of the city
cost only about $1,000.

Since hot dogs are $0.50 more in the

park, the added cost of a license each
year must be roughly $0.50 per hot dog
sold.

CRITICAL THINKING
1. Show on a graph how a higher-priced license increases hot dog prices.
2. Who is the woman in the coat?

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Output Markets: A Final Word (1 of 2)
• In the last four chapters, we have been building a model of
a simple market system under the assumption of perfect
competition.
• Changes in market price and thus profits are the basic
signal that leads to a reallocation of society’s resources.
• In the short run, producers are constrained by their scales
of operation.

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Output Markets: A Final Word (2 of 2)
• In the long run, however, we would expect to see
resources flow in to compete for these profits. What starts
as a shift in preferences thus ends up as a shift in
resources.
• You have now seen what lies behind the demand curves
and supply curves in competitive output markets.
• The next two chapters complete the picture by taking up
competitive input markets.

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Review Terms and Concepts
• breaking even • optimal scale of plant

• constant returns to scale • short-run industry supply curve

• decreasing returns to scale or • shutdown point

diseconomies of scale
Equation:
• increasing returns to scale or
• long-run competitive equilibrium,
economies of scale

• long-run average cost curve P  SRMC  SRAC  LRAC

(LRAC)

• long-run competitive equilibrium

• minimum efficient scale (MES)

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Chapter 9 Appendix: External Economies
and Diseconomies

• When industry growth results in a

decrease in long-run average costs,
there are external economies.
• When industry growth results in an
increase in long-run average costs,
there are external diseconomies.

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Table 9A.1 Construction of New Housing
and Construction Materials Costs, 2000–
2005
Year House Prices Housing Starts Housing Construction Consumer
% over the (Thousands) Starts % Materials Prices %
Previous Year Change Prices % Change over
over the Change over the Previous
Previous the Previous Year
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%

Source: Based on Economy.com and the Office of Federal Housing

Enterprise Oversight (OFHEO).
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The Long-Run Industry Supply Curve
(1 of 2)

• 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.

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The Long-Run Industry Supply Curve
(2 of 2)

• increasing-cost industry An industry that

encounters 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.
• 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.
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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.
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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.
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Appendix 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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