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Long- Run Costs and Output Decisions
Typology: Lecture notes
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Let us construct a hypothetical situation in which a firm is supposed to purchase a land for production costing INR 10,00,000. Suppose investor expects to earn a minimum return of say 10% p.a.. That means a firm have to pay INR 1,00,000 as nominal rate of return and thus a part of fixed cost. It sells a good at INR 50. Variable cost to a firm includes wages and raw material amounting INR 16,000. Some other fixed cost equal to INR 10,000. As the firm are competitive in nature, they are ready to sell all it wants at one single price INR
In figure 1, a) shows the competitive industry and b) shows a representative firm. Market is clearing at price INR 50 and we assume that a firm can sell anything at that price but is constrained by its capacity in the short run. Assume that the representative firm produces 3000 unit of output. We know that in a competitive market, a profit maximizing firm produces up to the point where price equals Marginal cost. In the short run, MC curve moves upward because fixed factor constrains the capacity. Total revenue is equal to the area ( TP0q). Total cost is equal to the area ( AC0q). Profit is simply the difference between TR and TC. That is equal to the area (ABPC). This firm is earning positive profits.
A firm is suffering loss if it is not earning positive profits or breaking even. These firm falls in the following two categories: a) those thinking of shutting down their operation immediately and bear loses equal to the fixed cost as that would help them to minimize their loses. b) Those that keep doing their business in the short run to minimize their losses. Fixed cost (FC) need to be paid whether you are in the business or shutting down, that’s why firms cannot completely exit the market in the short run. To keep continuing their operation every firm have to look whether it’s advantageous or not. As fixed cost needs to be paid, their decision depends on variable cost and the revenue earned. So, in the short run a firm will keep operating till revenue earned are more than variable cost. Operating profit (or loss) is the difference of total revenue (TR) and total variable cost (TVC). If, TR>TVC then firm will keep operating as the operating profit helps offsetting fixed cost and thus reducing losses. If TR<TVC, then firm will be better off shutting down rather than increasing losses. As now, total losses will be more than fixed cost.
Suppose that the above mentioned firm now selling at INR 30 due to competitive forces. This means that the total revenue (TR) now will be equal to INR 240,000 (30 X 8000). Variable cost remains at INR 160,000 and total fixed cost (FC) at INR 110,000. So, total cost equals to INR 270,000. Thus firm is bearing losses equals to INR 30,000. Now in the short run, the firm has to decide whether to remain in business or shut down. If they plan to shut down, it has to bear no variable cost but just bear loss equal to its fixed cost of INR 110,000. In case they decide to remain in business, then they will make operating profit of INR 80,000 which can be used to offset its total fixed cost and thus reduces losses from INR 110,000 to INR 30,000. Thus the firm total loss will be only INR 30,000.
In figure 2 we will show a) the industry and b) a representative firm suffering losses but showing an operating profit in the short run. Assume that the market price determined by the supply and demand is INR 35. Again as the firm is operating in the competitive world, they will operate where price (MR) is equal to the Marginal cost (MC) and produce
The short run industry supply curve is the sum of the individual firm MC curve (above AVC) of all the firms in an industry. Industry supply curve is the horizontal summation of the quantity supplied by the individual firms in the industry at each price level. In Figure 4 , shows the industry supply curve in the short run as a horizontal sum of the MC curves (above AVC) of all the firms in the industry. The short run Industry Supply curve can shit because of two reasons. One if the price of other input changes which shifts the individual firms MC curves simultaneously. With the change in the number of firms in the industry in the long run, the industry supply curve also shifts with the increase or decrease in the number of supply curves of individual firms. If the number of individual firm increases the industry supply curve will shift to right and if the number of individual firm decreases the industry supply curve will shift to left.
In the short run a firm will produce up to the point where P=MC. New firms will enter and old firms will expand in the long run if there are operating profits in the industry. In case firms suffering losses, it will produce if and only if there revenue is more than the AVC otherwise it will shut down in the short run and will bear cost equal to FC. In the short run, firm’s decision to operate depends on the shapes of its cost curves and the market price of its product. In the short run, costs are determined by the present scale of fixed factor whereas in the long run firms have to choose among many potential scale of fixed factor.
