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 Long-Run Costs and Output Decisions Summary

1. How do you find the profit for a firm that is following the MC = MR rule?

Profit is total revenue (TR) minus total cost (TC). Graphically, TR is a rectangle with a height of P and length a of q. TC is average total cost (ATC) multiplied by q. Graphically, TC is a rectangle with a height of ATC and a length of q. The difference between the TR and TC rectangles is the profit (or loss).

2. What is the difference between maximizing profits and minimizing losses?

There is no difference between maximizing profits and minimizing losses. When a firm follows the MC = MR rule, then it is both maximizing profits and minimizing losses. If the market price of the product is such that the firm will lose money no matter how many it produces, the rule is a cost-minimizing rule. If it is possible to make a profit, then the rule is a profit-maximizing rule.

3. When should a firm shut down?

A firm should shut down in the short run if the price is below the AVC curve. If price is that low, then the total revenue is less than the total variable cost. Not only is the firm unable to pay fixed costs, but it also cannot pay its variable costs. If the firm shuts down, it will only owe for the fixed costs, so it is better off shutting down. If the price is above the AVC but below the ATC, the firm is able to pay the variable costs and some of the fixed costs. So even though it is making a negative profit (suffering a loss), the firm should stay open, since closing would entail paying all of the fixed costs with no income.

4. How does the shut down rule change as the firm moves to the long run?

In the long run, all costs are variable, so the AVC curve is the same thing as the LRAC curve. The shut down rule then tells us that the firm should shut down, in the long run, if the price falls below the LRAC curve.

5. How is the industry supply curve of a perfectly competitive industry constructed?

Because firms will not supply anything if the price is below the AVC curve, the firm’s supply curve is the MC curve (as we saw in the last chapter) that is above the AVC curve. The individual supply curves for each firm are then added up horizontally, producing the industry supply curve.

6. Why do perfectly competitive firms not make any profit in the long run?

If there are any profits to be made in an industry, other firms will enter and increase the market supply, lowering price until profits disappear. When there are no more profits to be made, no more firms enter the market. If the industry is losing money, then firms leave the industry, driving the supply curve back, and, thus, raising prices. Prices rise until profits are zero, after which no more firms want to leave the industry. Profits or losses are never sustained in the long run. However, when firms are breaking even, they are still earning a normal rate of return.

7. Why is zero economic profit not such a bad thing?

Zero economic profit means that the firm is doing just as good as the next best thing it could be doing with its resources. It means the firm is making a normal rate of return on money invested, so investors are just as happy with the firm as other investment options. Put in other words, the firm could not do any better with its next best option.

8. Why are the average total cost and long-run average cost curves the same shape, but for different reasons?

The short-run average cost curve slopes down because of increased productivity and ultimately slopes up because of the law of diminishing returns. The law of diminishing returns does not hold in the long run, so the LRAC slopes down because of economies of scale and slopes up because of diseconomies of scale.

9. How do firms, in the long run, end up producing with a technology of the optimal scale?

In the long run, firms will compete until price falls down to the bottom of the LRAC. If there is a production technology that allows the firm to produce at a lower average cost, a firm will adopt that technology and price will be competed down to the bottom of that LRAC curve. In the end, all firms will produce at the optimal scale of production.

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