Long-Run Costs and Economies of Scale Module 56

Behind the Supply Curve

Costs and the Long Run Firm’s short run fixed cost is variable IN THE LONG RUN Way to frame it The Short-Run is a snapshot of a firm’s day The Long-Run is a series of snapshots turned into a video

Behind the Supply Curve In the Long-Run, firms can choose the appropriate fixed costs for output For example: Firms can choose to buy a variety of new equipment Lowers its ATC in the LONG-RUN By buying new machinery, fixed costs go UP but variable costs drop considerably

Firms adjust Upwards (Expansion) or Downwards (Contraction) in the Long Run Examples: McDonald’s franchise opens Local restaurant adds a new dining room Chrysler closes a factory in Twinsburg, Ohio Browns build a brand new stadium A pizza franchise closes down

Behind the Supply Curve Need to add time to the discussion of costs and the firm This means… All the ATC curves we have discussed are based on FIXED costs Therefore... There are many possibilities of fixed costs (short run) for a firm (“family” of SRC curves)

Behind the Supply Curve Long-Run Average Total Cost (LRATC) Based on output, LRATC is the relationship between output and average total cost, WHEN a fixed cost has been chose Chose a fixed cost? Rent, Machinery, etc Different combination of fixed costs

Behind the Supply Curve Economies of Scale Scale – the size of a firm’s operations Scale effects – Long-Run ATC change dramatically if quantity of output is changed Increasing returns to scale When output increases proportionally more than inputs Ex: Salsa Leads to decreasing LRATC

Behind the Supply Curve Diseconomies of Scale When LRATC increases as output increases Decreasing returns to scale

How could a firm enjoy economies of scale? Specialization of labor High startup costs Bulk buying of inputs

How could a firm suffer from dis-economies of scale? Inefficiencies Lack of coordination Lack of communication Size (limits?)

Internal Economies of Scale These are economies made within a firm as a result of mass production. As the firm produces more and more goods, so average cost begin to fall because of: Technical economies made in the actual production of the good. For example, large firms can use expensive machinery, intensively. Managerial economies made in the administration of a large firm by splitting up management jobs and employing specialist accountants, salesmen, etc. Financial economies made by borrowing money at lower rates of interest than smaller firms. Marketing economies made by spreading the high cost of advertising on television and in national newspapers, across a large level of output. Commercial economies made when buying supplies in bulk and therefore gaining a larger discount. Research and development economies made when developing new and better products. External Economies of Scale These are economies made outside the firm as a result of its location and occur when: A local skilled labor force is available. Specialist local back-up forms can supply parts or services. An area has a good transport network. An area has an excellent reputation for producing a particular good. Sheffield is associated with steel.

Internal Diseconomies of Scale These occur when the firm has become too large and inefficient. As the firm increases production, eventually average costs begin to rise because: The disadvantages of the division of labor take effect Management becomes out of touch with the shop floor and some machinery becomes over-manned. Decisions are not taken quickly and there is too much form filling. Lack of communication in a large firm means than management tasks sometimes get done twice. Poor labor relations may develop in large companies. External Diseconomies of Scale These occur when too many firms have located in one area. Unit costs begin to rise because: Local labor becomes scarce and firms now have to offer higher wages to attract new workers. Land and factories become scarce and rents begin to rise. Local roads become congested and so transport costs begin to rise.

Behind the Supply Curve Sunk Costs Cost that has already been incurred, and is NON- RECOVERABLE Sunk costs should be ignored in a decision about future actions Psychologically difficult to ignore sunk costs

Sunk Cost Examples Staff Training and Education Product Research Advertising Specialty Equipment Consultants