An Individual firm long run decision depends on what their cost are likely to be different at different scale of production. To arrive at long-run cost, firms must also compare their costs at different scales of plant. With the increases in the scale of production there may be Economies of scale which will help reduce production costs and help firm expands or perhaps as the complexities arises as the firms become large in size.
of operation determines the short run cost curves. LRAC is also known as envelope of the short run average cost curves because its wraps around short run cost curves. Each point on LRAC curve represent the least cost associated with that level of production. In the short run, the firm chooses a particular scale of production which fixed them into one cost curve where as in the long run, the scale of production can vary and with it the cost curves also vary.
Constant return means the relationship between input and output stays constant. If we double input level output level also doubles. In terms of cost, as the level of output rises the AC doesn’t change with scale. In other words, CRS mean that the firm’s LRAC curve is flat. The firm in figure 5 exhibits CRS between scale 2 and scale 3. The AC of production remains constant. There is an argument that most industries exhibit CRS after some level of output. Firms usually opt for cost saving technology and produce at most optimal scale. After achieving an optimal scale, a firm that wants to grow will try to do so by building another i.e. firms facing CRS can grow after achieving optimal scale only if they will be able to replicate their existing plants.
When doubling of inputs lead to less than doubling of the output. In terms of cost, with the increase in the scale of production, AC increases in case of decreasing return to scale. For instance when a corporation become very large the managerial inefficiencies crops up and thus it becomes very difficult to control. As the firm size increases, it finds itself facing problems with labour organization. In figure 6, we will describe a firm that exhibits both the economies and diseconomies of scale. AC decrease with the size of plant up to q* and AC increases when the size of plant increases after q*.
All short run AC curves are U shaped, because we assume a fixed scale of plant that constrain production and MC rises when diminishing return sets in. In the long run, there is no fixed factor and the scale of plants can be changed.
Note: the same firm can face diminishing return in the short run and still exhibits economies of scale in the long run.
Long run average cost curve (LRAC) can be of different shape. Its shape depends on how cost changes with the change in the scale of production. Every firm try to take advantage of economies of scale and avoids diseconomies of scale and thus try to operate at the optimal scale of plant i.e. try to minimize the AC.
In the long run, if the firms have an incentive to enter or exit in the industry then that industry cannot be at equilibrium. When there are profit opportunities, new firms will enter and when there are operating losses, firms will exit. In both the cases industry will not be in equilibrium and firm will change their behaviour. What can be the actual adjustment in the long run when there short run profits and losses? To know this lets analyse both the cases.
We assume a perfectly competitive industry in which firms are earning positive profits. All firms using same technology of production. Each firm has a LRAC curve that is U-shaped because there are some economies of scale to be realized in the industry and then at some scale of operations, all firms start running into diseconomies of scale. In figure 7, we will see how a competitive firm expand in the long run when increasing return to scale is available. When individual firm are earning economic profits at some market price that will lead to the entry of new firms or expansion of old firms as long as they are enjoying economic profits and economies of scale exist. This will continue happening till prices fall.
Both the entrance of new firms and expansion of old firms will lead to the shift of the short run industry supply curve from S to S’. As the industry supply curve is nothing but the sum of all the MC curves of all the firms, it will shift because of the two reasons. Firstly, new firms are being added, so their MC curves will also be added. Secondly, existing firms are expanding; their individual MC curves will also shift to the right. Finally, each firm in the competitive industry will choose to operate at optimal scale of operation in the long run.
The final long run competitive equilibrium condition will remain the same:
P*=SRAC=SRMC=LRAC
In the long run profits will be zero and at this point firms will be operating at the most optimal scale.
In efficient markets profit opportunities get quickly eliminated as they appear and Investment capital flows towards profit opportunities. When firms are generating profits, capital flows in the form of investment by new firms and old expanding firms and output expands and when they are incurring losses capital flows out in the form of disinvestment and firms’ contract and some go out of the industry. It continues happening till the long run competitive equilibrium condition is achieved and profits are driven to zero.
When the demand for any good rises at any price, which will cause excess demand situation followed by higher prices. At higher prices, producers are ready to supply more as they find themselves earning positive profits. The rise in the price will lead to the change in the
allocation of the society’s resources. In the long run the profits will lure more investment and resources in that goods market. So, just a change in the demand for a product will lead to reallocation of resources.
