Today Shifts in MC, ATC, and AVC curves. Production and cost in the long run.

Shifting the Short Run Cost Curves of the Firm They shift when: The price of an input changes. There is a change in the level of the fixed inputs (a change in plant size). There is a change in the state of technology (meaning know-how).

Example: Wages rise MC’ MC $/Q ATC’ ATC Variable costs rise at all levels of output. MC shifts up. ATC shifts up. AVC (not shown) shifts up. Q

Improvements in Technology MC $/Q MC’ ATC ATC’ Improvements in technology lead to lower costs. (Could save only fixed costs, but usually MC will fall.) Q

Different Plant Sizes Changing the short-run situation of the firm is best studied in the context of production and costs in the long-run.

Production and Cost in the Long Run

Long Run The firm’s planning horizon in which it can choose any combination of inputs. It is not locked into past decisions in its plans for the long run. Firms can “lock-in” to any short-run situation in the long run.

Choice of Inputs Goods can be produced using many different combinations of inputs. Examples: cleaning, building a house How does a firm decide which to use? Look at range of available production techniques for a given level of output. Calculate which costs least, given particular input prices.

Plant size Small plants achieve their lowest average total cost at a low level of output. Large plants achieve their lowest average total cost at a high level of output. In the SR, a firm is stuck with its current plant size. In the LR, a firm may choose any plant size (then it will be stuck at that one for future SR scenarios).

Average Costs for Various Plant Sizes SRAC3 $/Q SRAC0 SRAC4 SRAC1 SRAC2 q In the SR, this firm is using plant size 1. In the LR it could choose any of these plant sizes.

ATC in the SR and the LR SRAC3 c $/Q SRAC0 SRAC4 SRAC1 SRAC2 f b e a d qA qB q In the SR, what is its AC of producing qA? qB? In the LR, what is its AC of producing qA? qB?

Long Run Average Cost For any level of output, in the long run the firm will choose the plant size that gives the lowest possible average cost. At every q, LRAC  SRAC. (why?) The LRAC curve is thus the lower envelope of the SRAC curves.

Long Run ATC SRAC3 $/Q SRAC0 SRAC4 SRAC1 SRAC2 LRAC q

With an Infinite Variety of Plant Sizes $/Q LRAC q

The Saucer-Shaped LRAC curve $/q LRAC q0 q1 q Between q0 & q1: Constant returns to scale Between 0 and q0: Increasing Return to Scale Between q1 and : Decreasing Returns to Scale

Constant Returns to Scale Increasing the use of all inputs by an equal proportion will result in an increase in output by that same proportion. AC is constant. Sometimes called constant costs.

Increasing Returns to Scale Increasing the use of all inputs by an equal proportion will result in an increase in output by a greater proportion. AC is falling. Also called economies of scale or decreasing costs.

Decreasing Returns to Scale Increasing the use of all inputs by an equal proportion will result in an increase in output by a lesser proportion. AC is rising. Also called diseconomies of scale or increasing costs.

Be Sure to Know the Difference Between: Decreasing Returns to Scale: increasing all inputs by an equal % results in increasing average costs, and Diminishing Marginal Returns: holding one or more important factors constant, increasing the other factors by equal increments will eventually result in decreasing MP (increasing MC).

Shifting LRAC LRAC will shift any time there is a change in input prices a change in technology (know-how) Does the LRAC curve shift when plant size changes?

Example: Wages fall $/q LRAC LRAC’ q Why would we expect the downward shift will not be parallel?

Coming Up Begin study of profit maximization in the context of perfect competition.

Group Work Apply economies of scale to movie theaters. Make sure you have the correct answers to last week’s handout on firm costs.

More Screens The average number of movie screens per cinema has increased over the last several years. This seems to suggest there are increasing returns to scale: that increasing the number of screens at each location leads to a lower average cost.

Increasing Returns to Scale at the Cinema List several reasons why a firm’s average costs would fall as the number of screens at the same location rises.

Decreasing Returns to Scale at the Cinema? Even though the average number of screens per cinema has been rising, cinemas rarely have 20 or 30 screens each, even in highly populated, urban areas. This seems to be evidence that the LRAC for a cinema eventually turns upward. List some reasons why a cinema’s costs might rise if it were to grow that large.