1 Short Run and Long Run Costs Edit 7: Ch. 5 Pages Edit 6: Ch. 5 Pages

Production Processes X-Box Production UQM Technologies Scorpion Factory KTM Factory Factory Management 2

3 What would you need to start a Panera?

4 Short Run versus Long Run? short run - a period of time where some inputs are fixed (capital = building, equipment, etc.) long run - a period of time in which all inputs can be varied (no inputs are fixed)

5 Short Run Cost Function Definition: A function that defines the minimum possible cost of producing each output level when variable factors are employed in the cost-minimizing fashion. (Based on the inability to change the fixed factors)

6 In this case, what is your total product/output (Q)? Number of Paninis (for simplicity assume that Panera only produces a single product). In general a firm uses capital, labor and materials to produce the product/output where capital is often fixed in the short run.

7 In Short Run, how does the number of Paninis produced change as you change the number of workers? # of workers # of paninis

8 How does output change if you hire one more person? Depends on how many workers you currently have. Output increases by 5 paninis when you hire the 1 st worker, increases by 7 paninis when you hire the 2 nd worker, …., and increases 3 paninis when you hire the 5 th worker.

9 What happens to “productivity” as the first few employees are hired? Specialize and marginal product increases. Marginal Product is the change in total output attributable to the last unit of an input.

10 What would happen to “productivity” if you continued to hire more and more workers? Marginal product would start to fall because some inputs are fixed in the short run. Law of diminishing marginal returns OR Law of diminishing marginal product.

11 What costs would you have to pay even if you didn’t produce a single panini? Fixed Costs, FC (or Total Fixed Costs, TFC) (often involves building and equipment) Fixed Costs = Costs that do not change with changes in output

12 What costs would you have to pay only if you produced paninis? Variable Costs, VC (or Total Variable Costs, TVC) (often assumed to be labor and material) Variable Costs = Costs that change with changes in output

13 What costs would increase if we wanted to produce one more panini? Variable Costs (such as labor and materials)

14 If you hired more and more employees and the store became more and more crowded until the marginal product of a worker started to fall, what would happen to the cost of producing one more panini (marginal cost)? Marginal cost = cost of producing an additional unit of output

15 Costs QFCVCTCAFCAVCATCMC ( )/1= Fixed costs do not vary with output Variable costs increase by 50 from 0 to 1 unit of output and increases by 30 from 1 to 2 units. Average Fixed Costs (AFC) = Fixed Costs/Q so at an output of 2, AFC=100/2=50. Average Variable Costs (AVC) = Variable Costs/Q so at an output of 2, AVC=80/2=40. Average Total Costs (ATC) = Total Costs/Q so at an output of 2, ATC=180/2=90 or AFC+ATC.

16 Costs QFCVCTCAFCAVCATCMC

17 What is happening to TC as Q increases? TC= ATC*Q Increases!

18 What are total fixed costs in this example?AFC*Q 100*1=100

19 Why are AFC diminishing? Spreading a fixed number out over a larger and larger Q

20 Why is AVC getting closer to ATC? Because ATC = AVC+AFC and AFC is getting close to 0

21 Where does the law of diminishing marginal product set in and how do you know? Where MC starts increasing! Why does this happen? An input is fixed in the short run!

22 Where does MC cross ATC? Where does MC cross AVC? At their minimums What is the relationship between MC and ATC? MC and AVC? If MC<ATC, ATC is decreasing If MC>ATC, ATC is increasing Same for AVC

23 How do you know this is the short run? There are fixed costs

24 Fixed Cost versus Sunk Cost Fixed Cost = costs that do not change with changes in output Sunk Cost= a cost that is forever lost after it has been paid Does profit maximizing output depend on whether cost if fixed or sunk given that you produce paninis? Does the decision whether to produce any paninis depend on whether cost is fixed or sunk? No Yes

25 Short Run versus Long Run? short run - a period of time where some inputs are fixed (capital = building, equipment, etc.) long run - a period of time in which all inputs can be varied (no inputs are fixed)

26 Returns to Scale in Long Run Production Is the increase in output proportional to the increase in “inputs”? What is the marginal product of changing ALL inputs?

27 Economies to Scale Exist when long-run average costs decline as output is increased. Example in other words: to double output, you don’t have to double costs Example in other words: if you double costs, you more than double the output

28 Why does there exist Economies of Scale? Specialization in production - get more productive if specialize Can spread some costs over everything (ex: advertising, R&D, capital investments) Can command quantity discounts from suppliers

29 Diseconomies of Scale Exist when long-run average costs rise as output is increased. Example in other words: to double output, you have to more than double costs Example in other words: if you double costs, you cannot double the output

30 Why Diseconomies of Scale? 1. Monitoring 2. Morale

31 Constant Returns to Scale Exist when long-run average costs remain constant as output is increased. Example in other words: to double output, you have to double costs

32 Specific Example: Each of the following represent SATC curves at 3 different factory sizes that are fixed in the short run: Short Run -At least one input is fixed. Typically assume capital is fixed and labor/material is variable. Why do the ATC curves have the U-shape? Law of diminishing marginal returns to variable input Long Run - Nothing is fixed. Each of the following represents a short run SATC curve at different levels of capital (building, equipment)

33 Specific Example: Each of the following represent SATC curves at 3 different factory sizes that are fixed in the short run: Suppose we initially have a small factory and we’re producing one unit of output. If we want to increase output in the short run, how do we have to do it? add more variable inputs In the long run, is that the only option? No, build a bigger factory

34 Specific Example: 3 possible factory sizes The least expensive way to produce Q = 1 is with a ___________ factory. The least expensive way to produce Q = 2 is with a ___________ factory. The least expensive way to produce Q = 3 is with a ___________ factory. The least expensive way to produce Q = 4 is with a ___________ factory. The least expensive way to produce Q = 5 is with a ___________ factory. The least expensive way to produce Q = 6 is with a ___________ factory. small medium large

35 In the long run, you can choose any size factory you want...what is the LATC curve? LATC = Minimum of the SATCs! LATC ≤ SATC

36 Where do Economies of Scale exist? LATC Economies of Scale

37 Where do Diseconomies of Scale exist? LATC Diseconomies of Scale

General Example – many possible levels of fixed inputs If these are many SATC, what does the LATC look like? LATC - minimum of SATC Why does the LATC curve have the U-shape? Economies of Scale Constant Returns to Scale Diseconomies of Scale Minimum Efficient Scale – smallest output where average costs are minimized