ECON 520 (2010 Fall)

Kansas State University

Zijun Luo

LECTURE 8: Short-Run versus Long-Run in Producer Theory

Study tips for the lecture It is very important to remember that the differences between Long-run and Short-run are not simply a matter of time. The differences refer to the fact that whether the producer is able to freely adjust all her/his inputs. The upward-sloping supply curve, something you must be very familiar with from your principles class, is simply derived from the Marginal Cost curve. Unlike consumer theory, in which the distinction between individual demand and market demand makes no big difference, the differences between individual supply and market supply is a big deal in this lecture. This lecture could be one of the hardest lecture in this course to be fully understood.

1. What is Long-run?
Definition of Short-run: The period of time in which a firm must consider some inputs to be fixed in making its production decisions. Definition of Long-run: The period of time in which a firm may consider all of its inputs to be variable in making its production decisions. In a typical model of production with only Labor and Capital as inputs, we consider that in the short-run the firm can change their decision on Labor (i.e., it can employ more or less labor accordingly) but it cannot change its decision on Capital (i.e., the amount of Capital is fixed). Another way to see this is in terms of costs. In the short-run, because the amount of Capital is fixed and sunk, we have Fixed Cost, while in the long-run, because you can change your decision on either Labor or Capital, there will be NO Fixed Cost.

2. TC, AC, and MC curves

Notes for the graph (graphs on the next page): (1) These two graphs show the relationship between short-run (SR) and long-run (LR) TC, AC and MC curves. I did not label everything because of space constraint, but you should easily identify FC1, FC2, and FC3 on the upper panel, as well as SRMC1, SRMC2, SRAC1, and Page 1 of 7

ECON 520 (2010 Fall)

Kansas State University

Zijun Luo

SRAC2 on the lower panel. One should also note that, as before, all SRMC curve intercepts the lowest point of its corresponding SRAC (There might be some inaccuracy in the graphs). Dollar

SRTC3

SRTC2 SRTC1

E Slope=SRAC=SRMC=LRAC=LRMC

Q Dollar/Q

SRMC3 SRAC3

LRMC LRAC

QE

(2) The LRTC curve encircles all SRTC curves from below. The LRTC curve tangents the SRTC curves at certain points. Similarly, on the lower panel, the LRAC curve encircles all SRAC curves from below and tangents the SRAC curves at certain points which are corresponding to the upper panel. The LRMC curve is flatter than SRMC curves. (3) Because we defined long-run as the time period that is long enough for firm to adjust all its inputs, thus in long-run, there is no Fixed Cost. As a result, the LRTC starts from the origin (rather than some positive value on the Y-axis). Page 2 of 7

ECON 520 (2010 Fall)

Kansas State University

Zijun Luo

(4) Point E on the upper panel (or F on the lower panel) is the Zero-profit point in the long-run. Note that in the long-run, since there is no Fixed Cost, the (Long-run) Zero-profit point is also the Shut-down point. A firm can still compensate all its costs in the Long-run given that P is the market price. The firm can make positive profit in the Long-run at any price level that is beyond P. (5) There are two ways to think about those short-run curves: (i)representation of different firms and (i)how a single firm adjusts its production technology and inputs through time. For the TC curves, technology determined the curvature of the curve, and input levels determined the amount of Fixed Costs (Although I did not label the FCs, you should easily read them).

3. Individual Supply Curve: From Short-run to Long-run

We know that in order for a firm to maximize its profit, it should be producing at a point that satisfies MC=MR. If we are in a perfectly competitive market, we know that MR=P and P is exogenously given. Thus we can easily have the understanding that all points a firm should produce in order to maximize its profit must be on the Marginal Cost Curve. Hence, the whole MC curve serves as the baseline for our derivation of the Supply Curve. But obviously not the whole MC curve represents the Supply Curve. We already know that, at some price level, we would reach the Shut-down point, at which the firm should leave the market. Thus, we have the following definitions. Short-run Individual Supply Curve: The Short-run Individual Supply Curve is defined as the portion of the firms Short-run Marginal Cost Curve that is on or above the interception with the firms Average Variable Cost Curve. Long-run Individual Supply Curve: The Long-run Individual Supply Curve is defined as the portion of the firms Long-run Marginal Cost Curve that is on or above the interception with the firms Long-run Average Cost Curve. Based on what we have discussed, in the long-run, there is no Fixed cost. So the lowest point of the firms long-run Average Cost is the Shut-down point for a firm in the long-run. Graphically, we have the following:

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ECON 520 (2010 Fall)

Kansas State University

Zijun Luo

P SRMC

SRAC AVC

LRMC

LRAC

Q Notes for the graph:

(1) Curves in bold represents the firms Supply Curve. One should easily understand that when the price level is below the Shut-down price level, the firm will produce nothing hence the firms supply is a vertical line (Q=0) when the price is too low. (2) After ignoring the zero-production portion, we can see that the Supply Curve, regardless Short-run or Long-run, is upward-sloping.

4. Market Supply Curve: From Short-run to Long-run

To determine Short-run Market Supply Curve, we can use the method we used to determine the Market Demand Curve from the Individual Demand Curve, that is, horizontally sum up the points on different individual supply curves. Thus, the short-run Market Supply Curve is also upward-sloping but flatter than any Individual short-run Supply curve. But for the long-run Market Supply Curve, it is NOT as easy as sum-up the longrun Individual Supply Curves. The shape of the long-run Market Supply Curve depends on the nature of the industry.

