Chapter 9: Long-Run Costs and Output Decisions – Principles of Microeconomics

Long-Run Costs and Output Decisions

Introduction

This chapter explores how firms make output decisions in the long run, focusing on cost structures, profit maximization, and industry dynamics under perfect competition. The long run allows firms greater flexibility in adjusting inputs and scale, leading to important implications for market supply and resource allocation.

Short-Run Conditions and Long-Run Directions

Short-Run Circumstances

• Economic Profits: Firms earning profits above the normal rate of return.

• Economic Losses: Firms operating at a loss but continuing to minimize losses.

• Shutdown Decision: Firms shutting down when losses equal fixed costs.

Breaking Even: The situation in which a firm earns exactly a normal rate of return.

Maximizing Profits

Profit Maximization in Perfect Competition

• A perfectly competitive firm maximizes profit where P = MC (Price equals Marginal Cost).

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

• Average total cost (ATC) is calculated as:

$ATC = \frac{TC}{q}$

So, total cost can be found by:

$TC = ATC \times q$

Example: The Blue Velvet Car Wash

TFC (Total Fixed Cost)	TVC (Total Variable Cost)	TC (Total Cost)	TR (Total Revenue)
$2,000	$1,600	$3,600	$4,000

Profit = TR - TC = $400

Minimizing Losses

Operating vs. Shutting Down

• If Total Revenue (TR) > Total Variable Cost (TVC), the firm should continue operating to offset fixed costs.

• If TR < TVC, the firm should shut down to minimize losses, which will equal fixed costs.

Shutdown Point: The lowest point on the average variable cost (AVC) curve. If price falls below this point, the firm cannot cover variable costs and should shut down.

Short-Run Industry Supply Curve

Definition and Construction

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

• For a small number of firms, the industry supply is the horizontal sum of each firm's supply at each price.

Firm	Units Supplied at $6
Firm 1	150
Firm 2	150
Firm 3	150
Total Industry Supply	450

Long-Run Directions: A Review

Firm Decisions in the Long and Short Run

Short-Run Condition	Short-Run Decision	Long-Run Decision
TR > TC	P = MC: operate	Expand: new firms enter
TR > TVC (loss < total fixed cost)	P = MC: operate	Contract: firms exit
TR < TVC (loss = total fixed cost)	Shut down	Contract: firms exit

Long-Run Costs: Economies and Diseconomies of Scale

Key Concepts

• Long-run average cost curve (LRAC): Shows how per unit costs change with output in the long run.

• Increasing returns to scale (Economies of scale): Larger scale leads to lower costs per unit.

• Constant returns to scale: Costs per unit remain unchanged as scale increases.

• Decreasing returns to scale (Diseconomies of scale): Larger scale leads to higher costs per unit.

Sources of Economies of Scale

• Firm-level efficiencies and bargaining power.

• Advantages from larger firm size, not just plant size.

• Minimum efficient scale (MES): The smallest output at which LRAC is minimized.

Constant Returns to Scale

• Input-output relationship remains constant as output increases.

• LRAC curve is flat.

Diseconomies of Scale

• Average cost increases with scale due to factors like increased bureaucracy.

U-Shaped Long-Run Average Costs

• Optimal scale of plant: The scale that minimizes LRAC.

• Economies of scale push costs down to the minimum; beyond this, diseconomies push costs up.

Long-Run Adjustments to Short-Run Conditions

Industry Response to Changes in Demand

• When demand increases, firms initially earn profits, attracting new entrants and expanding industry output.

• In equilibrium, each firm has:

$SRMC = SRAC = LRAC$

and

$P = SRMC = SRAC = LRAC$

• Firms make no excess profits; supply equals demand.

Long-Run Adjustment Mechanism

• Entry and exit of firms are driven by profit opportunities, often involving capital markets.

• Profitable industries attract investment; unprofitable industries contract.

• Long-run competitive equilibrium: $P = SRMC = SRAC = LRAC$ and profits are zero.

Output Markets: A Final Word

Resource Allocation and Market Signals

• Market price changes and profits signal resource reallocation in society.

• Short-run constraints are due to fixed scales of operation; long-run adjustments allow for entry and exit.

• Understanding output market dynamics is essential before studying input markets.

Review Terms and Concepts

• Breaking even

• Constant returns to scale

• Decreasing returns to scale / Diseconomies of scale

• Increasing returns to scale / Economies of scale

• Long-run average cost curve (LRAC)

• Long-run competitive equilibrium

• Minimum efficient scale (MES)

• Optimal scale of plant

• Short-run industry supply curve

• Shutdown point

Key Equation:

$P = SRMC = SRAC = LRAC$

Appendix: External Economies and Diseconomies & Long-Run Industry Supply Curve

External Economies and Diseconomies

• External economies: Industry growth decreases LRAC (decreasing-cost industry).

• External diseconomies: Industry growth increases LRAC (increasing-cost industry).

• Constant-cost industry: No change in LRAC as industry grows.

Long-Run Industry Supply Curve (LRIS)

• LRIS traces price and total output as industry expands.

• Decreasing-cost industry: LRIS has a negative slope.

• Increasing-cost industry: LRIS has a positive slope.

• Constant-cost industry: LRIS is horizontal.

Summary Table: Types of Industry Cost Structures

Industry Type	External Effect	LRIS Slope
Decreasing-cost	External economies	Negative
Increasing-cost	External diseconomies	Positive
Constant-cost	No external effect	Horizontal

Additional info: These notes expand on textbook slides and provide definitions, formulas, and examples for key microeconomic concepts related to long-run costs and output decisions.