Today w Shifts in MC, ATC, and AVC curves. w Production and cost in the long run.

Shifting the Short Run Cost Curves of the Firm w They shift when: The price of an input changes. There is a change in the level of the fixed inputs (a change in plant size). There is a change in the state of technology (meaning know-how).

Example: Wages rise Q $/Q MC ATC ATC’ MC’ Variable costs rise at all levels of output. MC shifts up. ATC shifts up. AVC (not shown) shifts up.

Improvements in Technology Q $/Q MC ATC ATC’ MC’ Improvements in technology lead to lower costs. (Could save only fixed costs, but usually MC will fall.)

Different Plant Sizes w Changing the short-run situation of the firm is best studied in the context of production and costs in the long-run.

Production and Cost in the Long Run

Long Run w The firm’s planning horizon in which it can choose any combination of inputs. It is not locked into past decisions in its plans for the long run. w Firms can “lock-in” to any short-run situation in the long run.

Choice of Inputs w Goods can be produced using many different combinations of inputs. Examples: cleaning, building a house w How does a firm decide which to use? Look at range of available production techniques for a given level of output. Calculate which costs least, given particular input prices.

Plant size w Small plants achieve their lowest average total cost at a low level of output. w Large plants achieve their lowest average total cost at a high level of output. w In the SR, a firm is stuck with its current plant size. w In the LR, a firm may choose any plant size (then it will be stuck at that one for future SR scenarios).

Average Costs for Various Plant Sizes q $/Q SRAC 0 SRAC 1 SRAC 2 SRAC 3 SRAC 4 In the SR, this firm is using plant size 1. In the LR it could choose any of these plant sizes.

ATC in the SR and the LR q $/Q SRAC 0 SRAC 1 SRAC 2 SRAC 3 SRAC 4 In the SR, what is its AC of producing q A ? q B ? In the LR, what is its AC of producing q A ? q B ? qAqA qBqB a b c d e f

Long Run Average Cost w For any level of output, in the long run the firm will choose the plant size that gives the lowest possible average cost. w At every q, LRAC  SRAC. (why?) w The LRAC curve is thus the lower envelope of the SRAC curves.

Long Run ATC q $/Q SRAC 0 SRAC 1 SRAC 2 SRAC 3 SRAC 4 LRAC

With an Infinite Variety of Plant Sizes q $/Q LRAC

Economies of Scale How do you make cars differently if you plan to produce 100 cars per year compared to 500,000?

Very Small Auto Plants w Assembly line too costly, uses too much K. w Use proportionately more labor w Keep fixed costs low

Large Auto Plant w Assembly line, lots of machines and automation. w High fixed costs, but spread over lots of units. w The large plant can get the lowest average cost if it produces enough units.

Economies of Scale, Continued w There are Economies of Scale when the LRAC of making a good falls as output grows. w If you double output, total cost increases by less than double, average cost falls. w OR—If you double all inputs, you get more than double the output. w Also called Increasing Returns to Scale. w Downward-sloping portion of LRAC curve.

Examples of EOS w Almost all products have EOS at low levels of output. Which ones have EOS even at large levels of output? Auto manufacturing Coal mining Electricity generation & distribution Retailing? (Wal-Mart) w If small firms cannot compete against big ones, probably economies of scale are at work.

Constant Returns to Scale w You can produce, say, 20% more and your costs go up 20%. w LRAC stays the same w Sometimes called constant costs. w Horizontal LRAC w You should see firms of different sizes in the market.

Diseconomies of scale w Expanding output by 20% will increase costs by, say, 25%. w LRAC is rising. w Also called Decreasing Returns to Scale or increasing costs. w Intuition: The firm is so large it is inefficient. w Firms this big will go out of business or scale down.

The Saucer-Shaped LRAC curve q $/q q0q0 q1q1 Between 0 and q 0 : Economies of Scale Between q 0 & q 1 : Constant returns to scale Between q 1 and  : Diseconomies of Scale LRAC

Be Sure to Know the Difference Between: w Decreasing Returns to Scale: increasing all inputs by an equal % results in increasing average costs, and w Diminishing Marginal Returns: holding one or more important factors constant, increasing the other factors by equal increments will eventually result in decreasing MP (increasing MC).

Shifting LRAC w LRAC will shift any time there is a change in input prices a change in technology (know-how) w Does the LRAC curve shift when plant size changes?

Example: Wages fall q $/q Why would we expect the downward shift will not be parallel? LRAC LRAC’

Coming Up w Begin study of profit maximization in the context of perfect competition.

Group Work w Apply economies of scale to movie theaters.

More Screens w The average number of movie screens per cinema has increased over the last several years. This seems to suggest there are increasing returns to scale: that increasing the number of screens at each location leads to a lower average cost.

Increasing Returns to Scale at the Cinema w List several reasons why a firm’s average costs would fall as the number of screens at the same location rises. w Hint: Comparing a cinema with 1 screen to one with 2 screens, are all costs doubled?

Decreasing Returns to Scale at the Cinema? w Even though the average number of screens per cinema has been rising, cinemas rarely have 20 or 30 screens each, even in highly populated, urban areas. This seems to be evidence that the LRAC for a cinema eventually turns upward. w List some reasons why a cinema would have difficulty it were to grow that large.