Long run costs

LONG RUN COSTS

The long run(LR) opens up a whole new range of options
as there is no fixed cost. The LR cost possibilities are
determined by all possible short run options.
Three choices according to plant sizes: a small
factory(ATC1), a medium-sized factory(ATC2), a large
factory(ATC3).
In the LR, ell chose the plant hich gi es the lo est AC
for any desired rate of output.
ATC1 starts to rise at relatively low levels of output.
ATC2 can produce the maximum possible output of
ATC1 at lower cost. But ATC2 also rises.
To produce large quantities, ATC3 offers the lowest
ATC.

LRAC
SRAC2

SRAC1

SRAC3

LONG RUN COSTS with unlimited options

If plants of all sizes can be built, short run
options are infinite. In this case, the long run
average cost (LRAC) curves becomes a smooth U
shaped curve.
Each point on the curve represents lowest cost
production for a plant size suitable to one rate of
output.
The LRAC curve has its own MC curve. It is not
the composite of short run MC. The LR MC
intersects LRAC at its lowest point.

 The long-run average cost curve is the envelope

of an infinite number of short-run average total
cost curves, with each short-run average total
cost curve tangent to, or just touching, the longrun average cost curve at a single point
corresponding to a single output quantity.
When LRAC is falling, LRAC is tangential to the
falling portion of SRAC(s)
When LRAC is rising, LRAC is tangential to the
rising portion of SRAC(s)
When LRAC is minimum, it is tangential to the
lowest point of SRAC

Deriving a long-run average cost curve

Costs

LRAC

Output
fig

Minimum efficient scale (MES)

- the lowest point on the long run average cost
curve .
- range of output levels where the firm achieves
constant returns to scale and has reached the
lowest feasible cost per unit in the long run.

Economies and diseconomies of scale

Economies of scale refer to reductions in
minimum average cost attained with larger
plant size.
- the property whereby long-run average total
cost falls as the quantity of output increases
Diseconomies of scale- the property whereby
long-run average total cost rises as the
quantity of output increases.
- If ATC rises with plant size, diseconomies of
scale exist.

 constant returns to scale-the property

whereby long-run average total cost stays the
same as the quantity of output changes.
What might cause economies or
diseconomies of scale?
Economies of scale often arise because higher
production levels allow specialization among
workers, which permits each worker to
become better at his or her assigned tasks.
Diseconomies of scale can arise because of
coordination problems that are inherent in
any large organization.

 Economies of scale- internal and external

Internal economies of scale
- arise from the long term growth of the firm
itself.
1. Technical economies of scale- relate to
aspects of the production process.
-Specialization of labor
-capital investment in new technology
2. Marketing economies of scale
-advertising, marketing
-monopsony power

3. Managerial economies of scale

- division of labor
- better management; increased investment
in human resources; use of new
technology/equipment.
4. Financial economies of scale
- rating in the financial markets
- access to credit facilities

 External economies of scale

- occur outside of a firm but within an industry.
1. research and development
2. transportation facilities

 why long run average total cost curves are

often U shaped?
At low levels of production, the firm benefits
from increased size because it can take
advantage of greater specialization.
At high levels of production, the benefits of
specialization have already been realized, and
coordination problems become more severe
as the firm grows larger.

 Economies of scope
If a single firm can jointly produce goods X and
Y more cheaply that any combination of firms
could produce them separately, then the
production of X and Y is characterized by
economies of scope.
- occur when there are cost-savings arising from
production of range of products/by-products.
- depends on management structure,
administration systems and marketing
departments.

Break Even Analysis

Break even is the point of production where a
firms total revenue is equal to the total cost of
production.
When total revenue is equal to total cost the
process is at the break-even point.
TR = TC
Margin of safety - the difference between the
firms current level of output and break even
output

Break-Even Analysis
TR (p = Rs2)

Costs/Revenue

Profit

TC
VC

Loss
FC

Q1

Output/Sales

Market Structure

Market?
Components of Market
Sellers
Buyers
Product
Price
Exchange

Market is set of conditions in which buyers and sellers contact

each other and conduct exchange transactions.

