1. Long Run Cost

2. Making Long-Run ProductionDecisions To make their long-run decisions: Firms look at costs of various inputs and thetechnologies available for combining theseinputs. Then decide which combination offers thelowest cost. 3. Making Long-Run ProductionDecisions The firm makes long-run decisions on thebasis of the expected costs and expectedusefulness of inputs. 4. Technical Efficiency and Economic Efficiency Technical efficiency as few inputs aspossible are used to produce a givenoutput. Technical efficiency is efficiency that doesnot consider cost of inputs. 5. Technical Efficiency andEconomic Efficiency Economically efficient the method thatproduces a given level of output at thelowest possible cost. It is the least-cost technically efficientprocess. 6. Economies of Scale and Long-Run Cost Curves In the long run, a firm has many sizes tochoose from. The short run requires that scale be fixed only one or a few resources can bechanged. 7. Determinants of the Shape of the Long-Run Cost Curve The law of diminishing marginalproductivity does not hold in the longrun. All inputs are variable in the long run. 8. Determinants of the Shape of the Long-Run Cost Curve The shape of the long-run cost curve isdue to the existence of economies anddiseconomies of scale. 9. Economics of Scale Scale means size. Economies of scale: the decrease in per unitcosts as the quantity of production increasesand all resources are variable Diseconomies of scale: the increase in per unitcosts as the quantity of production increasesand all resources are variable Constant returns to scale: unit costs remainconstant as the quantity of production isincreased and all resources are variable 10. A Typical Long-Run Average Total Cost TableTotal CostsTotal Cost Total Costs = Average TotalQuantity of Labor of Machines TCL + TCM Costs = TC/Q 11 $381 $254 $635 $58 1239026065054 1340226867052 1442028070050 1545030075050 1648032080050 1751034085050 1854936691551 196004001,00053 206664441,11056McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 11. A Typical Long-Run Average Total Cost Curve$64 62 60 Costs per unit Average 58 total cost 56 Minimum efficient 54 level of production 52 50 48 11 12 13 14 15 16 17 18 19 20 QuantityMcGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 12. Economies of Scale Economies of scale long run averagetotal costs decrease as output increases. In real-world production processes,economies of scale are extremelyimportant at low levels of production. 13. Economies of Scale An indivisible setup cost is the cost ofan indivisible input for which a certainminimum amount of production must beundertaken before the input becomeseconomically feasible to use. 14. Economies of Scale Indivisible setup costs create many real-world economies of scale. The cost of a blast furnace or an oilrefinery is an example of an indivisiblesetup cost. 15. Economies of Scale In the longer run all inputs are variable, soonly economies of scale can influence theshape of the long-run cost curve. 16. Economies of Scale Because of the importance of economiesof scale, business people often talk of aminimum efficient level of production. 17. Economies of Scale The minimum efficient level ofproduction is the amount of productionthat spreads setup costs out sufficiently forfirms to undertake production profitably. 18. Economies of Scale The minimum efficient level of productionis reached once the size of the marketexpands to a size large enough so thatfirms can take advantage of all economiesof scale. 19. Minimum Efficient Scale Most industries experience both economies anddiseconomies of scale. The minimum efficient scale (MES) is theminimum point of the long-run average-costcurve; the output level at which the cost per unitof output is the lowest. The MES varies considerably across industries. 20. Diseconomies of Scale Diminishing marginal productivityrefers to the decline in productivity causedby increasing units of a variable inputbeing added to a fixed input. !tention ductivity P ay at inal prorgt -run!in g ma the Shor Dim inish plies in po n ly a 21. Diseconomies of Scale Diseconomies of scale refer to decreasesin productivity which occur when there areequal increases of all inputs (no input isfixed). Diseconomies of scale occur on the rightside of the long-run average cost curvewhere it is upward sloping, meaning thataverage cost is increasing. 22. Diseconomies of Scale As the size of the firm increases,monitoring costs generally increase. Monitoring costs are those incurred bythe organizer of production in seeing to itthat the employees do what they aresupposed to do. 23. Diseconomies of Scale As the size of the firm increases, teamspirit or morale generally decreases. Team spirit is the feelings of friendshipand being part of a team that brings outpeoples best effort 24. Constant Returns to Scale Constant returns to scale is where long-run average total costs do not change asoutput increases. It is shown by the flat portion of theLRATC curve. 25. Long-Run andShort-Run Cost Curves (1) 26. Economies and Diseconomiesof Scale $64 Economies Constant Diseconomies62of Scalereturnsof Scale60 to ScaleCosts per unitAverage58 total cost5654525048 11 12 13 14 15 16 17 18 19 20 Quantity 27. A Typical Long-Run AverageCostsTotal Cost Curveper unit $60Long-runMinimumaverage totalefficient cost (LRATC) $55 level of production $50 Q11 14 1720 ATC falls because ATC is constant ATC rises becauseof economies because of constant of diseconomies of scalereturns to scale of scale13-27 28. Long-Run andShort-Run Cost Curves (3) 29. Importance of Economies andDiseconomies of Scale Economies and diseconomies of scaleplay important roles in real-world long-runproduction decisions. 30. Importance of Economies andDiseconomies of Scale The long-run and the short-run averagecost curves have the same U-shape, butthe underlying causes of these shapesdiffer. 31. Importance of Economies andDiseconomies of Scale Economies and diseconomies of scaleaccount for the shape of the long-run totalcost curve. 32. The Envelope Relationship Long-run costs are always less than or equal to short-runcosts because: In the long run, all inputs are flexible In the short run, some inputs are fixed There is an envelope relationship between long-run andshort-run average total costs. Each short-run cost curvetouches the long-run cost curve at only one point. In the short run all expansion must proceedby increasing only the variable input This constraint increases cost13-32 33. The Envelope of Short-Run Average Total CostCosts Curvesper unit LRATCSRATC4 SRATC1 SRMC1 SRMC4 The long-run average SRMC2 SRATC2SRATC3 total cost curve (LRATC)SRMC3is an envelope of theshort-run average totalcost curves (SRATC1-4) Q 13-33 34. Short-Run andLong-RunAverage-CostCurves 35. Long-Run Average Total Cost Long-run average total cost (LRATC):the lowest-cost combination of resourceswith which each level of output isproduced when all resources are variable. The long-run average total cost curve getsits shape from economies anddiseconomies of scale. 36. Shape of LRATC If producing each unit of output becomes lesscostly there are economies of scale. If producing each unit of output becomesmore costly there are diseconomies ofscale. If unit costs remain constant as output risesthere are constant returns to scale. 37. Long-Run andShort-Run Cost Curves (2)