MODULE 56 : LONG-RUN COSTS AND ECONOMIES OF SCALE

Key Economic Concepts For This Module: • In the long run, all inputs can be changed. Because there are no fixed inputs in the long run, there are no fixed costs in the long run. Another way to say this is that all costs are variable in the long run. • Expansion in the long run requires additional costs, but larger output levels can justify this expense. If the projected level of output is large enough, the new short-run ATC will be lower than ATC prior to expansion. • If the firm finds the lowest possible average total cost that can be achieved for each output level when fixed inputs are free to change, we can draw out the long-run average total cost curve. • The long-run average total cost curve (LRATC) is the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output. • If the LRATC curve is falling as the firm expands, the firm is said to be experiencing economies of scale. • If the LRATC is rising as the firm expands, the firm is said to be suffering from diseconomies of scale. • Sunk costs are past expenses that cannot be recovered. These costs should not be used to make future decisions. Economists insist that sunk costs be ignored.

Module Presentation: I. Short-Run versus Long-Run Costs A. Returns to Scale II. Sunk Costs A. Summing Up Costs: The Short and Long of It

I. Short-Run versus Long-Run Costs LONG RUN (examples): • McDonald’s can open a new franchise. • A local restaurant can build an expanded dining room. • GM can close a factory in Indiana. • A professional baseball team can build a new, larger, stadium. • A college can build a new dorm to house a larger student population. • A regional pizza monopoly can close an unprofitable franchise in a nearby town. Because these actions can only take place in the long run, these are costs that are only incurred in the long run and this differentiates long-run costs from short-run costs.

I. Short-Run versus Long-Run Costs Specifically, the long-run average total cost curve (LRATC) is the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output.

A. Returns to Scale Economies of Scale: the LRATC is falling as the firm expands. In this range, the firm is benefiting from expansion due to increasing returns to scale.

Why would a firm enjoy economies of scale? • Specialization. The firm expands and finds ways to give labor and capital opportunities to perform tasks that are best suited to their talents. For example a firm could purchase a machine that is both a copier and a fax. • High set-up costs. A large piece of capital is expensive when it is initially purchased, but if the firm can produce many many units, the per-unit costs fall and economies of scale exist. • Buying inputs in bulk. Larger firms need lots of raw materials and when they are bought in large quantities, the per-unit costs are lower. Think of buying 24 single cans of Coke from a vending machine versus buying a case of 24 cans from the grocery store.

A. Economies of Scale Diseconomies of Scale: the LRATC is rising as the firm expands. In this range, the firm is not benefiting from expansion due to decreasing returns to scale. This simply means that output is increasing at a slower rate than production costs.

A. Economies of Scale Why would a firm suffer diseconomies of scale? • Problems with coordination and communication. Vast firms have offices and subsidiaries spread across the globe. It takes time, effort, and money to coordinate production, marketing, and sales activities within large firms. At some point, the firm becomes so large that per-unit costs actually begin to rise.

II. Sunk Costs Suppose you have purchased a concert ticket for $100 and accidentally drop the ticket in a storm drain, losing it forever. Should you buy another ticket or sit at home and sulk? Economists would say that the loss of the first ticket is a moot point. You can’t get your $100 back, it is gone. Whether or not you buy another ticket depends upon whether you can afford another $100. The first $100 is a sunk cost . A sunk cost is a cost that has been incurred in the past and cannot be recovered. College tuition is another good example. A student has paid $10,000 in tuition. Should she attend as many classes as possible, so that those dollars are not “wasted”? Those dollars are sunk. You go to class on a daily basis if you believe the benefits from attendance outweigh the costs. And those costs do not include one nickel of the $10,000.

II. Sunk Costs

APE U3 L3 A30 LONG RUN AVERAGE COST CURVES In the long run the firm can vary its plant capacity and its output. The shape of the average cost curve results from economies and diseconomies of scale. Sources of economies of scale are: -Specialization of resources -More efficient uses of equipment -Reduction in per-unit costs of factor inputs -Effective use of production by-products -increase in shared facilities. Sources of diseconomies of scale are: -Limitations on management decision making -Competition for factor inputs.

APE U3 L3 A30 Part A: Use Figure 30.1 to answer the following questions: Long Run ATC Curves SRATC2 SRATC1 SRATC COST Q QLR Q1 OUTPUT 1. What does each of the SR ATC curves represent ______________________ 2. The firm can minimize cost by producing output level Q using firm size _____. It would be (underutilizing/overutilizing) plant size (SRATC/SRATC1). 3. Label the optimal output level in the diagram as QLR A different-size plant SRATC

APE U3 L3 A30 Part A: Use Figure 30.1 to answer the following questions: Long Run ATC Curves SRATC2 SRATC1 SRATC LRATC COST QLR Q Q1 OUTPUT SRATC2 4. To produce output level Q1, the firm should use plant size ________. This means that it would be (underutilizing/overutilizing) plant size (SRATC1/SRATC2). Draw in the LRATC and indicate its tangency points with each SR ATC. Label 6. The firm experiences (economies/diseconomies) of scale up to output level ______ and (economies/diseconomies) of scale beyond output level ____________. QLR QLR

APE U3 L3 A30 Part B: LRATC for a firm experiencing CONSTANT returns to scale. Explain & example. 7 LRATC PRICE QUANTITY Q Q1 Between Q & Q1, there are constant costs for all the firm sizes, as shown by a flat LRATC. Examples: furniture industry, household-appliance industry

APE U3 L3 A30 Part B: LRATC for a firm experiencing DECREASING returns to scale. Explain & example. 8 PRICE LRATC QUANTITY LRATC decreases over the entire relevant levels of output. Example: utilities

APE U3 L3 A30 Part B: LRATC for a firm experiencing INCREASING returns to scale. Explain & example. 9 LRATC PRICE Q QUANTITY LRATC: For all levels of output greater than Q, the costs are increasing for all plant sizes. Example: Retail trades.

APE U3 L3 A30 Part C: True, false, or uncertain. Explain. 10. In the LR, a cost minimizing firm will overutilize its plant when it produces at an output level greater than the optimal level. TRUE. At output levels > optimum, the points on LRATC are on the upward sloping part of SRATC—overutilizing a plant size.

APE U3 L3 A30 Part C: True, false, or uncertain. Explain. 11. The SR ATC curve declines and then increases as a factor input increases because of economies and diseconomies of scale. FALSE. SRATC is U-shaped because of diminishing returns. As additional units of variable inputs are added the FIXED plant size, the additional output actually decreases.

Practice Question 1. In the long run, a. all inputs are variable. b. all inputs are fixed. c. some inputs are variable and others are fixed. d. a firm will go out of business. e. firms increase in size.

Practice Question 2. Which of the following is always considered the long run? a. 1 month b. 1 year c. 5 years d. 10 years e. none of the above

Practice Question 3. Which of the following statements is generally correct?    I. The long-run average total cost curve is U-shaped.    II. The short-run average total cost curve is U-shaped.    III. Firms tend to experience economies of scale at low levels of production and diseconomies of scale at high levels of production. a. I only b. II only c. III only d. I and II only e. I, II, and III

Practice Question 4. When making decisions, which of the following costs should be ignored? a. average costs b. total costs c. marginal costs d. sunk costs e. None—no costs should be ignored.

Practice Question 5. Economies of scale will allow which of the following types of cities to lower their average total cost of clearing snow by investing in larger snow plow fleets? Cities with a. more people. b. more existing snow plows. c. less snowfall. d. larger budgets. e. more snowfall.