SAYRE | MORRIS Seventh Edition Costs in the Long Run CHAPTER 7 7-1© 2012 McGraw-Hill Ryerson Limited

Learning Objectives: Costs in the Long Run LO1: Distinguish between the short run and the long run LO2: Understand why medium-sized firms are sometimes just as efficient as big firms LO3: Understand why big firms sometimes enjoy great cost advantages LO4: Understand why firms can sometimes be too big CHAPTER 7 7-2© 2012 McGraw-Hill Ryerson Limited

Learning Objectives: Costs in the Long Run LO5: Understand the effect of technological change on a firm’s cost LO6: Explain what is meant by the right size of firm LO7: Explain why markets can sometimes be too small CHAPTER 7 7-3© 2012 McGraw-Hill Ryerson Limited

The Long Run Long Run the period of time during which all inputs are variable all production processes operate in the short run, and diminishing marginal productivity applies in the long run, all costs are variable and diminishing marginal productivity does not apply a firm can plan as if it is in the long run, but it always operates in the short run 7-4© 2012 McGraw-Hill Ryerson Limited LO1

The Long Run Long Run Average Cost Curve a graphical representation of the per unit costs of production in the long run Constant Returns to Scale the situation in which a firm’s output increases by the same percentage as the increase in its inputs 7-5© 2012 McGraw-Hill Ryerson Limited LO2

Average Costs of Production in Four Plant Sizes 7-6© 2012 McGraw-Hill Ryerson Limited LO2

Self-Test 7-7© 2012 McGraw-Hill Ryerson Limited The accompanying table shows the average costs associated with three different plant sizes: a) Which plant is best suited to produce an output of 4 units? b)What is the value of long-run average cost? LO2 Output Plant 1 Average Cost Plant 2 Average Cost Plant 3 Average Cost 1$45$62$

Self-Test 7-8© 2012 McGraw-Hill Ryerson Limited The accompanying table shows the average costs associated with three different plant sizes: a)Which plant is best suited to produce an output of 4 units? Plant 3 (It is the lowest average cost for that output.) LO2 Output Plant 1 Average Cost Plant 2 Average Cost Plant 3 Average Cost 1$45$62$

Self-Test 7-9© 2012 McGraw-Hill Ryerson Limited The accompanying table shows the average costs associated with three different plant sizes: b)What is the value of long-run average cost? $36 (It is the lowest average cost in all three plants.) LO2 Output Plant 1 Average Cost Plant 2 Average Cost Plant 3 Average Cost 1$45$62$

Economies of Scale cost advantages achieved as a result of large-scale operations firms in industries characterized by assembly-line production of standardized products tend to experience declining long-run average cost these industries are often dominated by a few large firms 7-10© 2012 McGraw-Hill Ryerson Limited LO3

Economies of Scale Reasons for Economies of Scale 1.big plants are able to exploit specialization of labour on a far greater scale than small plants 2.large-scale production encourages management specialization 3.large scale production encourages machine specialization 4.big firms enjoy pecuniary economies of scale 7-11© 2012 McGraw-Hill Ryerson Limited LO3

Economies of Scale Pecuniary Economies of Scale Lower cost of borrowing Buying in bulk Selling in bulk Economies of scale in marketing and advertising 7-12© 2012 McGraw-Hill Ryerson Limited LO3

Economies of Scale 7-13© 2012 McGraw-Hill Ryerson Limited LO3

Self-Test 7-14© 2012 McGraw-Hill Ryerson Limited Indicate the presence of either constant returns to scale or increasing returns to scale in each set of data. LO3 Total CostOutput Set 1$ Set

Self-Test 7-15© 2012 McGraw-Hill Ryerson Limited Indicate the presence of either constant returns to scale or increasing returns to scale in each set of data. LO3 Total CostOutput Set 1$ Set Set 1: increasing returns to scale. (Average cost drops from $ to $160.) Set 2: constant returns to scale. (The average cost remains the same at $4500.)

Diseconomies of Scale bureaucratic inefficiencies in management that result in decreasing returns to scale Decreasing Returns to Scale the situation in which a firm’s output increases by a smaller percentage than its inputs 7-16© 2012 McGraw-Hill Ryerson Limited LO3

LRAC Curve under Diseconomies of Scale 7-17© 2012 McGraw-Hill Ryerson Limited LO2

Self-Test 7-18© 2012 McGraw-Hill Ryerson Limited Decide in each of the following cases (A–D) whether constant returns, economies, or diseconomies of scale exist. LO3 Inputs 1Inputs 2Output 1Output 2 A B C D

Self-Test 7-19© 2012 McGraw-Hill Ryerson Limited Decide in each of the following cases (A–D) whether constant returns, economies, or diseconomies of scale exist. LO3 A: constant returns to scale (Inputs  100%, output  100%.) B: economies of scale (Inputs  100%, output  136%.) Inputs 1Inputs 2Output 1Output 2 A B C D

Self-Test 7-20© 2012 McGraw-Hill Ryerson Limited Decide in each of the following cases (A–D) whether constant returns, economies, or diseconomies of scale exist. LO3 C: economies of scale (Inputs  50%, output  60%.) D: diseconomies of scale (Inputs  108%, output  100%.) Inputs 1Inputs 2Output 1Output 2 A B C D

Changes in Short Run and Long Run Costs Technological Improvement changes in production techniques that reduce the costs of production causes a decrease in short-run costs since long-run average cost curve is derived from short-run cost curves, the long-run average costs also decrease 7-21© 2012 McGraw-Hill Ryerson Limited LO5

The Right Size of Firm 7-22© 2012 McGraw-Hill Ryerson Limited LO6

The Right Size of Firm 7-23© 2012 McGraw-Hill Ryerson Limited LO6

Can a Market Be Too Small Minimum Efficient Scale (MES) the smallest sized plant capable of achieving the lowest long-run average cost of production 7-24© 2012 McGraw-Hill Ryerson Limited LO7

Can a Market Be Too Small 7-25© 2012 McGraw-Hill Ryerson Limited LO7

© 2012 McGraw-Hill Ryerson Limited7-26 Firms always operate in the short run Firms can plan as if they are in the long run where all inputs are variable and diminishing marginal productivity does not apply Constant returns to scale exist when an increase in inputs result in a proportional increase in output Economies of scale involves either technical or pecuniary economies Chapter 7 Summary

© 2012 McGraw-Hill Ryerson Limited7-27 Diseconomies of scale can occur due to inefficiencies costs can decrease due to a decrease in factor prices, technological improvement, or mergers reduce average fixed costs A firm is the right size if it captures economies of scale but does not suffer diseconomies A market is too small if it limits output to below economic capacity (SR) or below minimum efficient scale (LR) Chapter 7 Summary