Chapter 8
Slide 1
Cost Curves in long run

Chapter 8
Slide 2
Long-run total cost curve
nshows how minimized total cost varies with output, holding input prices fixed and selecting inputs
to minimize cost
nBecause the cost-minimizing input combination moves us to higher isocost lines, the long-run total
cost curve must be increasing in Q.
nwhen Q=0 => long-run TC=0 (because the firm is free to vary all inputs even the capital if it
produces a zero quantity, the cost-minimizing input combination is zero labor and zero capital)
n
n

Chapter 8
Slide 3
nWe have production function:
n
n
1)How does minimized total cost depend on the output Q and the input prices w and r for this
production function?
2)What is the graph of the long-run total cost curve when w=25 and r=100?

Chapter 8
Slide 4
Long-run total cost curve –  one input price (capital) change?

Chapter 8
Slide 5
Long-run total cost curve –  one input prices (capital) change?

Chapter 8
Slide 6
LONG-RUN AVERAGE AND MARGINAL COST CURVES
nLong-run average cost is the firm’s cost per unit of output. It equals long-run total cost divided
by Q: AC(Q) = [TC(Q)]/Q.
nLong-run marginal cost is the rate at which long-run total cost changes with respect to a change
in output: MC(Q) = (ΔTC)/(ΔQ). Thus, MC(Q) equals the slope of TC(Q).
nAlthough long-run average and marginal cost are both derived from the firm’s long-run total cost
curve, the two costs are generally different
nrelationship between the longrun average and long-run marginal cost curves:
1)If average cost is decreasing as quantity is increasing, then average cost is greater than
marginal cost: AC(Q) > MC(Q).
2)If average cost is increasing as quantity is increasing, then average cost is less than marginal
cost: AC(Q) < MC(Q).
3)If average cost is neither increasing nor decreasing as quantity is increasing, then average cost
is equal to marginal cost: AC(Q)=MC(Q).
n
n

Chapter 8
Slide 7
Long-run total cost curve –  input prices change?

Chapter 8
Slide 8
To the left of point A, average cost AC is
decreasing as quantity Q is increasing, so
AC(Q) > MC(Q). To the right of point A,
AC is increasing as Q is increasing, so
AC(Q) < MC(Q). At point A, AC is at a
minimum, neither increasing nor decreasing,
so AC(Q) = MC(Q).

Chapter 8
Slide 9
The marginal cost of an additional student
is less than the average cost per student
until enrollment reaches about 30,000 students.
Until that point, average cost per
student falls with the number of students.
Beyond that point, the marginal cost of
an additional student exceeds the average
cost per student, and average cost
increases with the number of students.

Chapter 8
Slide 10
Exercise
nWe have production function:
n
n
1)We know from previous exercise, that TC=2Q and w=25 and r=100. What are the long-run average and
marginal cost curves associated with this long-run total cost curve?
2)Whenever the long-run total cost is a straight line long-run average and long-run marginal cost
curves will be the same and will be a horizontal line.

Chapter 8
Slide 11
Economies and Diseconomies of Scale
nchange in long-run average cost as output increases:
1)economies of scale: a characteristic of production in which average cost decreases as output goes
up.
2)diseconomies of scale: opposite situation, where average cost goes up when output goes up.
nEconomies of scale can also explain why some firms are more profitable than others in the same
industry. Claims of economies of scale are often used to justify mergers between two firms
producing the same product
n

Chapter 8
Slide 12
There are economies of scale for outputs
less than Q´. Average costs are
flat between and Q´ and Q´´and there
are diseconomies of scale thereafter.
The output level Q&#7; is called the minimum
efficient scale.

Chapter 8
Slide 13
Economies of Scale
ncauses:
1)physical properties of processing units that give rise to increasing returns to scale in inputs
2)can also arise due to specialization of labor (specialization which can increase worker
productivity).
3)result from the need to employ indivisible inputs (An input  that is available only in a certain
minimum size. Its quantity cannot be scaled down as the firm’s output goes to zero. An example of
an indivisible input is a high-speed packaging line for breakfast cereal. Even the smallest such
lines have huge capacity––14 million pounds of cereal per year. A firm that might only want to
produce 5 million pounds of cereal a year would still have to purchase the services of this
indivisible piece of equipment.