In this chapter, we learned about the three short run condition in which any firm will find themselves. How the short run changes affects the shape of long run cost curves. We learned about when and how the economies of scale and diseconomies of scale arise with the change in the scale of production? We also learned about what long run adjustment need to be taken when the short run conditions changes the equilibrium. Investment moves towards the profit opportunities.
d) A fixed factor of production.
a) price is greater than or equal to AFC. b) AFC is greater than AVC. c) AVC is greater than MC. d) price is greater than or equal to AVC.
a) Individual firms operate at the most efficient scale of plant. b) The level of output produced coincides with the minimum point on the LRAC curve. c) P = LRAC. d) All of the above.
a) MC curve that lies below the AVC curve b) MC curve that lies above the AVC curve c) MC curve that lies below the ATC curve d) MC curve that lies above the ATC curve
Correct Answers/Options for the Multiple Choice Questions Question Number Option 1 C 2 C 3 D 4 D 5 B
Answer 1. Option c) Operating losses are difference between total revenue and total variable cost. When revenues are less than the total variable cost, there are operating losses.
Answer 2. Option c) When AC falls with the rise in the level of output, that firm will exhibit IRS.
Answer 3. Option d) A firm will choose to operate rather than shut down as long as revenue is more than the AVC. In other words, till the firm is enjoying operating profits it will choose to operate rather than shut down.
Answer 4. Option d) A firm attains long run competitive equilibrium when they are producing at the optimal level and there will be zero profits and P=LRMC=SRAC=SRMC
Answer 5. Option b) The short run supply curve of a firm in a perfectly competitive industry is the portion of its MC curve that lies above its AVC.
Answer 1. Option a) is incorrect, as they define the case of operating profits Option b) is wrong as it represents the profit situation of a firm. Option d) is also incorrect as they also represent the case of operating profits.
Answer 2. Option a) is incorrect because diminishing return is a short run concept and in the short run scale of production doesn’t changes. Option b) is not correct because in CRS, AC doesn’t change. Option d) is wrong as fixed factor of production is only related to the short run.
Answer 3. Option a), b) and c) are incorrect because at all this point there is no situation of operating losses.
Answer 4. All of the options are correct. As a firm attains long run competitive equilibrium when they are producing at the most efficient level which means they are producing at the minimum point of LRAC curve and P=LRMC=SRAC=SRMC.
Answer 5. Option a) is incorrect because in the competitive firm P = MC and any price below AVC represent shut down which means no production. Option c) and d) are incorrect because even if firms are not able to gain economic profits they will continue producing till they are generating operating profits.
When Economies and Diseconomies are found on industry wide basis rather than on within the firm they are known as external Economies and Diseconomies. Sometimes AC increases or decreases with the size of the industry. When LRAC decreases (increases) as a result of industry growth we say that there are external economies (diseconomies). For instance when government announces agricultural subsidy that will lead to the External economies as AC falls because the subsidy has been given to the entire agricultural industry rather than a particular firm. Similarly, when oil prices increases it will affect the entire industry and leads to the External Diseconomies as all the firms AC will rise along with the rise in the oil prices.
In figure 9, we will see that the industry and a representative firm both are at long run equilibrium. P* is the equilibrium price determined by the intersection of demand, DD 1 and supply curves, SS 1. All firms at this points have zero economic profits and the price P* intersects the LRAC curve at its minimum point, i.e. at optimal point. When demand increases, it will shift the demand curve from DD 1 to DD2, price rises along with the demand from P* to P*. Rising prices increases the profit opportunities and new firms will enter and old firms will expand. This will shifts the supply curve from SS 1 to SS2, driving price down. If the LRAC falls as a result of expansion to LRAC 2 from LRAC 1 , the final price will be below the original price, P. So, the long run industry supply curve (LRIS) slopes downwards an industry is enjoying external economies. Such an industry is also known as decreasing cost industry.
Similarly, in figure 10 we will see that the industry and a representative firm both are at long run equilibrium. P* is the equilibrium price determined by the intersection of demand, DD 1 and supply curves, SS 1. When demand increases, it will shift the demand curve from DD 1 to DD2, price rises along with the demand from P* to P**. With the rise in prices new firms will enter and existing firm expands shifting the supply curve from SS 1 to SS2, driving price down. If the long run industry supply curves (LRIS) slopes upwards an industry is facing external diseconomies. Such an industry is known as Increasing cost industry.
