1. ECON 211 ELEMENTS OF ECONOMICS I
Session 6– Production and Costs (Part 2)
Lecturer: Dr. (Mrs.) Nkechi S. Owoo, Department of Economics
Contact Information:

2. Session Overview
This session discusses a variety of other cost concepts useful for the analysis that follows, including totals (total cost, total variable cost, total fixed cost), averages (average total cost, average variable cost, average fixed cost), marginal cost, among others.
We long run cost concepts in this session.

3. Session Outline
The key topics to be covered in the session are as follows:
Production and Costs in the Long-Run
The relationship between Long-run and Short-run costs
Explaining the Shape of the LRATC curve
Economies of Scale
Diseconomies of Scale

4. Reading List
Hall and Lieberman
Chapter 5 : pp:

5. Production and costs in the LONG run
Topic One
Production and costs in the LONG run

6. Production And Cost in the Long Run
In the long run, firms behave differently because firms can adjust all their inputs in the way that they want
In the long run, all inputs and all costs are variable
In order to choose its production level therefore, a firm must follow the least-cost rule, in order to maximize profits
Least Cost Rule
To produce any given level of output, the firm will choose the input mix with the lowest cost
Illustration

7. Production and Costs in the Long Run
Let us apply the least-cost rule to Spotless Car Wash
Suppose we want to know the cost of washing 196 cars per day
In the short run, the firm does not have to worry about how to produce this as it is stuck with only one automated line and the only way to wash 196 cars is to hire 6 workers (see slides from last session)
Total costs in the short run would be (6 x Ghc120) + Ghc150 = Ghc870
In the long run, however, the firm can vary its number of automated lines, as well as the number of workers
The four different options for washing 196 cars are presented in the table below
Method
Quantity of Capital
Quantity of Labour
Cost
(Ghc) A 9
1080 B 1 6
870 C 2 4
780 D 3
810

8. Production and Costs in the Long Run
Combination A uses the least capital and the most labour
No automated lines and workers wash the cars by hand
Combination D uses the most capital and the least number of workers
Spotless chooses the combination with the least cost, which is combination C

9. Production And Cost in the Long Run
The Long-run total cost (LRTC) indicates the cost of producing each quantity of output when the least-cost input mix is chosen in the long run
Long-run average total cost (LRATC)
The cost per unit of output
in the long run
all inputs are variable
LRTC ≤ TC
LRATC ≤ ATC

10. The relationship between long run costs and short run costs
Topic One
The relationship between long run costs and short run costs

11. Graphing the LRATC Explaining the LRATC
In the figure on the next slide, each ATC curve represents potential production outcomes of Spotless Car Wash
For example, ATCo represents the short run cost curve of the firm if it used no automated lines
In the long run, the firm is able to examine all these costs and potential production levels and decide what quantity to produce
In the figure, if a firm decides to wash 130 cars a day, the lowest cost is achieved along ATC1, with 1 automated line.
If the firm decides to wash 184 cars, the lowest costs are attained along ATC2 with 2 automated lines
Therefore, we can trace out the firm’s LRATC curve by combining the lowest portions of all the ATC curves from which the firm can choose
For each output level, the firm always chooses to operate on the ATC with the lowest possible cost

12. Graphing the LRATC Curve
Figure Long-Run Average Total Cost
196
184
Dollars
1.00
2.00
3.00
$4.00
Units of Output 30 90
130
160
250
300
ATC1
LRATC
ATC3
ATC0
ATC2 C D B A E
175
Use 0 automated lines
Use 1 automated lines
Use 2 automated lines
Use 3 automated lines

13. Explaining the shape of the lratc curve
Topic One
Explaining the shape of the lratc curve

14. The Shape of LRATC The LRATC curve is U-Shaped
As output increases, LRATC first decrease, then remain constant, and finally rise
In the portion of the LRATC where costs are falling, the firm is said to be experiencing economies of scale
In the portion of the LRATC where costs are constant, the firm is said to be experiencing constant returns to scale
In the portion of the LRATC where costs are rising, the firm is said to be experiencing diseconomies of scale

15. The Shape of LRATC Economies of scale
Here, the LRATC decreases as output increases
i.e. The more output is produced, the lower the cost per unit
Why should a firm experience economies of scale?
Gains from specialization
At low levels of output, few workers hired and these workers may have to perform a greater variety of tasks, slowing them down and making them less productive
As output increases, more workers are hired and more options exist for specialization
Spreading Costs of Lumpy inputs
These are inputs that cannot be increased in tiny increments, but rather must be increased in large jumps.
E.g. a hospital centre needs an x-ray machine, and the average costs would be lower if more patients use the machine

16. The Shape of LRATC Constant returns to scale
- LRATC is unchanged as output increases
LRATC curve is flat

17. The Shape of LRATC Diseconomies of scale
LRATC increases as output increases
As the firm expands, its bigness begins to cause problems
E.g. large firms may require more layers of management, so that communication and decision-making becomes time consuming and costly
Large firms also have a harder time screening out misfits among new hires and monitoring those already employed
This can lead to increases in mistakes, shirking of responsibilities, theft from the firm, etc which may all raise average costs of production in the long run

18. The Shape of LRATC U-shape of LRATC curve
Economies of scale at relatively low levels of output
Constant returns to scale at some intermediate levels of output
Diseconomies of scale at relatively high levels of output

19. Constant Returns to Scale
The Shape Of LRATC
Figure 6 The Shape Of LRATC
Dollars
1.00
2.00
3.00
$4.00
130
184
LRATC
Economies of Scale
Constant Returns to Scale
Diseconomies of Scale
Units of Output

20. References
Economics: Principles and Applications: Hall R.E. and Lieberman M. (2008), Thomson/ South Western (4th Edition)