For educational purpose only

1. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
CHAPTERCHAPTER 88
Prepared by: Fernando QuijanoPrepared by: Fernando Quijano
and Yvonn Quijanoand Yvonn Quijano
Costs and Output Decisions inCosts and Output Decisions in
the Long Runthe Long Run

2. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Concept of ProfitThe Concept of Profit
• ProfitProfit is the difference between total revenueis the difference between total revenue
and total cost.and total cost.
• The economic concept of profit takes intoThe economic concept of profit takes into
account the opportunity cost of capital.account the opportunity cost of capital.
• Total economic cost includes a normal rate ofTotal economic cost includes a normal rate of
return. Areturn. A normal rate of returnnormal rate of return is the rate that isis the rate that is
just sufficient to keep current investors interestedjust sufficient to keep current investors interested
in the industry.in the industry.
• Breaking evenBreaking even is a situation in which a firm isis a situation in which a firm is
earning exactly a normal rate of return.earning exactly a normal rate of return.

3. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Blue Velvet Car Wash Weekly CostsBlue Velvet Car Wash Weekly Costs
Maximizing Profit–An ExampleMaximizing Profit–An Example
• If Blue Velvet washes 800 cars each week, itIf Blue Velvet washes 800 cars each week, it
takes in revenues of $4,000.takes in revenues of $4,000.
• This revenue is sufficient to cover both fixed costsThis revenue is sufficient to cover both fixed costs
of $2,000 and variable costs of $1,600, leaving aof $2,000 and variable costs of $1,600, leaving a
positive economic profit of $400 per week.positive economic profit of $400 per week.
TOTAL FIXED COSTS (TOTAL FIXED COSTS (TFCTFC))
TOTAL VARIABLE COSTSTOTAL VARIABLE COSTS
((TVCTVC) (800 WASHES)) (800 WASHES)
TOTAL COSTSTOTAL COSTS
((TCTC == TFCTFC ++ TVCTVC)) $$ 3,6003,600
1.1. Normal return toNormal return to
investorsinvestors $$ 1,0001,000
1.1.
2.2.
LaborLabor
MaterialsMaterials
$$1,0001,000
600600
Total revenue (Total revenue (TRTR))
atat PP = $5 (800 x $5)= $5 (800 x $5) $$ 4,0004,000
2.2. Other fixed costsOther fixed costs
(maintenance contract,(maintenance contract,
insurance, etc.)insurance, etc.) 1,0001,000
$$1,6001,600 Profit (Profit (TRTR −− TCTC)) $$ 400400
$$ 2,0002,000

4. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Minimizing LossesMinimizing Losses
• Operating profit (or loss)Operating profit (or loss) oror netnet
operating revenueoperating revenue equals total revenueequals total revenue
minus total variable cost (TR – TVC).minus total variable cost (TR – TVC).
• If revenues exceed variable costs, operatingIf revenues exceed variable costs, operating
profit is positive and can be used to offset fixedprofit is positive and can be used to offset fixed
costs and reduce losses, and it will pay the firmcosts and reduce losses, and it will pay the firm
to keep operating.to keep operating.

5. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Minimizing LossesMinimizing Losses
• If revenues are smaller than variable costs, theIf revenues are smaller than variable costs, the
firm suffers operating losses that push totalfirm suffers operating losses that push total
losses above fixed costs. In this case, the firmlosses above fixed costs. In this case, the firm
can minimize its losses by shutting down.can minimize its losses by shutting down.
• Operating profit (or loss)Operating profit (or loss) oror netnet
operating revenueoperating revenue equals total revenueequals total revenue
minus total variable cost (TR – TVC).minus total variable cost (TR – TVC).

6. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
A Firm Will Operate If Total Revenue Covers Total Variable CostA Firm Will Operate If Total Revenue Covers Total Variable Cost
Minimizing LossesMinimizing Losses
CASE 1: SHUT DOWNCASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $3CASE 2: OPERATE AT PRICE = $3
Total Revenue (Total Revenue (qq = 0)= 0) $$ 00 Total Revenue ($3 x 800)Total Revenue ($3 x 800) $$ 2,4002,400
Fixed costsFixed costs
Variable costsVariable costs
Total costsTotal costs
++
$$
$$
2,0002,000
00
2,0002,000
Fixed costsFixed costs
Variable costsVariable costs
Total costsTotal costs
++
$$
$$
2,0002,000
1,6001,600
3,6003,600
Profit/loss (Profit/loss (TRTR −− TCTC)) −− $$ 2,0002,000 Operating profit/loss (Operating profit/loss (TRTR −− TVCTVC)) $$ 800800
Total profit/loss (Total profit/loss (TRTR −− TCTC)) −− $$ 1,2001,200

7. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
A Firm Will Shut Down If Total Revenue Is Less Than Total VariableA Firm Will Shut Down If Total Revenue Is Less Than Total Variable
CostCost
Shutting Down to Minimize LossShutting Down to Minimize Loss
CASE 1: SHUT DOWNCASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $1.50CASE 2: OPERATE AT PRICE = $1.50
Total Revenue (Total Revenue (qq = 0)= 0) $$ 00 Total revenue ($1.50 x 800)Total revenue ($1.50 x 800) $$ 1,2001,200
Fixed costsFixed costs
Variable costsVariable costs
Total costsTotal costs
++
$$
$$
2,0002,000
00
2,0002,000
Fixed costsFixed costs
Variable costsVariable costs
Total costsTotal costs
++
$$
$$
2,0002,000
1,6001,600
3,6003,600
Profit/loss (Profit/loss (TRTR −− TCTC)) −− $$ 2,0002,000 Operating profit/loss (Operating profit/loss (TRTR −− TVCTVC)) −− $$ 400400
Total profit/loss (Total profit/loss (TRTR −− TCTC)) −− $$ 2,4002,400

8. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Profits, Losses, and Perfectly CompetitiveProfits, Losses, and Perfectly Competitive
Firm Decisions in the Long and Short RunFirm Decisions in the Long and Short Run
SHORT-RUNSHORT-RUN
CONDITIONCONDITION
SHORT-RUNSHORT-RUN
DECISIONDECISION
LONG-RUNLONG-RUN
DECISIONDECISION
ProfitsProfits TR > TCTR > TC P = MC: operateP = MC: operate Expand: new firms enterExpand: new firms enter
LossesLosses 1. With operating profit1. With operating profit P = MC: operateP = MC: operate Contract: firms exitContract: firms exit
((TRTR ≥≥ TVCTVC)) (losses < fixed costs)(losses < fixed costs)
2. With operating losses2. With operating losses Shut down:Shut down: Contract: firms exitContract: firms exit
((TRTR << TVCTVC)) losses = fixed costslosses = fixed costs
• In the short-run, firms have to decide how much toIn the short-run, firms have to decide how much to
produce in the current scale of plant.produce in the current scale of plant.
• In the long-run, firms have to choose among manyIn the long-run, firms have to choose among many
potential scales of plant.potential scales of plant.

9. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Long-Run Costs: Economies andLong-Run Costs: Economies and
Diseconomies of ScaleDiseconomies of Scale
• Increasing returns to scaleIncreasing returns to scale, or, or
economies of scale,economies of scale, refers to anrefers to an
increase in a firm’s scale ofincrease in a firm’s scale of
production, which leads toproduction, which leads to lowerlower
average costs per unit produced.average costs per unit produced.

10. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Long-Run Costs: Economies andLong-Run Costs: Economies and
Diseconomies of ScaleDiseconomies of Scale
• Constant returns to scaleConstant returns to scale refers torefers to
an increase in a firm’s scale ofan increase in a firm’s scale of
production, which hasproduction, which has no effectno effect onon
average costs per unit produced.average costs per unit produced.

11. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Long-Run Costs: Economies andLong-Run Costs: Economies and
Diseconomies of ScaleDiseconomies of Scale
• Decreasing returns to scaleDecreasing returns to scale refersrefers
to an increase in a firm’s scale ofto an increase in a firm’s scale of
production, which leads toproduction, which leads to higherhigher
average costs per unit produced.average costs per unit produced.

12. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Short-Run Profits:Short-Run Profits:
Expansion to EquilibriumExpansion to Equilibrium
• The existence of positive profits will attractThe existence of positive profits will attract
new entrants to an industry.new entrants to an industry.
• As capital flows into the industry, the supplyAs capital flows into the industry, the supply
curve shifts to the right, and price falls.curve shifts to the right, and price falls.
• Firms will continue to expand as long asFirms will continue to expand as long as
there are economies of scale to be realized,there are economies of scale to be realized,
and new firms will continue to enter as longand new firms will continue to enter as long
as positive profits are being earned.as positive profits are being earned.

13. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Short-Run Profits:Short-Run Profits:
Contraction to EquilibriumContraction to Equilibrium
• As long as losses are being sustained in anAs long as losses are being sustained in an
industry, firms will shut down and leave theindustry, firms will shut down and leave the
industry, thus reducing supply.industry, thus reducing supply.
• As this happens, price rises.As this happens, price rises.
• This gradual price rise reduces losses for firmsThis gradual price rise reduces losses for firms
remaining in the industry until those losses areremaining in the industry until those losses are
ultimately eliminated.ultimately eliminated.

14. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Long-Run Adjustment MechanismThe Long-Run Adjustment Mechanism
• The central idea in our discussion of entry,The central idea in our discussion of entry,
exit, expansion, and contraction is this:exit, expansion, and contraction is this:
• In efficient markets, investment capital flowsIn efficient markets, investment capital flows
toward profit opportunities.toward profit opportunities.
• The actual process is complex and varies fromThe actual process is complex and varies from
industry to industry.industry to industry.

15. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
• The central idea in our discussion of entry,The central idea in our discussion of entry,
exit, expansion, and contraction is this:exit, expansion, and contraction is this:
The Long-Run Adjustment MechanismThe Long-Run Adjustment Mechanism
• Investment—in the form of new firms andInvestment—in the form of new firms and
expanding old firms—will over time tend to favorexpanding old firms—will over time tend to favor
those industries in which profits are being made,those industries in which profits are being made,
and over time industries in which firms areand over time industries in which firms are
suffering losses will gradually contract fromsuffering losses will gradually contract from
disinvestment.disinvestment.