Chapter 8
Slide 14
Diseconomies of Scale
ncauses:
1)managerial diseconomies  - a situation in which a given percentage increase in output forces the
firm to increase its spending on the services of managers by more than this percentage.
2)minimum efficient scale - the smallest quantity at which the long-run average cost curve attains
its minimum point.
3)

Chapter 8
Slide 15
Short-run total cost curve
ntells us the minimized total cost of producing Q units of output when at least one input (usually
capital) is fixed at a particular level.
nThe short-run total cost curve is the sum of two components: the total variable cost curve TVC(Q)
and the total fixed cost curve TFC—that is, STC(Q)=TVC(Q) + TFC.
nThe total variable cost curve TVC(Q) is the sum of expenditures on variable inputs, such as labor
and materials
nTotal fixed cost is equal to the cost of the fixed capital services and thus does not vary with
output (total fixed cost is independent of output)
n
n

Chapter 8
Slide 16


Chapter 8
Slide 17
Relationship between the LR and SR cost curves
nIn the long run, the firm can freely vary the quantity of both inputs, but in the short run the
quantity of capital is fixed. Thus, the firm is more constrained in the short run than in the long
run, so it makes sense that it will be able to achieve lower total costs in the long run
n
n

Chapter 8
Slide 18
Initially, the firm produces 1 million TVs per year and operates at point A, which minimizes cost
in both the long run and the short run, if the firm’s usage of capital is fixed at K1. If Q is
increased to 2 million TVs per year, and capital remains fixed at K1 in the short run, the firm
operates at point B. But in the long run,
the firm operates at point C, on a lower isocost line than point B.

Chapter 8
Slide 19
When the quantity of capital is fixed at K1, STC(Q) is always above TC(Q), except at point A. Point
A solves both the long-run and the short-run cost-minimization problem when the firm produces 1
million TVs per year.

Chapter 8
Slide 20
Fill in as much of the table as possible. If you cannot determine the number in a box, explain why
it is not possible to do so.

Chapter 8
Slide 21
Fill in as much of the table as possible. If you cannot determine the number in a box, explain why
it is not possible to do so.

Chapter 8
Slide 22
nA firm produces a product with labor and capital, and its production function is described by
Q=LK. Suppose that the price of labor equals 2 and the price of capital equals 1. Derive the
equations for the long-run total cost curve and the long-run average cost curve.

Chapter 8
Slide 23
nConsider a production function of two inputs, labor and capital, given by:
n
a)Suppose the firm is required to produce Q units of output. Show how the cost-minimizing quantity
of labor depends on the quantity Q. Show how the cost-minimizing quantity of capital depends on the
quantity Q.
b) Find the equation of the firm’s long-run total cost curve.
c)Find the equation of the firm’s long-run average cost curve.

Chapter 8
Slide 24
Perfectly Competitive Markets
nMarket Characteristics:
nThe industry is fragmented – many buyers and sellers with imperceptible effect on market price
nUndifferentiated products - products are identical no matter who produces them
nConsumers have perfect information about prices
nThe industry is characterized by equal access to resources - All firms (those currently in the
industry, as well as prospective entrants) have access to the same technology and inputs
n

Chapter 8
Slide 25
Perfectly Competitive Markets
nthree implications for how perfectly competitive markets work:
n1) Price taking: the individual firm sells a very small share of total market output and so cannot
influence market price. The individual consumer buys too small a share of output to have any impact
on the price.
n 2) Product homogeneity: the products of all firms are perfect substitutes.
n 3) Free entry and exit: new firm has access to the same technology and inputs that existing firms
have.

Chapter 8
Slide 26
Perfectly Competitive Markets
nIn previous chapter, we distinguished between economic cost and accounting cost:
neconomic profit = sales revenue - economic costs
naccounting profit = sales revenue - accounting costs
nNote: economic costs = accounting costs + opportunity costs
n
n

Chapter 8
Slide 27
Profit Maximization
nDo firms maximize profits?
lPossibility of other objectives
uRevenue maximization
uDividend maximization
uShort-run profit maximization
lImplications of non-profit objective
uOver the long-run investors would not support the company
uWithout profits, survival unlikely

Chapter 8
Slide 28
Marginal Revenue, Marginal Cost and π Maximization
nDetermining the profit maximizing level of output
lProfit (    ) = Total Revenue - Total Cost
lTotal Revenue (TR) = PxQ
lTotal Cost (TC) = CxQ
lTherefore:

Chapter 8
Slide 29
nComparing R(q) and C(q)
lOutput levels: 0 - q0:
uC(q)> R(q): negative profit
uFC + VC > R(q)
uMR > MC
lOutput levels: q0 -  q*
uR(q)> C(q)
uMR > MC: higher profit at higher output. Profit is increasing
u
0
Cost,
Revenue,
Profit
($s per year)
Output (units per year)
R(q)
C(q)
A
B
q0
q*
Marginal Revenue, Marginal Cost and π Maximization

Chapter 8
Slide 30
nComparing R(q) and C(q)
lOutput level: q*
uR(q)= C(q)
uMR = MC
uProfit is maximized
R(q)
0
Cost,
Revenue,
Profit
$ (per year)
Output (units per year)
C(q)
A
B
q0
q*
Marginal Revenue, Marginal Cost and π Maximization

Demand and MR Faced by a Competitive Firm
Output
(bushels)
Price
$ per
bushel
Price
$ per
bushel
Output
(millions
of bushels)
d
$4
100
200
100
Firm
Industry
D
$4

Chapter 8
Slide 32
nThe competitive firm’s demand
uIndividual firm sells all units for $4 regardless of their level of output.
uIf the firm tries to raise price, sales are zero.
uIf the firm tries to lower price, he cannot increase sales
uP = D = MR = AR
uProfit Maximization: MC(q) = MR = P
Marginal Revenue, Marginal Cost and π Maximization

Chapter 8
Slide 33
q0
Lost profit for
q1 < q*
Lost profit for
q2 > q*
q1
q2
A Competitive Firm making a Positive Profit: SR
10
20
30
40
Price
($ per
unit)
0
1
2
3
4
5
6
7
8
9
10
11
50
60
MC
AVC
ATC
AR=MR=P
Output
q*
At q*: MR = MC
and P > ATC
D
A
B
C
q1 : MR > MC and
q2: MC > MR and
q0: MC = MR but
MC falling

Chapter 8
Slide 34
Would this producer
continue to produce with a loss?
A Competitive Firm Incurring Losses: SR
Price
($ per
unit)
Output
AVC
ATC
MC
q*
P = MR
B
F
C
A
E
D
At q*: MR = MC
and P < ATC
Losses = (P- AC) q* or ABCD

Chapter 8
Slide 35
Choosing Output in the Short Run
nSummary of Production Decisions
lProfit is maximized when MC = MR
lIf P > ATC the firm is making profits.
lIf AVC < P < ATC the firm should produce at a loss.
lIf P < AVC < ATC the firm should         shut-down.

Chapter 8
Slide 36
A Competitive Firm’s Short-Run Supply Curve
Price
($ per
unit)
Output
MC
AVC
ATC
P = AVC
What happens
if P < AVC?
P2
q2
P1
q1
The firm chooses the
output level where MR = MC,
as long as the firm is able to
cover its variable cost of
production.

Chapter 8
Slide 37
Price
($ per
unit)
MC
Output
AVC
ATC
P = AVC
P1
P2
q1
q2
S = MC above AVC
A Competitive Firm’s Short-Run Supply Curve
Shut-down

Chapter 8
Slide 38
MC2
q2
Input cost increases
and MC shifts to MC2
and q  falls to q2.
MC1
q1
The Response of a Firm to a Change in Input Price
Price
($ per
unit)
Output
$5
Savings to the firm
from reducing output

Chapter 8
Slide 39
MC3
Industry Supply in the Short Run
$ per
unit
0
2
4
8
10
5
7
15
21
MC1
S
The short-run
industry supply curve
is the horizontal
summation of the supply
curves of the firms.
Quantity
MC2
P1
P3
P2
Question: If increasing
output raises input
costs, what impact
would it have on
market supply?

Chapter 8
Slide 40
The Short-Run Market Supply Curve
nElasticity of Market Supply
n
n
nPerfectly inelastic short-run supply arises when the industry’s plant and equipment are so fully
utilized that new plants must be built to achieve greater output.
nPerfectly elastic short-run supply arises when marginal costs are constant.

Chapter 8
Slide 41
A
D
B
C
Producer
Surplus
Alternatively, VC is the
sum of MC or ODCq* .
R is P x q* or OABq*.
Producer surplus =
R - VC or ABCD.
Producer Surplus for a Firm
Price
($ per
unit of
output)
Output
AVC
MC
0
P
q*
At q*  MC = MR.
Between 0 and q ,
MR > MC for all units.

