Lecture notes Prepared by Anton Ljutic

© 2004 McGraw–Hill Ryerson Limited Costs in the Long Run CHAPTER SEVEN

© 2004 McGraw–Hill Ryerson Limited This Chapter Will Enable You to: Distinguish between the short run and the long run Understand what happens to a firm’s output when it increases its inputs Understand why big firms can enjoy great advantages yet small firms can also be successful Understand why firms can sometimes be too big Explain what is meant by the right size of firm Explain why markets can sometimes be too small

© 2004 McGraw–Hill Ryerson Limited Short Run Versus the Long Run (I) Short run –A period of time in which at least one factor of production is fixed –All production processes operate in the short run –Diminishing marginal productivity is an unavoidable reality

© 2004 McGraw–Hill Ryerson Limited Long run –The period of time during which all inputs are variable –Diminishing marginal productivity does not apply –A firm can plan in the long run Long-run average cost curve –A graphical representation of the per unit costs of production in the long run Short Run Versus the Long Run (II)

© 2004 McGraw–Hill Ryerson Limited Constant Returns to Scale The situation in which a firm’s output increases by the same percentage as the increase in its inputs This term is used only in the long run These conditions result in a horizontal long- run average cost curve

© 2004 McGraw–Hill Ryerson Limited Economies of Scale The situation in which a firm’s output increases by a greater percentage than do its inputs These conditions result in a decreasing long-run average cost curve Firms in industries characterized by assembly-line production usually experience increasing returns to scale

© 2004 McGraw–Hill Ryerson Limited Economies of Scale Cost advantages achieved as a result of large-scale operations (division of labour and specialization) –Technical Economies Of Scale, also referred to as increasing returns to scale –Pecuniary economies of scale Cost of borrowing is cheaper High-volume firms may buy inputs in bulk Previously wasted products can be sold Advantages in marketing and advertising

© 2004 McGraw–Hill Ryerson Limited LRAC Under Economies of Scale LRAC Plant 1 Plant 2 Plant 3 Costs Output/dayQ1Q1 Q2Q2 Q3Q3 AC 1 AC 2 AC 3 Figure 7.2

© 2004 McGraw–Hill Ryerson Limited Diseconomies of Scale –The situation in which a firm’s output increases by a smaller percentage than its inputs –These conditions result in a rising long-run average cost curve –What causes decreasing returns to scale? –Diseconomies of scale Bureaucratic inefficiencies in management that result in decreasing returns to scale

© 2004 McGraw–Hill Ryerson Limited Changes in Short and Long-Run Costs A decrease in input prices –would shift both the short-run and long-run average cost curves downward Technological improvement –Changes in production techniques that reduce the costs of production –This would also shift both the short-run and long-run average cost curves downward

© 2004 McGraw–Hill Ryerson Limited Economies of scale for output levels up to Q1. Constant returns to scale between Q1 and Q2 Diseconomies of scale for output levels above Q2 Economies of scale for output levels up to Q1. Constant returns to scale between Q1 and Q2 Diseconomies of scale for output levels above Q2 Q2Q2 The Complete Long Run Average Cost Curve Costs Q1Q1 Output LRAC Figure 7.4

© 2004 McGraw–Hill Ryerson Limited Is bigger better? –It depends on the industry in question –Appropriately sized firms are able to take advantage of any economies of scale that exist without becoming too big and experiencing diseconomies of scale What is the Right Size of the Firm (I)?

© 2004 McGraw–Hill Ryerson Limited Three Possible LRAC Curves AC B Costs QQ LRAC. Q A: the firm would have to be very large. B: a variety of firm sizes would be appropriate. C: only small firms would be appropriate Figure 7.5

© 2004 McGraw–Hill Ryerson Limited What is The Right Size of the Firm (II)? Can a market be too small? –Minimum efficient scale (MES) The smallest size plant capable of achieving the lowest long-run average cost of production The Canadian economy has historically had difficulty achieving minimum efficient scale

© 2004 McGraw–Hill Ryerson Limited Minimum Efficient Scale (MES) Costs If a small market limits the firm’s output to Q 1, then Plant 1 is not able to achieve MES. A large market that allowed an output of Q 2, and thus Plant 2, would enable the firm to achieve its MES. If a small market limits the firm’s output to Q 1, then Plant 1 is not able to achieve MES. A large market that allowed an output of Q 2, and thus Plant 2, would enable the firm to achieve its MES. Figure 7.6 AC 1 AC 2 Plant 1 Plant 2 LRAC Q1Q1 Q2Q2 AC 1 AC 2

© 2004 McGraw–Hill Ryerson Limited Does new technology alter the scale of the firm that uses it? As production becomes more customized and computers become more sophisticated, will efficient production mean smaller firms? Are huge corporations finding it cheaper to farm out work to lower-cost specialists? There is no definitive answer to these questions Are the Advantages of Scale Changing ?

© 2004 McGraw–Hill Ryerson Limited Chapter Summary: What to Study and Remember Distinguish between the short run and the long run Understand what happens to a firm’s output when it increases its inputs Understand why big firms can enjoy great advantages yet small firms can also be successful Understand why firms can sometimes be too big Explain what is meant by the right size of firm Explain why markets can sometimes be too small