ECON 211 ELEMENTS OF ECONOMICS I Session 6– Production and Costs (Part 2) Lecturer: Dr. (Mrs.) Nkechi S. Owoo, Department of Economics Contact Information: nowoo@ug.edu.gh

Session Overview This session discusses a variety of other cost concepts useful for the analysis that follows, including totals (total cost, total variable cost, total fixed cost), averages (average total cost, average variable cost, average fixed cost), marginal cost, among others. We long run cost concepts in this session.

Session Outline The key topics to be covered in the session are as follows: Production and Costs in the Long-Run The relationship between Long-run and Short-run costs Explaining the Shape of the LRATC curve Economies of Scale Diseconomies of Scale

Reading List Hall and Lieberman Chapter 5 : pp: 174- 182

Production and costs in the LONG run Topic One Production and costs in the LONG run

Production And Cost in the Long Run In the long run, firms behave differently because firms can adjust all their inputs in the way that they want In the long run, all inputs and all costs are variable In order to choose its production level therefore, a firm must follow the least-cost rule, in order to maximize profits Least Cost Rule To produce any given level of output, the firm will choose the input mix with the lowest cost Illustration

Production and Costs in the Long Run Let us apply the least-cost rule to Spotless Car Wash Suppose we want to know the cost of washing 196 cars per day In the short run, the firm does not have to worry about how to produce this as it is stuck with only one automated line and the only way to wash 196 cars is to hire 6 workers (see slides from last session) Total costs in the short run would be (6 x Ghc120) + Ghc150 = Ghc870 In the long run, however, the firm can vary its number of automated lines, as well as the number of workers The four different options for washing 196 cars are presented in the table below Method Quantity of Capital Quantity of Labour Cost (Ghc) A 9 1080 B 1 6 870 C 2 4 780 D 3 810

Production and Costs in the Long Run Combination A uses the least capital and the most labour No automated lines and workers wash the cars by hand Combination D uses the most capital and the least number of workers Spotless chooses the combination with the least cost, which is combination C

Production And Cost in the Long Run The Long-run total cost (LRTC) indicates the cost of producing each quantity of output when the least-cost input mix is chosen in the long run Long-run average total cost (LRATC) The cost per unit of output in the long run all inputs are variable LRTC ≤ TC LRATC ≤ ATC

The relationship between long run costs and short run costs Topic One The relationship between long run costs and short run costs

Graphing the LRATC Explaining the LRATC In the figure on the next slide, each ATC curve represents potential production outcomes of Spotless Car Wash For example, ATCo represents the short run cost curve of the firm if it used no automated lines In the long run, the firm is able to examine all these costs and potential production levels and decide what quantity to produce In the figure, if a firm decides to wash 130 cars a day, the lowest cost is achieved along ATC1, with 1 automated line. If the firm decides to wash 184 cars, the lowest costs are attained along ATC2 with 2 automated lines Therefore, we can trace out the firm’s LRATC curve by combining the lowest portions of all the ATC curves from which the firm can choose For each output level, the firm always chooses to operate on the ATC with the lowest possible cost

Graphing the LRATC Curve Figure Long-Run Average Total Cost 196 184 Dollars 1.00 2.00 3.00 $4.00 Units of Output 30 90 130 160 250 300 ATC1 LRATC ATC3 ATC0 ATC2 C D B A E 175 Use 0 automated lines Use 1 automated lines Use 2 automated lines Use 3 automated lines

Explaining the shape of the lratc curve Topic One Explaining the shape of the lratc curve

The Shape of LRATC The LRATC curve is U-Shaped As output increases, LRATC first decrease, then remain constant, and finally rise In the portion of the LRATC where costs are falling, the firm is said to be experiencing economies of scale In the portion of the LRATC where costs are constant, the firm is said to be experiencing constant returns to scale In the portion of the LRATC where costs are rising, the firm is said to be experiencing diseconomies of scale

The Shape of LRATC Economies of scale Here, the LRATC decreases as output increases i.e. The more output is produced, the lower the cost per unit Why should a firm experience economies of scale? Gains from specialization At low levels of output, few workers hired and these workers may have to perform a greater variety of tasks, slowing them down and making them less productive As output increases, more workers are hired and more options exist for specialization Spreading Costs of Lumpy inputs These are inputs that cannot be increased in tiny increments, but rather must be increased in large jumps. E.g. a hospital centre needs an x-ray machine, and the average costs would be lower if more patients use the machine

The Shape of LRATC Constant returns to scale - LRATC is unchanged as output increases LRATC curve is flat

The Shape of LRATC Diseconomies of scale LRATC increases as output increases As the firm expands, its bigness begins to cause problems E.g. large firms may require more layers of management, so that communication and decision-making becomes time consuming and costly Large firms also have a harder time screening out misfits among new hires and monitoring those already employed This can lead to increases in mistakes, shirking of responsibilities, theft from the firm, etc which may all raise average costs of production in the long run

The Shape of LRATC U-shape of LRATC curve Economies of scale at relatively low levels of output Constant returns to scale at some intermediate levels of output Diseconomies of scale at relatively high levels of output

Constant Returns to Scale The Shape Of LRATC Figure 6 The Shape Of LRATC Dollars 1.00 2.00 3.00 $4.00 130 184 LRATC Economies of Scale Constant Returns to Scale Diseconomies of Scale Units of Output

References Economics: Principles and Applications: Hall R.E. and Lieberman M. (2008), Thomson/ South Western (4th Edition)