© 2003 McGraw-Hill Ryerson Limited Production and Cost Analysis II Chapter 10

© 2003 McGraw-Hill Ryerson Limited Making Long-Run Production Decisions u To make their long-run decisions, firms look at costs of various inputs and the various production technologies available for combining these inputs, and then decide which combination offers the lowest cost.

© 2003 McGraw-Hill Ryerson Limited Technical Efficiency and Economic Efficiency u Technical efficiency means that the fewest possible inputs are used to produce a given output. u Technical efficiency is efficiency that does not consider costs of production.

© 2003 McGraw-Hill Ryerson Limited Technical Efficiency and Economic Efficiency u The economically efficient method of production is the method that produces a given level of output at the lowest possible cost.

© 2003 McGraw-Hill Ryerson Limited Determinants of the Shape of the Long-Run Cost Curve u The law of diminishing marginal productivity does not hold in the long run since all inputs are variable.

© 2003 McGraw-Hill Ryerson Limited Determinants of the Shape of the Long-Run Cost Curve u The shape of the long-run cost curve results from the existence of economies and diseconomies of scale.

© 2003 McGraw-Hill Ryerson Limited Economies of Scale u There are economies of scale in production when the long run average cost decreases as output increases. u Economies of scale (increasing returns to scale) are cost savings associated with larger scale of production.

© 2003 McGraw-Hill Ryerson Limited Economies of Scale u An indivisible setup cost is the cost of an indivisible input for which a certain minimum amount of production must be undertaken before the input becomes economically feasible to use.

© 2003 McGraw-Hill Ryerson Limited Economies of Scale u Indivisible setup costs are the source of many real-world economies of scale.

© 2003 McGraw-Hill Ryerson Limited Economies of Scale u Economies of scale occur whenever inputs do not need to be increased in proportion to the increase in output. u As output increases, cost per unit falls in the long run, so this can also be seen as an increase in productivity.

© 2003 McGraw-Hill Ryerson Limited Economies of Scale u Doubling the inputs more than doubles the output, when there are economies of scale. u Firms can economize on management cost, or they can take advantage of specialized labour and specialized capital.

© 2003 McGraw-Hill Ryerson Limited A Typical Long-Run Average Total Cost Table, Fig. 10-1a, p 217 Quantity Total Costs of Labor Total Cost of Machines Total Costs = TC L + TC M Average Total Costs = TC/Q $ $ $ ,000 1,110 $

© 2003 McGraw-Hill Ryerson Limited Long run average total cost $ Quantity Minimum efficient scale of production A Typical Long-Run Average Total Cost Curve, Fig. 10-1b, p 217 Economies of scale Constant returns to scale Diseconomies of scale Costs per unit

© 2003 McGraw-Hill Ryerson Limited Economies of Scale u The minimum efficient scale of production is the amount of production that spreads setup costs out sufficiently for firms to undertake production profitably.

© 2003 McGraw-Hill Ryerson Limited Economies of Scale u The minimum efficient scale of production will be at the beginning of the constant returns portion of the average cost curve—where average total costs are at a minimum.

© 2003 McGraw-Hill Ryerson Limited Economies of Scale u The implication of economies of scale is that in some industries firms must be of a certain size to be able to compete successfully.

© 2003 McGraw-Hill Ryerson Limited Diseconomies of Scale u Diseconomies of scale or decreasing returns to scale refer to the increasing long run average costs as output increases.

© 2003 McGraw-Hill Ryerson Limited Diseconomies of Scale u Diseconomies occur for a number of reasons as the firm increases its size l Coordination of a large firm is more difficult l Information costs and communication costs increase as firm increases l Monitoring costs increase l Team spirit may decrease

© 2003 McGraw-Hill Ryerson Limited Constant Returns to Scale u Constant returns to scale (CRTS) occur where long-run average total costs do not change as output increases. u It is shown by the flat portion of the long run average total cost curve.

© 2003 McGraw-Hill Ryerson Limited Summary of Returns to Scale, Table 10-1, p 219 Returns to scaleDoubling inputs results in: Slope of the LRAC Increasing returns to scale (IRTS; economies of scale) Output more than doubles. downward Constant returns to scale (CRTS) Output exactly doubles. horizontal Decreasing returns to scale (DRTS; diseconomies of scale) Output less than doubles. upward

© 2003 McGraw-Hill Ryerson Limited Importance of Economies and Diseconomies of Scale u Economies and diseconomies of scale play important roles in real-world long- run production decisions.

© 2003 McGraw-Hill Ryerson Limited Importance of Economies and Diseconomies of Scale u The long-run and the short-run average cost curves have the same U-shape, but the underlying causes of these shapes differ.

© 2003 McGraw-Hill Ryerson Limited Importance of Economies and Diseconomies of Scale u Economies and diseconomies of scale account for the shape of the long-run total cost curve.

© 2003 McGraw-Hill Ryerson Limited Importance of Economies and Diseconomies of Scale u The assumption of initially increasing and then eventually diminishing marginal productivity (as a variable input is added to a fixed input) accounts for the shape of the short-run cost curve.

© 2003 McGraw-Hill Ryerson Limited The Envelope Relationship u In the long run all inputs are variable, while in the short run some inputs are fixed. u As a result, long-run cost will always be less than or equal to short-run cost.

© 2003 McGraw-Hill Ryerson Limited 0 Quantity SRAC 2 SRAC 3 SRAC 4 LRAC SRAC 1 SRMC 1 SRMC 2 SRMC 3 SRMC 4 Q2Q2 Q3Q3 Envelope of Short-Run Average Total Cost Curves, Fig.10-2, p 220 Q1Q1 Costs per unit

© 2003 McGraw-Hill Ryerson Limited Economies of Scope u Economies of scope play an important role in firms’ decisions of what combination of goods to produce.

© 2003 McGraw-Hill Ryerson Limited Economies of Scope u Globalization, by allowing firms to segment the production process, has made economies of scope even more important to firms in their production decisions.

© 2003 McGraw-Hill Ryerson Limited Production and Cost Analysis II End of Chapter 10