4.1 Cost-Industry and Returns-to-Scale

When an industry expands, under perfect competition, it could be the case that each firm produces more or new firms enter the market. In either situation, there could be three different cases. (1) Increasing Cost-Industry: In order to expand, firms may need to employ new capitals as well as new labors. The Average Cost of the firm could be increasing due Page 4 of 7

ECON 520 (2010 Fall)

Kansas State University

Zijun Luo

to the production technology. Also, new entry of firms can cause the competition of hiring labor more intense. This can give rise to the wage rate hence increases the Average Cost of the firms in the industry. (2) Decreasing Cost-Industry: Firms can have excess capital or labor even when they dont need all of them. While the industry expands, firms may utilize their capital and labor more effectively thus we can observe a decrease in the Average Cost of the firm. (3) Constant Cost-Industry: There could be cases that when a firm or an industry needs to be expanded, they need to hire capital and labor in such a way that the Average Cost is constant. One could easily compare the statements above to our definition of the Returns-toScale, and realize there must be connection. Hence, we have the following relationships: Decreasing Returns to Scale Increasing Cost-Industry; Increasing Returns to Scale Decreasing Cost-Industry; Constant Returns to Scale Constant Cost-Industry.

4.2 Long-run Market Supply Curve: Three Cases

In order to derive the long-Run Market Supply, one should first understand the Price Adjustment Mechanism. Price Adjustment Mechanism: Under Perfect Competition, when there is excess demand (Demand > Supply), the price tends to go up. When there is excess Supply (Supply > Demand), the price tends to go down. This Price Adjustment Mechanism implies the following facts: (1) If Demand increases, price tends to increase; If Demand decreases, price tends to decrease; (2) If Supply increases, price tends to decrease; If Supply decreases, price tends to increase; (3) If price increases, Demand tends to decrease and Supply tends to increase; (4) If price decreases, Demand tends to increase and Supply tends to decrease. The Price Adjustment Mechanism ensures that the market price and quantity is stable at its equilibrium, which is the interception of the Demand Curve and Supply Curve. Under perfect competition, it can be induced from the Price Adjustment Mechanism that the market price will be at a level such that it only allows the firm to get Zero-profit in the long-run. This comes from the fact that if firms in the market can get positive profit, new Page 5 of 7

ECON 520 (2010 Fall)

Kansas State University

Zijun Luo

firms will keep entering the market thus drives the price to go down until it reaches the Zeroprofit price level. Now we can graphically derive the long-run Market Supply Curve. Case 1: Increasing Cost-Industry1 P
S1 S2 P2
LRAC

SRMC LRMC

P3 P1 D1 Q1 Q2 Q3 D2

LRS

Case 2: Decreasing Cost-Industry P

S1

P2

S2

P1 P3 D1 Q1 Q2 Q3 LRS D2

Case 3: Constant Cost-Industry P

S1 P2 S2

P1 D1 Q1 Q2 Q3 D2

LRS

Page 315, Nicholson and Snyder, 2007. Page 318, Nicholson and Snyder, 2007. 3 Page 312, Nicholson and Snyder, 2007.
2

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ECON 520 (2010 Fall) Notes for the graph:

Kansas State University

Zijun Luo

(1) I did not label everything. You should be able to figure out the rest of them. (2) At the beginning, Demand Curve is given by D1, Supply Curve is given by S1. At the Market Equilibrium, market price and quantity is P1 and Q1 respectively. Then Demand shifts to D2 which means there is an increase in Demand. In the short-run, this shifts in Demand as well as drives the Price to P2 and Quantity to Q2. Because there is excess demand, price went up, firms now can make positive profit, new firms enter the market. (3) In the Increasing Cost-Industry case, as shown in the first set of graphs, market expansion drives the Average Cost to go up. When the Market price is P3, firms make Zeroprofit in the Long-run. The corresponding Market Demand is Q3. The new Short-run Supply Curve is given by S2, which intercepts D2 at the new Market Equilibrium point. (4) In the Decreasing Cost-Industry case, as shown in the second set of graphs, market expansion drives the Average Cost to go down. When the Market price is P3, firms make Zero-profit in the Long-run. The corresponding Market Demand is Q3. The new Shortrun Supply Curve is given by S2, which intercepts D2 at the new Market Equilibrium point. (5) In the Constant Cost-Industry case, as shown in the third sets of graphs, market expansion has no effect on the firms Average Cost. When the Market price goes back P1, firms make Zero-profit in the Long-run. The corresponding Market Demand is Q3. The new Short-run Supply Curve is given by S2, which intercepts D2 at the new Market Equilibrium point. (6) The bold line connecting the old and new Market Equilibrium represents Longrun Supply curve. In the Increasing Cost-Industry case, long-run Supply curve is upwardsloping. In the Decreasing Cost-Industry case, long-run Supply curve is downward-sloping. In the Constant Cost-Industry case, long-run Supply curve is horizontal. (7) The panels with SRMC, LRMC and LRAC are showing these curves in terms of individual firms by assuming all firms have the same technology. The panels with short-run Demand curve, short-run Supply curve and long-run Supply curve are showing these curves in terms of the whole market.

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