Module 15 1 Costs in the Long Run

ObjectivesObjectives  Define long run average cost. 2

ObjectivesObjectives  Understand how to construct the long run average cost curve. 3

ObjectivesObjectives  Define long run average cost.  Understand how to construct the long run average cost curve.  Define the concept of returns to scale, and understand how it affects the shape of the long run average cost curve. 4

ObjectivesObjectives  Define long run average cost.  Understand how to construct the long run average cost curve.  Define the concept of returns to scale, and understand how it affects the shape of the long run average cost curve.  Define minimum efficient scale (MES) and be able to identify the MES on a graph. 5

Objective 1: Define long run average cost curve  The long run is defined as the time period during which all factors of production are variable. 6

Objective 1: Define long run average cost curve  The long run is defined as the time period during which all factors of production are variable. relevant cost in the long run  The relevant cost in the long run is the total cost of production or average total cost (ATC) if we are interested in cost per unit. 7

Objective 1: Define long run average cost curve  The long run is defined as the time period during which all factors of production are variable. relevant cost in the long run  The relevant cost in the long run is the total cost of production or average total cost (ATC) if we are interested in cost per unit.  ATC or simply average cost (AC) is calculated by: Total Cost ÷ Quantity 8

Objective 1: Define long run average cost curve  The long run is defined as the time period during which all factors of production are variable. relevant cost in the long run  The relevant cost in the long run is the total cost of production or average total cost (ATC) if we are interested in cost per unit.  ATC or simply average cost (AC) is calculated by: Total Cost ÷ Quantity long run average cost  The long run average cost curve shows the lowest average cost at which a firm is able to produce a given quantity of output in the long run when all inputs are variable. 9

 In the long run, a firm has much greater flexibility to meet its production needs. It can adjust all its inputs. 10 Understand how to construct a long run average cost curve Understand how to construct a long run average cost curve Objective 2

 In the long run, a firm has much greater flexibility to meet its production needs. It can adjust all its inputs.  Here, we will focus on variations in plant size. 11 Understand how to construct a long run average cost curve Understand how to construct a long run average cost curve Objective 2

 In the long run, a firm has much greater flexibility to meet its production needs. It can adjust all its inputs.  Here, we will focus on variations in plant size.  For example, suppose the Acme Box Company faces three different choices of plant size in the long run: (1) a small plant, (2) a medium-sized plant, and (3) a large plant. 12 Understand how to construct a long run average cost curve Understand how to construct a long run average cost curve Objective 2

13  SRATC 1 small  SRATC 1 represents the short run average total cost curve associated with a small plant. Objective 2: … constructing a long run average cost curve

14  SRATC 1 small  SRATC 1 represents the short run average total cost curve associated with a small plant.  Once Acme builds a plant, it is locked into that specific plant size which is why the average total cost curves are labeled short run average total cost. Objective 2: … constructing a long run average cost curve

15  SRATC 2  SRATC 2 represents the short run average total cost curve associated with a medium-sized plant. Objective 2: … constructing a long run average cost curve

16  SRATC 3  SRATC 3 is the short run average total cost curve associated with a large plant. Objective 2: … constructing a long run average cost curve

 Which of the three plant sizes will Acme select? 17 Objective 2: … constructing a long run average cost curve

 Which of the three plant sizes will Acme select?  Well, that depends on the anticipated normal sustained rate of output per period. 18 Objective 2: … constructing a long run average cost curve

 Which of the three plant sizes will Acme select?  Well, that depends on the anticipated normal sustained rate of output per period. Q 1 small  If the expected rate of output per period is Q 1 then it will select the small plant to achieve the lowest average cost. 19 Objective 2: … constructing a long run average cost curve

Q 2 medium-sized  If the expected rate of output per period is Q 2 then it will select the medium-sized plant. 20 Objective 2: … constructing a long run average cost curve Objective 2: … constructing a long run average cost curve

21 Objective 2: … constructing a long run average cost curve Objective 2: … constructing a long run average cost curve Q 3 large  If the expected rate of output per period is Q 3 then it will select the large plant.

long run average cost curve  The long run average cost curve is derived by tracing the points that represent the lowest per- unit cost for each level of output. 22 Objective 2: … constructing a long run average cost curve

long run average cost curve  The long run average cost curve is derived by tracing the points that represent the lowest per- unit cost for each level of output.  In the diagram below, the LRAC curve is the red scalloped curve. 23 Objective 2: … constructing a long run average cost curve

smooth  Now, if there is an innumerable number of plant sizes, and if it is possible for the firm to build any plant size that generates the lowest short run average total cost for any output level, then we will arrive at a smooth LRAC curve like the red curve below. 24 Objective 2: … constructing a long run average cost curve

long run average cost curve  The long run average cost curve is constructed by combining the short run average total cost curves for many, many different plant sizes so as to arrive at the lowest average cost at each level of output when the firm is free to vary its plant size. 25 Objective 2: … constructing a long run average cost curve

