Long-Run Costs and Output Decisions in Perfect Competition

Long-Run Costs and Output Decisions

Introduction

This chapter explores how firms make output and cost decisions in the long run, focusing on the differences between short-run and long-run behavior, the concepts of economies and diseconomies of scale, and the mechanisms that drive industry adjustment and equilibrium in perfectly competitive markets.

Short-Run Conditions and Long-Run Directions

Short-Run vs. Long-Run Decisions

• Short run: Firms operate with some fixed inputs and cannot freely enter or exit the industry.

• Long run: All inputs are variable, and firms can enter or exit the industry as they wish.

• Managers must balance immediate constraints with long-term planning.

Short-Run Firm Outcomes

• Economic profit: Total revenue (TR) exceeds total cost (TC).

• Economic loss (but continue operating): TR covers total variable cost (TVC) but not total fixed cost (TFC).

• Shutdown: TR is less than TVC; the firm minimizes losses by ceasing production and bearing losses equal to TFC.

• Breaking even: The firm earns exactly a normal rate of return (TR = TC).

Profit Maximization in the Short Run

• A perfectly competitive firm maximizes profit where price (P) equals marginal cost (MC):

$P = MC$

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

$\text{Profit} = TR - TC$

• Total cost can be found by multiplying average total cost (ATC) by quantity (q):

$TC = ATC \times q$

• Example: At $q^* = 800$, $TR = 5 \times 800 = 4000$, $TC = 4.50 \times 800 = 3600$, so profit is $400$.

Minimizing Losses and the Shutdown Point

• If TR > TVC, the firm should continue operating to cover some fixed costs.

• If TR < TVC, the firm should shut down to minimize losses.

• Shutdown point: The lowest point on the AVC curve; below this, the firm cannot cover variable costs.

Short-Run Supply Curve

• The short-run supply curve of a perfectly competitive firm is the portion of its MC curve above the AVC curve.

• The industry supply curve is the horizontal sum of all firms' MC curves above AVC.

Summary Table: Short-Run and Long-Run Decisions

Short-Run Condition	Short-Run Decision	Long-Run Decision
Profits (TR > TC)	Operate (P = MC)	Expand: new firms enter
Losses (TR ≥ TVC)	Operate (loss < TFC)	Contract: firms exit
Losses (TR < TVC)	Shut down (loss = TFC)	Contract: firms exit

Long-Run Costs: Economies and Diseconomies of Scale

Long-Run Average Cost Curve (LRAC)

• The LRAC shows how per-unit costs change with output when all inputs are variable.

• Firms can choose the most efficient scale of operation in the long run.

Types of Returns to Scale

• Economies of scale (increasing returns): LRAC decreases as output increases.

• Constant returns to scale: LRAC remains unchanged as output increases.

• Diseconomies of scale (decreasing returns): LRAC increases as output increases.

Sources of Economies of Scale

• Technological advantages, firm-level efficiencies, and bargaining power.

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

Diseconomies of Scale

• Occur when increased size leads to higher per-unit costs, often due to increased bureaucracy or coordination problems.

U-Shaped Long-Run Average Cost Curve

• Many firms experience economies of scale at low output, constant returns at intermediate output, and diseconomies at high output.

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

Long-Run Adjustments to Short-Run Conditions

Industry Response to Demand Changes

• When demand increases, firms earn profits, attracting new entrants and expanding output until profits return to zero.

• When demand decreases, firms incur losses, leading to exit and contraction until losses are eliminated.

Long-Run Competitive Equilibrium

• In equilibrium, price equals short-run marginal cost (SRMC), short-run average cost (SRAC), and long-run average cost (LRAC):

$P = SRMC = SRAC = LRAC$

• Firms earn zero economic profit, and supply equals demand.

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

External Economies and Diseconomies

• External economies: Industry growth leads to lower LRAC for all firms (decreasing-cost industry).

• External diseconomies: Industry growth leads to higher LRAC for all firms (increasing-cost industry).

Long-Run Industry Supply Curve (LRIS)

• Decreasing-cost industry: LRIS slopes downward; costs fall as industry expands.

• Increasing-cost industry: LRIS slopes upward; costs rise as industry expands.

• Constant-cost industry: LRIS is flat; costs do not change as industry expands.

Key Terms and Concepts

• Breaking even

• Constant returns to scale

• Diseconomies of 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

• External economies and diseconomies

• Long-run industry supply curve (LRIS)