©2001ClaudiaGarcia-Szekely1 Costs in the Long Run When the firm can expand or contract the plant size

2 In the Long Run all inputs are variable There are no fixed costs in the long run. Firms PRODUCE in the short run Restricted by the size of the plant. Firms PLAN in the long run Any plant size is available. When firms are planning

ATC Plant 1 With this plant, we can produce any amount from zero units to 5,000. 5,000 The minimum ATC occurs at 2500 units 2, $2 12,000 5,000 $1 ATC Plant 2 With this plant, we can produce any amount from zero units to 12,000. The minimum ATC occurs at 5,000 units ATC Plant 3 With this plant, we can produce any amount from zero units to 15, ,000 The minimum ATC occurs at 10,000 units 10,000 $0.5

In the long run firms choose a plant size… We identify the plant size with the Average Total Cost Curve. There is no single “best” plant size… Which plant is “best” depends on the volume of production.

5 Building the Long Run Average Total Cost Curve (LRATC) Match the lowest SRATC with each output level The LRATC shows the minimum ATC for each output level.

SRATC1 To produce 100 units, ATC =$ To produce 100 units, ATC =$6 SRATC2 SRATC3 To produce 100 units, ATC =$7 4 Plant1 has the lowest cost to produce 100 units: LRATC = $ Plant 1 has the lowest ATC from Zero to Q 0 Q0Q0 Plant1 has the lowest cost to produce 200 units: LRATC = $2

SRATC1 To produce 300 units, the per unit cost using plant 1 is $ To produce 300 units, the per unit cost using plant 2 is $2 SRATC2 SRATC3 To produce 300 units, the per unit cost using plant 3 is $ Plant 2 has the lowest from Q 0 to Q 1 Q1Q1 SRATC2 has the lowest cost of producing Q0Q0

SRATC2 SRATC3 Q1Q1 Q0Q0 SRATC2 has the lowest cost between Q 0 and Q 1 LRATC SRATC1 SRATC3 has the lowest cost above Q 1 SRATC1 has the lowest cost between 0 and Q 0 Long Run ATC 0

LRATC The LRATC is an envelope of SRATC curves 3 different plant sizes Each point of the LRATC tells you the lowest cost of producing a given output level when you can change the size of the plant

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

Building the LRATC Plant 1 has lowest cost for volumes up to 400. Plant 2 has lowest cost between 400 and 900. Plant 3 has lowest cost above 900. LRATC Output

Building the LRATC OUTPUTPLANT 1PLANT 2PLANT 3 OUTPUTLRATC

13 Increasing Returns to Scale Economies of Scale ATC drops as Plant Size increase

Per unit costs decrease because Fixed costs are spread out over more units of output. Variable costs decrease with the use of mass production technologies which increase labor productivity. 14

15 ATC = TC Q Q Double Inputs Four times as much output Four times as much output ATC decreases ATC decreases 2TC 4Q Double Costs 4 times Output Economies of Scale: add more to the “bottom line” Q increase by 10% Costs increase by less than 10% Q increase by 20% Costs increase by less than 20% Economies of Scale ATC

SRATC1 SRATC2 SRATC4 SRATC7 SRATC8 SRATC3 output LRATC SRATC5 SRATC6 Economies of scale or Increasing Returns to Scale $8 $7 $6 $5 $4 $3 $2 $1 Output increases by a larger percentage than costs Output increases by a larger percentage than costs ATC Drops

17 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.

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

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

20

ATC = TC Q Q Twice as much output Twice as much output ATC increases 3TC 2Q Triple Costs Diseconomies of to Scale ATC Triple Inputs Double Output

SRATC1 SRATC2 SRATC4 SRATC3 SRATC7 SRATC8 SRATC6 output LRATC SRATC5 As the plant size increase, per unit costs increase Diseconomies of scale

A typical LRATC Units of output LRATC ATC Constant Returns to Scale Diseconomies of Scale ATC decrease ATC same ATC Increase Economies of Scale

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

LRATC 25 OUTPUTLRATC Increasing Returns to scale Constant Returns to scale Decreasing Returns to scale

SMALLEST PLANT WITH LOWEST ATC IN THE LONG RUN Only firms with plants with the lowest cost will survive in the long run. 26 MINIMUM EFFICIENT SCALE (MES)

500,000 SRATC1 SRATC2 SRATC3 SRATC4 SRATC5 SRATC6 SRATC7 LRATC Total Market Demand = 3,000, ,000 # of Firms = 3,000,000/500,000 = 6 firms each selling 500,000 # of Firms = 3,000,000/150,000 = 20 firms each one sells 150,000 10,000 # of Firms = 3,000,000/10,000 = 300 firms each sells 10,000 The smaller the size of the MES, the more competitive the industry is. The larger the size of the MES, the more concentrated the industry is. The smaller the size of the MES, the larger the number of firms MES