Classification of Market
Based on
Area (Local, Regional, National,)
Volume of business (Wholesale & Retail)
Time (short period, long period,)
Status of sellers (Producers, Wholesalers,
Retailers,)
Regulations (Regulated and Un-regulated)
Competition (Perfect,..,Monopoly)

Alternative Market Structures

Different market structures
Perfect competition

Imperfect competition
Monopoly

Duopoly
Monopolistic competition

Oligopoly
With product differentiation
Without product differentiation

Classifying Markets
Classifying markets (by degree of
competition)
number of firms
freedom of entry to industry
free, restricted or blocked?

nature of product
homogeneous or differentiated?

nature of demand curve

degree of control the firm has over price

Features of the four market structures

Type of
market

Number
of firms

Freedom of
entry

Perfect
competition

Very
large/
Very
many

Unrestricted/
very easy

Monopolistic
competition

Many /
several

Oligopoly

Monopoly

Few

One

Unrestricted/
relatively
easy
Restricted

Restricted or
completely
blocked

Nature of
product

Examples

Implications for
demand curve
faced by firm

Homogeneous
(undifferentiated)

Cabbages, carrots
(approximately)

Horizontal:
firm is a price taker

Differentiated

Builders,
restaurants

Downward sloping,
but relatively
elastic

Undifferentiated

Cement

or differentiated

cars, electrical
appliances

Downward sloping.
Relatively inelastic
(shape depends on
reactions of rivals)

Local water
company, train
operators (over
particular routes)

Downward sloping:
more inelastic than
oligopoly. Firm has
considerable

Unique

Pure Competition

Monopoly

Duopoly

Oligopoly (undifferentiated)

Oligopoly (differentiated)

Monopolistic Firms

Perfectly Competitive Market

Features of Perfect Competition

Large number of buyers and sellers
Seller is a price taker

Homogeneous Product

Pure
Market

Identical, Perfect substitutes

Free entry and exit

Profit-firms will enter the market and vice-versa

Perfect knowledge of the market

Buyers & Sellers are completely aware of prices

Perfect mobility of factors of production

Factors of production can be easily move in & move out

Absence of transport cost

Price equilisation of commodity and factors geographically

Existence of a single and uniform price

Both buyers and sellers cannot influence the price

Non-intervention of Government
Market economy

Short-run equilibrium of industry and firm under perfect

competition

P
S

Pe

D
O
Q (millions)

Industry

Perfect Competition: Price & Revenue

No:
Output

Price

Total
Revenue

Average
Revenue

Marginal
Revenue

12

18

24

30

36

42

Hence we say under perfect competition, Price=AR=MR

P=AR=MR

P = AR = MR

Qe
Market Supply
and Demand

Perfect Competition
Short-run equilibrium of the firm
Price
given by market demand and supply

Output
Where MC=MR and MC cuts MR from below

Profit
= TR-TC
(AR AC) Q
possible supernormal profits

Equilibrium of industry and firm under perfect competition

P
S

Pe

D = AR
= MR

AR

O
Q (millions)

Equilibrium Point
-MC=MR=Price
- MCDcut MR from below &
O after
MC must be raising
Equilibrium Point

(a) Industry

Qe
Q (thousands)

(b) Firm

Short-run equilibrium of industry and firm under perfect

competition

P
S

Pe

Super Normal
Profit
Rs
(AC < Price)

MC

D = AR
= MR

AR
AC

D
O

O
Q (millions)

(a) Industry

AC

Qe
Q (thousands)

(b) Firm

Loss minimising under perfect competition

Loss (AC > Price)

AC
P1

AC

MC

D1 = AR1

AR1

= MR1

D
O

O
Q (millions)

(a) Industry

Qe
Q (thousands)

(b) Firm

Normal Profit

P
S

Normal Profit
MC = MR
RsAC = AR

MC
AC

P2

D2 = AR2

AR2

= MR2

D2
O

O
Q (millions)

(a) Industry

Q (thousands)

