Long Run Costs Module KRUGMAN'S MICROECONOMICS for AP* 20 56 Micro: Margaret Ray and David Anderson

What you will learn in this Module: Why do firm’s costs differ in the short run versus the long run? What are economies of scale? Can you explain and give an example of sunk costs? The purpose of this module is to introduce long-run costs and differentiate costs in the long run from those in the short run. Because the firm is free to expand or contract in the long run, short-run fixed costs can be changed in the long run. This long-run flexibility allows us to draw a long-run average cost curve and examine the possibility of economies and diseconomies of scale. The important concept of sunk costs is also introduced.

Returns to Scale The long-run average cost curve for a firm is “U- shaped” like the short-run average cost curves – but for a different reason. 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.

Returns to Scale 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.

Short-run versus Long-run Costs Long-run average total cost curve (LRATC) is the relationship between output and ATC when fixed cost has been chosen to minimize average total cost for each possible level of output. A firm adjusts its fixed cost and the ATC curve shifts because of new inputs. It is important to reiterate the key difference between the short run and the long run. In the long run, all inputs can be changed. The plant size can be adjusted upward (expansion) or downward (contraction) in the long run. There are many possible short-run ATC curves, each corresponding to a different choice of fixed cost, giving rise to what is called a firm’s “family” of short-run ATC curves.   Here is why;    -At any given time, a firm will find itself on one of its short-run cost curves, the one corresponding to its current level of fixed cost; a change in output will cause it to move along that curve. -If the firm expects that change in output level to be long-standing, then it is likely that the firm’s current level of fixed cost is no longer optimal. -Given sufficient time, it will want to adjust its fixed cost to a new level that minimizes average total cost for its new output level. Specifically, the long-run average total cost curve (LRATC) is the relationship between output and ATC when fixed cost has been chosen to minimize average total cost for each level of output. A firm adjusts its fixed cost to a new level that minimizes average total cost for its new output level.

Economies of Scale: 1 input = > 1 output Economies of Scale: the LRATC is falling as the firm expands. Examples: Specialization High set-up costs [large costs at first] bulk inputs [labor, capital] better bargaining power [labor, inputs, capital, loans, politics] With economies of scale, the firm is benefiting from expansion due to increasing returns to scale. This simply means that output is increasing at a faster rate than production costs. You might imagine the firm increases total costs by 50% but this allows the firm to increase output by 100%.   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. When the firm expands output, this become inefficient because workers need to make copies, but this requires other workers to wait to send a fax, which is inefficient. The firm buys a new fax machine that allows both the workers and the machine to be more specialized. High set-up costs. A large piece of capital is expensive when it is initially purchased, but if the firm can produce 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. With diseconomies of scale, 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. You might imagine a firm that increases total costs by 100% but this allows the firm to increase output by only 50%. 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.

Diseconomies of Scale 1 input = < 1 output Diseconomies of Scale: the LRATC is rising as the firm expands. Examples: Poor communication poor cooperation Corruption, moochers With economies of scale, the firm is benefiting from expansion due to increasing returns to scale. This simply means that output is increasing at a faster rate than production costs. You might imagine the firm increases total costs by 50% but this allows the firm to increase output by 100%.   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. When the firm expands output, this become inefficient because workers need to make copies, but this requires other workers to wait to send a fax, which is inefficient. The firm buys a new fax machine that allows both the workers and the machine to be more specialized. High set-up costs. A large piece of capital is expensive when it is initially purchased, but if the firm can produce 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. With diseconomies of scale, 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. You might imagine a firm that increases total costs by 100% but this allows the firm to increase output by only 50%. 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.

Practice The Microsoft Company produces Windows with a production process that exhibits constant returns to scale in the long run. Microsoft is producing 200 copies and LRATC is $20. What is the new LRATC if Microsoft were to double the number of copies? a. $50     b. $40      c. $30      d. $20    e. $10 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. Sunk costs don’t factor into decision-making because they can not be recovered and therefore don’t affect marginal values.

Practice Now, suppose the production shows economies of scale, what is the new LRATC? a. $50     b. $40      c. $30      d. $20    e. $10 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. Sunk costs don’t factor into decision-making because they can not be recovered and therefore don’t affect marginal values.

Practice Economies of scale exist when the: a. total average cost falls b. total average cost rises c. total fixed cost falls d. marginal cost rises e. marginal cost decreases 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. Sunk costs don’t factor into decision-making because they can not be recovered and therefore don’t affect marginal values.

Sunk Costs A sunk cost is a cost that has been incurred in the past and cannot be recovered. Sunk costs don’t matter in rational decision-making! Small group: 1) Use your computers to research some sunk costs 2) Come up with some examples from your life 3) Prepare to share 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. Sunk costs don’t factor into decision-making because they can not be recovered and therefore don’t affect marginal values.