Costs/Productivity - Part 4 (Pp of textbook) M. Padula AIS Theory of the Firm Part I

Upcoming Topics Long-Run Cost Curves Average Costs in the Long Run Long-run Average Total Cost Curve Economies of Scale Diseconomies of Scale Constant Returns to Scale Minimum Efficient Scale

Long Run vs. Short Run In the long run: There are ____ fixed inputs or fixed costs All inputs or costs are ___________ Average Total Costs = Average _______ Costs Long Run = “Variable Plant Period” Long Run Average Total Costs The average cost per unit of output over the long run (where all inputs are considered to be ___________) Almost always less than short-term unit costs: In the LT, companies have the flexibility to change major components of their operations (e.g., factories), for optimal efficiency A goal of firms is to determine the lower bounds of LRATC

The LRATC Curve What is the Long Run Average Total Cost Curve? It represents the firm’s planning horizon; it considers: 1. What is the market telling me is the right level of production? 2. At what size/scale would I need to be to match that Quantity, w/o experiencing Diminishing Marginal Returns? 3. Which SRATC curve allows me to minimize my LRATC ? The Long-Run Average Total Cost (LRATC) Curve: A curve that shows the lowest possible average cost that can be attained by a firm for any level of output when all of the firm’s inputs are variable. It is also known as a planning curve or envelope curve.

The Shape of the LRATC The LRATC has a U-shape, reflecting the concept of Economies of Scale Economies of Scale: Decreases in average costs of production as a firm increases its output by increasing fixed inputs (and thus all of inputs) As output increases, if all inputs increase, average cost falls: Specialization of labor: _______________________________________ Specialization of management: __________________________________ Efficiency of capital equipment: _________________________________ Indivisibility of capital equipment: ________________________________ Indivisibility of efficient processes: _______________________________ Spreading of certain costs over larger volumes of output: _______________

Opportunities to decrease average costs by increasing plant size

The Shape of the LRATC Economies of Scale are not unlimited…eventually a firm can reach: Diseconomies of Scale Diseconomies of Scale: Increases in average costs of production as a firm increases its output by increasing fixed inputs (and thus all of inputs) As output increases, and the firm increases plant size, average costs increase: Management inefficiencies: ____________________________________ Control and communication problems: ____________________________ Poor worker motivation: ______________________________________

Can a firm become “too big for its own good”? At this point, continuing to add plants and increase output causes ATC to rise.

The Shape of the LRATC Constant Economies of Scale—the flat part of the curve Minimum Efficient Scale (MES): Occurs when the firm has exhausted all possible economies; any further output will result in constant or increasing average costs

Before you leave… Be sure you can: Explain the difference between SR and LR Explain the derivation of the LRATC curve Identify the three regions of the LRATC curve Give examples for why there are Economies of of Scale and Diseconomies of Scale Explain Minimum Efficient Scale