Chapter 8
Slide 42
nProducer Surplus in the Short-Run
The Short-Run Market Supply Curve

Chapter 8
Slide 43
D
P*
Q*
Producer
Surplus
Market producer surplus is
the difference between P*
and S from 0 to Q*.
Producer Surplus for a Market
Price
($ per
unit of
output)
Output
S

Chapter 8
Slide 44
q1
A
B
C
D
In the short run, the
firm is faced with fixed
inputs.  P = $40 > ATC.
Profit is equal to ABCD.
Output Choice in the Long Run
Price
($ per
unit of
output)
Output
P = MR
$40
SAC
SMC
In the long run, the plant size will be
increased and output increased to q3.
Long-run profit, EFGD > short run
profit ABCD.
q3
q2
G
F
$30
LAC
E
LMC

Chapter 8
Slide 45
q1
A
B
C
D
Output Choice in the Long Run
Price
($ per
unit of
output)
Output
P = MR
$40
SAC
SMC
Question: Is the producer making
a profit after increased output
lowers the price to $30?
q3
q2
G
F
$30
LAC
E
LMC

Chapter 8
Slide 46
Choosing Output in the Long Run
nZero-Profit
lIf R > wL + rK, economic profits are positive
lIf R = wL + rK, zero economic profits, but the firm is earning a normal rate of return; indicating
the industry is competitive
lIf R < wL + rK, consider going out of business
Long-Run Competitive Equilibrium

S1
Long-Run Competitive Equilibrium
Output
Output
$ per
unit of
output
$ per
unit of
output
$40
LAC
LMC
D
S2
P1
Q1
q2
Firm
Industry
$30
Q2
P2
•Profit attracts firms
•Supply increases until profit = 0

Chapter 8
Slide 48
Choosing Output in the Long Run
nLong-Run Competitive Equilibrium
n 1) MC = MR
n 2) P = LAC
uNo incentive to leave or enter
uProfit = 0
n 3) Equilibrium Market Price

Chapter 8
Slide 49
Choosing Output in the Long Run
nQuestions
n 1) Explain the market adjustment when     P < LAC and firms have identical costs.
n 2) Explain the market adjustment when  firms have different costs.
n 3) What is the opportunity cost of land?

Chapter 8
Slide 50
Choosing Output in the Long Run
nEconomic Rent = the difference between what firms are willing to pay for an input minus the
minimum amount necessary to obtain it.
nAn Example: Two firms, A & B, both own their land
lA is located on a river which lowers A’s shipping cost by $10,000 compared to B. The demand for
A’s river location will increase the price of A’s land to $10,000
lEconomic rent = $10,000
u$10,000 - zero cost for the land
lEconomic rent increases; Economic profit of A = 0

Chapter 8
Slide 51
nThe shape of the long-run supply curve depends on the extent to which changes in industry output
affect the prices the firms must pay for inputs.
nTo determine long-run supply, we assume:
lAll firms have access to the available production technology.
lOutput is increased by using more inputs, not by invention.
lThe market for inputs does not change with expansions and contractions of the industry.
The Industry’s Long-Run Supply Curve

A
P1
AC
P1
MC
q1
D1
S1
Q1
C
D2
P2
P2
q2
B
S2
Q2
Economic profits attract new
firms.  Supply increases to S2 and
the market returns to long-run
equilibrium.
LR Supply in a Constant-Cost Industry
Output
Output
$ per
unit of
output
$ per
unit of
output
SL
Q1 increase to Q2.
Long-run supply = SL = LRAC.
Change in output has no impact on
input cost.

LR Supply in an Increasing-Cost Industry
Output
Output
$ per
unit of
output
$ per
unit of
output
S1
D1
P1
LAC1
P1
SMC1
q1
Q1
A
SL
P3
SMC2
Due to the increase
in input prices, long-run
equilibrium occurs at
a higher price.
LAC2
B
S2
P3
Q3
q2
P2
P2
D1
Q2

S2
B
SL
P3
Q3
SMC2
P3
LAC2
Due to the decrease
in input prices, long-run
equilibrium occurs at
a lower price.
LR Supply in a Decreasing-Cost Industry
Output
Output
$ per
unit of
output
$ per
unit of
output
P1
P1
SMC1
A
D1
S1
Q1
q1
LAC1
Q2
q2
P2
P2
D2