Costs in the Short Run Three Costs Marginal Cost Average Total Cost Average VariableCost Output: Q

Costs in the Long Run

With this plant, we can produce any amount from zero units to 7,000. SRATC Plant 1 SRATC Plant 2 SRATC Plant 3 With this plant, we can produce any amount from zero units to 7,000. With this plant, we can produce any amount from zero units to 12,000. With this plant, we can produce any amount from zero units to 15,000 $2 The minimum ATC occurs at 5,000 units The lowest ATC occurs at 2,500 units The minimum ATC occurs at 10,000 units $1 $0.5 2,500 5,000 7,000 10,000 12,000 15,000

Building the Long Run Average Total Cost Curve LRATC Match the lowest Short Run ATC with each output level The LRATC shows the lowest per unit cost for each output level across plant sizes

2 100 200 Q0 Plant 3 ATC =$7 SRATC3 7 SRATC1 SRATC2 6 Plant 2 ATC =$6 5.7 5.7 Plant 1 has the lowest ATC up to Q0 4 4 4 Plant 1 ATC = $4 2 2 Plant1 has the lowest cost: for Q= 200 LRATC = $2 Plant1 has the lowest cost: for Q= 100 LRATC = $4 100 200 Q0 200

Plant 2 has the lowest from Q0 to Q1 SRATC3 SRATC2 SRATC1 5 3 3 Plant 2 has the lowest from Q0 to Q1 2.5 2 1 Q0 300 400 Q1

Long Run ATC: envelope of lowest SRATC LRATC Plant 1 has the lowest ATC between 0 and Q0 Plant 2 has the lowest ATC between Q0 and Q1 Plant 3 has the lowest ATC above Q1 Q0 Q1

The LRATC is an envelope of SRATC curves Each point on LRATC tells you the lowest cost of producing a given output level across plant sizes 3 different plant sizes Long Run ATC SRATC1 has the lowest ATC between 0 and Q0 SRATC2 has the lowest ATC between Q0 and Q1 SRATC3 has the lowest ATC above Q1

The larger the number of plant size options… The smoother the LRATC

In the long run firms choose a plant size… ATC1 ATC2 ATC3 There is no single “best” plant size… Which plant is “best” depends on the volume of production.

Building the LRATC ATC1 LRATC ATC2 ATC3 Plant 1 has lowest cost for volumes up to 400 Plant 2 has lowest cost between 400 and 800 Plant 3 has lowest cost above 800 800 400 Plant 1 Plant 2 Plant 3 LRATC 400 800 Output

Building the LRATC LRATC SRATC1 SRATC2 SRATC3 OUTPUT PLANT 1 PLANT 2   LRATC 100 90 96 99 200 84 93 300 78 87 400 72 81 500 66 60 600 54 75 700 48 800 42 900 36 57 1000 30 27 1100 102 21 1200 108 15 1300 114 9 1400 120 3 1500 126 6

Choose the lowest ATC for each Output level SRATC1 SRATC2 SRATC3 LRATC OUTPUT PLANT 1 PLANT 2 PLANT 3   LRATC 100 90 96 99 200 84 93 300 78 87 400 72 81 500 66 60 600 54 75 700 48 800 42 900 36 57 1000 30 27 1100 102 21 1200 108 15 1300 114 9 1400 120 3 1500 126 6 Choose the lowest ATC for each Output level

Increasing Returns to Scale 10 40 Economies of Scale Costs increase by less than 20% Costs increase by less than 10% LRATC ATC Savings due to Size 20 LRATC ATC 10 10 20 200 Double Costs Double Inputs 400 2TC ATC decrease TC Q ATC = Mass Production Technology 4Q 40 Four times as much output Q increase by 10% Q increase by 20% 10

Increasing Returns to Scale SRATC1 SRATC2 SRATC3 SRATC4 LRATC SRATC5 SRATC6 $8 SRATC7 $7 SRATC8 $6 $5 $4 $3 LRATC $2 $1 LRATC downward sloping output

Constant Returns to Scale 20 10 ATC ATC 20 Constant Returns to Scale 20 400 20 200 Double Costs Double Inputs 2TC ATC Remains the same TC Q ATC = 2Q Double Output 20 Twice as much output 10

Constant Returns to Scale ATC $2 Horizontal LRATC As the plant size increase ATC remains the same Q

As the plant size increase, per unit costs increase Diseconomies of scale As the plant size increase, per unit costs increase SRATC8 SRATC7 SRATC6 SRATC5 SRATC4 SRATC3 SRATC2 SRATC1 4 3 LRATC slopes upward 2 1 output

Increasing, Constant and Decreasing returns to scale SRATC1 SRATC7 SRATC5 SRATC2 SRATC4 SRATC6 SRATC3 LRATC

Constant Returns to Scale A typical LRATC A typical LRATC: has a “U” shape LRATC ATC ATC decrease Economies of Scale Diseconomies of Scale ATC Increase Constant Returns to Scale ATC same Units of output

LRATC Increasing Returns to scale Constant Returns to scale OUTPUT LRATC 100 90 200 84 300 78 400 72 500 60 600 54 700 48 800 42 900 36 1000 27 1100 21 1200 1300 1400 28 1500 37 1600 43 1700 50 Increasing Returns to scale Constant Returns to scale Decreasing Returns to scale

Constant Returns to Scale The benefits of expanding the plant size eventually end.. Further expansion leaves per unit costs the same Output increases by the SAME percentage as costs.

Increasing Returns To Scale To Labor Hiring more workers to a fixed Plant Marginal Product of Labor increase as workers specialize Short Run ATC (SRATC) decrease Increase both capital and Labor: Larger Plant Larger plant allows the use of mass production technologies and lower input costs Long Run ATC (LRATC) decrease Wage (Same) MC decrease TC increase less MP(increase) than Output

Smallest plant? Smallest plant with lowest LRATC? The smaller the size of the MES, the larger the number of firms Smallest plant? The larger the size of the MES, the more concentrated the industry The smaller the size of the MES, the more competitive the industry SRATC1 SRATC7 SRATC5 SRATC2 SRATC6 SRATC3 MES SRATC4 Smallest plant with lowest LRATC? LRATC 6 firms 150,000 500,000 10,000 300 firms 20 firms Total Market Demand = 3,000,000 /500,000 /150,000 /10,000

SRATC1 SRATC2 SRATC7 SRATC5 SRATC6 SRATC3 SRATC3 SRATC4 SRATC4 9 7 LRATC 5 ATC drops 3 100,000 300,000 500,000 200,000 200,000 400,000 700,000