(b) Firm

Short-run shut-down point

P
S

AC

MC

AVC

P2

D2 = AR2

AR2

= MR2

D2
O

O
Q (millions)

(a) Industry

Q (thousands)

(b) Firm

Perfect Competition
Short-run equilibrium of the firm (cont.)
short-run supply curve of firm
the MC curve

Short-run supply curve of industry

sum of supply curves of firms

Perfect Competition
The long run
long-run equilibrium of the firm
all supernormal profits competed away
LRAC = AC = MC = MR = AR

Long-run equilibrium under perfect competition

Profits return
Supernormal
New firms enter
to normalprofits
P

P
S1
Se

LRAC
P1

AR1

D1

PL

ARL

DL

D
O

O
Q (millions)

(a) Industry

QL
Q (thousands)

(b) Firm

Long-run equilibrium of the firm under perfect competition

Rs

(SR)MC
(SR)AC

LRAC

DL
AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

 Firm is in equilibrium when MC =MR and

MC cuts MR from below.
Firm maximizes the profit when the price
exceeds the AC.
In the short run firms earn either
supernormal profits(when AR exceeds
AC),losses(when AC exceeds the AR)or
will be forced to shut down(when AR
falls short of minimum of AVC)

Long Run Equilibrium

Long run shows the entry and exit of the
firms into the industry. If firms make
supernormal profits in the SR, new firms
will enter the industry till the excess
profits get wiped out.
Similarly, If firms are making losses,
existing firms will quit the industry so
that the remaining ones will be able to
make at least normal profits.
Thus, under long run, firm and industry
under perfectly competitive market will
earn only normal profits.

MONOPOLY

 A monopoly is a market structure in which

there is a single seller of a product.
- Monopolist or a monopoly firm is the sole
seller of its product and its product does not
have close substitutes.
The fundamental cause of monopoly is
barriers to entry: A monopoly remains the only
seller in its market because other firms cannot
enter the market and compete with it. Barriers
to entry, in turn, have three main sources:

 A key resource is owned by a single firm.

The government gives a single firm the
exclusive right to produce some good or
service.
The costs of production make a single
producer more efficient than a large number
of producers.

 Types of Monopoly
Government-created monopolies- monopolies
arise because the government has given one
person or firm the exclusive right to sell some
good or service.
Eg. patent and copyright laws
Natural monopoly- a monopoly that arises
because a single firm can supply a good or
service to an entire market at a smaller cost
than could two or more firms.

 Economies of scale as a cause of monopolyWhe a fir s a erage-total-cost curve

continually declines, the firm has what is
called a natural monopoly. In this case, when
production is divided among more firms, each
firm produces less, and average total cost
rises. As a result, a single firm can produce any
given amount at the smallest cost.
Monopoly lead to higher prices, increased
incentive for innovation/creative activity.

OUTPUT

PRICE

TOTAL
AVERAGE MARGINAL
REVENUE REVENUE REVENUE

10

10

10

10

18

24

28

30

30

28

-2

24

-4

 A o opolists MR is al a s less tha the

price(AR) of its good.
- because a monopoly faces a downward
sloping demand curve. To increase the
amount sold, a monopoly firm must lower the
price of its good.
- because the price on all units sold must fall if
the monopoly increases production, marginal
revenue is always less than the price.

Output-price determination
A o opolists profit a i isi g le el of output
is determined where marginal revenue equals
marginal cost (MR=MC). It then uses the demand
curve to find the price that will induce consumers
to buy that quantity.
Profit Maximisation
At low levels of output say Q1, MC is less than
MR, then the firm can increase profit by
producing more units.
At high levels of output say Q2, MC is greater
than MR, then the firm can raise profit by
reducing production.

Competition versus Monopoly

The marginal revenue of a competitive firm
equals its price, whereas the marginal revenue
of a monopoly is less than its price.
In competitive markets, price equals marginal
cost. In monopolized markets, price exceeds
marginal cost.
For a competitive firm: P= MR = MC.
For a monopoly firm: P > MR = MC.