Define the concept of returns to scale and understand how it affects the shape of the long run average cost curve U-shaped  The long run average cost curve is also U-shaped. 26 Objective 3

Define the concept of returns to scale and understand how it affects the shape of the long run average cost curve U-shaped  The long run average cost curve is also U-shaped.  The shape of the long run average cost curve is not due to the law of diminishing marginal returns. 27 Objective 3

Define the concept of returns to scale and understand how it affects the shape of the long run average cost curve U-shaped  The long run average cost curve is also U-shaped.  The shape of the long run average cost curve is not due to the law of diminishing marginal returns.  The law of diminishing marginal returnsdoes not apply in the long run.  The law of diminishing marginal returns does not apply in the long run. returns to scale  The shape of the long run average cost curve derives from a concept called returns to scale 28 Objective 3

Define the concept of returns to scale and understand how it affects the shape of the long run average cost curve 29 Objective 3 U-shaped  The long run average cost curve is also U-shaped.  The shape of the long run average cost curve is not due to the law of diminishing marginal returns.  The law of diminishing marginal returnsdoes not apply in the long run.  The law of diminishing marginal returns does not apply in the long run. returns to scale.  The shape of the long run average cost curve derives from a concept called returns to scale.  Returns to scale  Returns to scale examines what happens to average cost when a firm changes its scale of operations.

 Initially, as a firm increases its output, its long run average cost tends to fall. We say that the increasing returns to scale economies of scale. firm experiences increasing returns to scale or economies of scale. 30 Objective 3: … returns to scale

 Initially, as a firm increases its output, its long run average cost tends to fall. We say that the increasing returns to scale economies of scale. firm experiences increasing returns to scale or economies of scale.  When production displays economies of scale, average cost falls as output increases downward sloping. its long run average cost falls as output increases and therefore, the long run average cost curve is downward sloping. 31 Objective 3: … returns to scale

 In many industries there is a wide range of output where long run average cost remains constant. constant returns We say that production displays constant returns to scale to scale. 32 Objective 3: … returns to scale

 In many industries there is a wide range of output where long run average cost remains constant. constant returns We say that production displays constant returns to scale to scale. long-run average costs are constant as output increases horizontal  Constant returns to scale occur when long-run average costs are constant as output increases resulting in a horizontal long run average cost curve. 33 Objective 3: … returns to scale

diseconomies of scaledecreasing returns to scale  As firms continue to expand, they eventually experience diseconomies of scale or decreasing returns to scale. 34 Objective 3: … returns to scale

diseconomies of scaledecreasing returns to scale  As firms continue to expand, they eventually experience diseconomies of scale or decreasing returns to scale. slopes upwards  Diseconomies of scale occur when long-run average costs are rising as output is increasing. Thus, the long-run average cost curve slopes upwards. 35 Objective 3: … returns to scale

diseconomies of scaledecreasing returns to scale  As firms continue to expand, they eventually experience diseconomies of scale or decreasing returns to scale. slopes upwards  Diseconomies of scale occur when long-run average costs are rising as output is increasing. Thus, the long-run average cost curve slopes upwards.  One reason why diseconomies of scale arise is due to managerial inefficiency. 36 Objective 3: … returns to scale

Define minimum efficient scale …  In many industries, the long run average cost curve displays a portion of declining average cost, followed by a range of output over which average costs are constant, and ultimately a segment of increasing average cost. 37 Objective 4

Define minimum efficient scale …  In many industries, the long run average cost curve displays a portion of declining average cost, followed by a range of output over which average costs are constant, and ultimately a segment of increasing average cost. 38 Objective 4  At the output level where economies of scale ends and constant returns to scale start, the firm encounters its minimum efficient scale.

 The minimum efficient scale is denoted by “a” on the graph. 39 Objective 4: … and be able to identify the minimum efficient scale on a graph

 The minimum efficient scale is denoted by “a” on the graph. 40 Objective 4: … and be able to identify the minimum efficient scale on a graph  The minimum efficient scale occurs at the lowest rate of output at which long run average cost is minimized.

 The maximum efficient scale is denoted by “b” on the graph. 41 Objective 4: … and be able to identify the minimum efficient scale on a graph

 The maximum efficient scale is denoted by “b” on the graph. 42 Objective 4: … and be able to identify the minimum efficient scale on a graph  The maximum efficient scale occurs at the highest rate of output at which long run average cost is minimized.

 All firms with outputs between the minimum and maximum efficient scales have identical and minimal average costs. No firm has a cost advantage over other such firms because of its size. 43 Objective 4: … and be able to identify the minimum efficient scale on a graph

End of Module Costs in the Long Run Song:That’s All Folks (Looney Tunes closing theme)