1. Lecture 6 - Production & Cost in the Long Run
What is long run Production????
What is an isoquant????

2. Production & Cost in the Long Run
What are the characteristics of an isoquant???
Represents different combinations of K & L for producing different outputs
What is Marginal Rate of Technical Substitution????

3. Production & Cost in the Long Run
What is the relationship between MRTS & MP????
MRTS = - ΔK = MPL = w
ΔL MPK r
MPL = w
MPK r

4. Production & Cost in the Long Run
MPL = MPK
w r
Principle to produce a given level of output at the lowest cost when 2 input K & L are variable and respectively prices of the inputs w & r

5. Output maximization for a given level of cost
Principle In the case of 2 variable inputs K & L the manager of the firm maximises output for a given number of cost by using L & K such that MRTS = w/r. Refer to graph Fig 9.5 Page 204

6. Optimization and Cost
What is the expansion path?????
Refer o fig 9.6

7. Optimization and Cost What is constant returns to scale???
What is increasing returns to scale???
What is decreasing returns to scale???

8. Long Run Costs What is LR cost or LAC????
What is LR marginal cost or LMC????

9. Economies of Scale
The advantages of large scale production that result in lower unit (average) costs (cost per unit)
AC = TC / Q
Economies of scale – spreads total costs over a greater range of output

10. Economies of Scale
Internal – advantages that arise as a result of the growth of the firm
Technical
Commercial
Financial
Managerial
Risk Bearing

11. Economies of Scale
External economies of scale – the advantages firms can gain as a result of the growth of the industry – normally associated with a particular area
Supply of skilled labour
Reputation
Local knowledge and skills
Infrastructure
Training facilities

12. Economies of Scale
Capital
Land
Labour
Output TC AC
Scale A 5 3 4
100
Scale B 10 6 8
300
Assume each unit of capital = £5, Land = £8 and Labour = £2
Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility
What happens and why?

13. Economies of Scale
Capital
Land
Labour
Output TC AC
Scale A 5 3 4
100 57
0.57
Scale B 10 6 8
300
164
0.54
Doubling the scale of production (a rise of 100%) has led to an increase in output of 200% - therefore cost of production
PER UNIT has fallen
Don’t get confused between Total Cost and Average Cost
Overall ‘costs’ will rise but unit costs can fall
Why?

14. Economies of Scale Internal: Technical
Specialisation – large organisations can employ specialised labour
Indivisibility of plant – machines can’t be broken down to do smaller jobs!
Principle of multiples – firms using more than one machine of different capacities - more efficient
Increased dimensions – bigger containers can reduce average cost

15. Economies of Scale Indivisibility of Plant:
Not viable to produce products like oil, chemicals on small scale – need large amounts of capital
Agriculture – machinery appropriate for large scale work – combines, etc.

16. Economies of Scale Principle of Multiples:
Some production processes need more than one machine
Different capacities
May need more than one machine to be fully efficient

17. Economies of Scale Principle of Multiples: e.g. Machine A Machine B
Machine C
Machine D
Capacity = 10 per hour
Capacity = 20 per hour
Capacity = 15 per hour
Capacity = 30 per hour
Cost = £100 per machine
Cost = £50 per machine
Cost = £150 per machine
Cost = £200
per machine
Company A = 1 of each machine, output per hour = 10
Total Cost = £500
AC = £50 per unit
Company B = 6 x A, 3 x B, 4 x C, 2 x D – output per hour = 60
Total Cost = £1750
AC = £29.16 per unit
The aim here is to show a simple example of how a production process involving a combination of machines operating at different capacities can have an effect on unit costs. The example could be a bottling plant with each machine doing a different task – filling the bottles, labelling, putting the tops on and packaging. Company A being small can only afford 1 of each machine, it is constrained by the capacity of the slowest machine – machine A, the rest of the machines are not being used to their full capacity and so are wasted for some of the time. They still however represent a cost to the firm but there is no return coming in.
The larger company can afford to buy multiples of each machine to ensure that they are all working to full capacity, the point to stress is that the total cost rises – obviously because there are more machines – by 2.5 times compared to company A but the output rises by 5 times the output level of company A hence AC falls. The point can be made that company A is at a significant cost disadvantage and hence this could affect its pricing structure and put it at a distinct competitive disadvantage.

18. Economies of Scale Increased Dimensions: e.g.
Transport container = Volume of 20m3
Total Cost: Construction, driver, fuel,
maintenance, insurance, road tax =
£600 per journey
AC = £30m3 2m 2m 5m
Total Cost = £1800 per journey
AC = £11.25m3
The explanation that accompanies this slide is fairly straight forward – The first container has a carrying capacity of 20 cubic metres. The cost of carrying the product involves the actual construction of the container/lorry etc, the cost of the maintenance, driver etc. This is assumed to be £600 per journey and as such gives an average cost of £30 per cubic metre.
Doubling the dimensions of the container increases the carrying capacity by 8 times. However, the cost of the construction, maintenance etc is not likely to rise by 8 times. The example shows cost having risen 2 times. As a result the cost per unit is now £11.25 per cubic metre! Again the point about the relative competitive advantage is worth highlighting. 4m 4m
10m
Transport Container 2 = Volume 160m3

19. Economies of Scale Commercial
Large firms can negotiate favourable prices as a result of buying in bulk
Large firms may have advantages in keeping prices higher because of their market power

20. Economies of Scale Financial
Large firms able to negotiate cheaper finance deals
Large firms able to be more flexible about finance – share options, rights issues, etc.
Large firms able to utilise skills of merchant banks to arrange finance

21. Economies of Scale Managerial
Use of specialists – accountants, marketing, lawyers, production, human resources, etc.

22. Economies of Scale Risk Bearing Diversification
Markets across regions/countries
Product ranges
R&D

23. Economies of Scale
Minimum Efficient Scale – the point at which the increase in the scale of production yields no significant unit cost benefits
Minimum Efficient Plant Size – the point where increasing the scale of production of an individual plant within the industry yields no significant unit cost benefits

24. Economies of Scale
Unit Cost
Scale A
82p
Scale B
54p
LRAC
MES
Output

25. Diseconomies of Scale
The disadvantages of large scale production that can lead to increasing average costs
Problems of management
Maintaining effective communication
Co-ordinating activities – often across the globe!
De-motivation and alienation of staff
Divorce of ownership and control

26. Long run costs
What are economies of scope???

27. Summary In the long run inputs are variable.
Isoquants show all possible combinations of labor and capital capable of producing a given level of output.
Isoquants are downward sloping reflecting if larger amounts of labor are used less capital is required to produce same output.

28. Summary
MRTS is the absolute value of the slope of an isoquant and measures the rate at which the 2 inputs can be substituted for one another while maintaining a constant level of output
MRTS = - ΔK = MPL
ΔL MPK

29. Summary
Isocost curves the various combinations of inputs that maybe purchased for a given dollar output.
The slope of the isocost is (-w/r)
A manager minimizes the total cost of producing a given level of output by choosing an input combination at point of tangency between isocost and isocurve.

30. Summary Optimization condition slopes of isocosts and isoquants
MPL = MPK
w r
The expansion path shows equilibrium input combination for every level of output.

31. Summary
All points on the expansion path are both cost minimising and output maxising combinations of K & L
LMC lies LAC over range for which LAC is decreasing and vice versa.
When LAC is decreasing there is economies of scale

32. Summary When LAC is increasing there is diseconomies of scale
LAC gives the lowest possible unit cost of producing various outputs because in the LR all outputs are variable or adjusted optimally.