Economics 111.3 Winter 14

March 19th, 2014Lecture 24

Ch. 11: Long-run costsCh. 12: Perfect competition

• In the long run, the firm can vary both its use of labour and of capital.

• It will vary the use of both factors of production to maximize profits.

• As a result, long-run cost will always be less or equal to short-run cost.

Long Run Cost

© 2010 Pearson Education Canada

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Figure 7-7

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Firm Size & Costs

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Figure 7-7

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Firm Size & Costs

The Long-Run Average Cost Curve• The segments of the short-run

average total cost curves along which average total cost is the lowest make up the long-run average total cost curve.

• For every plant capacity size, there is a corresponding short-run ATC curve

• It shows the least ATC at which any output can be produced after the firm has had time to make all appropriate adjustments in its plant size.

• LRAC curve is the firms planning curve

Figure 7-8

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the number of possible plant sizes is virtually unlimited

the number of possible plant sizes is virtually unlimited

The Long-run Cost Curve

Determinants of the Shape of the Long-Run Cost Curve: the existence of economies and diseconomies of scale

Economies of Scale• There are economies of scale in production when the long run

average cost decreases as output increases.• Economies of scale (increasing returns to scale) are cost

savings associated with larger scale of production.Economies of Scale are based on • labour specialization• managerial specialization• efficient capital• other factors, e.g., expected demand or “learning by doing”:

learning by doing means that as we do something, we learn what works and what doesn’t, and over time we become more proficient at it

Economies of Scale and Increasing Returns to Scale

• Increasing Returns to Scale occur whenever inputs do not need to be increased in proportion to the increase in output.

• Or when a given percentage increase in all the firm’s inputs results in the firm’s output increasing by a larger percentage.

Constant Returns to Scale• Constant returns to

scale (CRTS) occur where long-run average total costs do not change as output increases.

• It is shown by the flat portion of the long run average total cost curve.

Diseconomies of Scale• Diseconomies of scale or decreasing returns to

scale refer to the increasing long run average costs as output increases. Diseconomies occur for a number of reasons as the firm increases its size– Coordination of a large firm is more difficult– Information costs and communication costs

increase as firm increases– Monitoring costs increase– Team spirit may decrease

Diseconomies of scale in terms of firm’s technology are called

Summary of Returns to Scale

Returns to scale Doubling inputs results in:

Slope of the LRAC

Increasing returns to scale (IRTS; economies of scale)

Output more than doubles.

downward

Constant returns to scale (CRTS)

Output exactly doubles. horizontal

Decreasing returns to scale (DRTS; diseconomies of scale)

Output less than doubles. upward

Minimum efficient scale of production

• A firm’s minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level

• The minimum efficient scale of production will be at the beginning of the constant returns portion of the average cost curve—where average total costs are at a minimum.

Economies of Scale

• The implication of economies of scale is that in some industries firms must be of a certain size to be able to compete successfully.

Competitive industries

The firms in some industries minimize their average costs at a small plant size: apparel, food processing, furniture, wood products, snowboarding, and small-appliance industries are examples.

Minimum Efficient ScaleFigure 7- 9c

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Oligopolistic industries

In oligopolistic industries, in order to take full advantage of economies of scale, firms must produce with very large facilities that allow the firms to spread costs over an extended range of output. Examples would be: automobiles, aluminium, steel, and other heavy industries. This pattern also is found in several new information technology industries.

Minimum Efficient ScaleFigure 7- 9b

Output

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• Min ATC

Quantity (millions of kilowatt-hours)

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Natural Monopoly

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Natural MonopolyA natural monopoly is an industry in which

one firm can produce at a lower cost than can two or more firms.

Rationale: technology is such that minimum efficient scale is so large that average total costs fall within the range of potential output.