Price Discrimination
First degree
Second degree
Third degree

Consumer surplus
Amount that buyers are willing to pay for a good
minus the amount they actually pay for it.
Or the difference between this willingness to
pay and the market price.
The area below the demand curve and above
the price measures the consumer surplus in a
market

Price Discrimination
Price discrimination- the business practice of
selling the same good at different prices to
different customers.
First-degree: the fir is a are of ea h u ers
demand curve.
Second-degree: the firm charges a different
price, depending on the quantity each buyer
purchases.
Third-degree: the firm breaks buyers into groups
based upon their price elasticity of demand.

1. First Degree Price Discrimination (Perfect

Price Discrimination)
Each consumer is charged the price he/she is
willing to pay.
Producer takes all the consumer surplus
Eg. Road side sellers of fruits and vegetables.

2. Second Degree Price Discrimination (nonlinear pricing)

Different price is charged for a different
quantity bought (but not across consumers).
set one price for a first bundle, a lower price
for a second bundle, ....
extract some, but not all of consumer surplus
Eg.
-A single t shirt is priced 100 rupees, but a pack
of three would cost you only 245.
-Telephone companies charging different prices
for different quantities

Note:
In first degree case: different prices
charged for different consumers
In second degree case: different prices
charged for different quantities (for same
consumer)

3. Third Degree Price Discrimination

Practice of dividing consumers into two or
more groups with separate demand curves
and charging different prices to each group
Eg.
regular versus special airline fares, premium
versus non premium brands of liquor, canned
food or frozen vegetables, discounts to senior
citizens & students

Is price discrimination always undesirable?

Post offices charging the same price for letters
going between two points in a state,
regardless of the differences in cost of
delivering it.
Discounts in buses provided to students,
senior citizens.
Lower doctors fees for needy patients.

 Eg. Firm with and without price discrimination- effect

on revenues

lo i o e fa ilies( a t pa ore tha

25rupees for good A)
100 high income families(can be charged upto
75/- for good A)
No price discrimination i.e. charging 25/- for
good A to both groups,
Total revenue = 1100*25=27,500/ With price discrimination i.e. charging 25/for low income and 75/- for high income
1000*25=25,000/- and 100* 75=7500/Total revenue = 32,500/-

 Eg. Continues with respect to cost of production

Suppose the cost of producing A for 100

families is 8000/- and that for 1100 families is
30,000/-.
Incomes earned will be 7500/- for high income
if charged 75/- and charging a uniform price of
25/- for 1100 families will earn 27,500/-.
In both cases the incomes earned are lower
than the cost of production.
But with discriminatory prices, the firm earns
32,500/- which will cover the 30,000/production cost of both sets of customers.

MONOPOLISTIC COMPETITION

Monopolistic Competition
Features
Number of buyers and sellers are many, all of
whom are small
Freedom of entry and exit
Perfect information
Differentiated products
Attributes that differentiate products need
not be real(packaging , quality)

Monopolistically Competitive SR
Rs
MC

22
18
14
10
6
2

ATC
AR
MR
1

10

Quantity

Monopolistically Competitive SR
Rs
MC

22
18
14
10
6
2

ATC
AR
MR
1

10

Quantity

Monopolistically Competitive SR
Rs
MC

22
18
14
10
6
2

ATC
AR
MR
1

10

Quantity

Monopolistically Competitive SR
Rs
MC

22
18
14
10
6
2

ATC
AR
MR
1

10

Quantity

Monopolistically Competitive
Fir s Pri e, Qua tit , a d Profit
Long Run

Monopolistically Competitive LR
Rs

MC

22
18
14
10
6
2

ATC
AR
MR
1

10 Quantity

Monopolistically Competitive LR
Rs

MC

22
18
14
10
6
2

ATC
AR
MR
1

10 Quantity

 The economic profits cannot persist under

monopolistic competition because it will
entice the new firms to enter the market.
New firms will offer products that are close
enough to take away some business from the
existing firms that are making profits.
More firms enter and wipe away the
economic profits and in the long run firms
make normal profit.