1. Long Run Production and Costs
Economies of Scale
Long Run Production and Costs

2. In the Long Run In the long-run
“But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”
John Maynard Keynes, 1936

3. Long Run Costs
Economies of scale are not relevant in the short run production function
Economies of scale are the cost advantages that a business can exploit by expanding their scale of production in the long run. The effect of economies of scale is to reduce the long run average costs of production over a range of output.

4. Long Run Returns to Scale
Long Run Output (Units)
Total Costs (£s)
Long Run Average Cost (£ per unit)
1000
12000 12
2000
20000 10
5000
45000 9
10000
80000 8
144000
7.2
50000
330000
6.6
100000
640000
6.4
500000 6

5. Returns to Scale – Work out the total cost for each scale of production
Factor Inputs
Production
Costs
(K)
(La)
(L)
(Q)
(TC)
(TC/Q)
Capital
Land
Labour
Output
Total Cost
Average Cost
Scale A 5 3 4
100
Scale B 10 6 8
300
Scale C 15 9 12
500
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200

6. Now calculate average cost for each scale
Factor Inputs
Production
Costs
(K)
(La)
(L)
(Q)
(TC)
(TC/Q)
Capital
Land
Labour
Output
Total Cost
Average Cost
Scale A 5 3 4
100
3256
Scale B 10 6 8
300
6512
Scale C 15 9 12
500
9768
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200

7. Measuring the Returns to Scale
Factor Inputs
Production
Costs
(K)
(La)
(L)
(Q)
(TC)
(TC/Q)
Capital
Land
Labour
Output
Total Cost
Average Cost
Scale A 5 3 4
100
3256
32.6
Scale B 10 6 8
300
6512
21.7
Scale C 15 9 12
500
9768
19.5
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200

8. The Long Run Average Cost Curve
The LRAC curve or ‘envelope curve’ is drawn on the assumption of their being an infinite number of plant sizes – hence its smooth appearance
If LRAC is falling when output is increasing then the firm is experiencing economies of scale
When LRAC rises, the firm experiences diseconomies of scale
If LRAC is constant, then the firm is experiencing constant returns to scale

9. Drawing the Long Run Average Cost Curve
Cost per unit
AC1
AC2
AC3
Output

10. Drawing the Long Run Average Cost Curve
Cost per unit
AC1
AC2
AC3
LRAC
Output

11. Drawing the Long Run Average Cost Curve
Cost per unit
AC1
AC2
AC3
LRAC Q1 Q2 Q3
Output

12. The LRAC as a cost boundary
Cost per unit
Attainable costs per unit
LRAC
Output

13. Cost advantages of economies of scale
AC1
AC2
AC3

14. Scale economies – higher output
MC1
AC1
AC2
AC3

15. Scale economies – higher output
MC1
AC1
AC2
AC3
MC3

16. Scale economies – higher output
MC1
AC1
AC2
AC3
MC3 AR MR

17. Scale economies – higher output
MC1
AC1
AC2
AC3
MC3 AR MR

18. Scale economies – higher output
MC1
AC1
AC2
AC3
MC3 AR MR

19. Scale economies – higher profit
MC1
AC1
AC2
AC3
MC3 AR MR

20. Internal Economies of Scale
Internal economies of scale arise from the internal growth of a business as it expands the scale of its operations
External economies of scale result from the expansion of the industry as a whole of which the business is a member

21. Technical Economies of Scale
Expensive capital inputs: Large-scale businesses can afford to invest in expensive and specialist capital machinery
Specialisation of the workforce: Within larger firms there is the possibility of splitting complex production processes into separate tasks to boost factor productivity
The law of increased dimensions or the “container principle
Learning by doing: The unit (average) costs of production typically decline in real terms as a result of production experience

22. Exploiting Size and Scale

23. The container principle

24. Scale economies in printing
Advances in printing technology and the use of huge printing presses have driven down the costs of publishing
Print on demand increases the elasticity of supply for many publishing businesses

25. Marketing Economies of Scale
A large firm can spread its advertising and marketing budget over a much larger output
It can purchase its factor inputs in bulk at negotiated discounted prices if it has monopsony (buying) power in the market

26. Managerial Economies of Scale
This is a form of division of labour
For example, large-scale manufacturers employ specialists to supervise production systems
Increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication

27. Financial Economies of Scale
Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and have access to credit facilities, with favourable rates of borrowing
Businesses quoted on the stock market can normally raise fresh money (extra financial capital) more cheaply through the sale (issue) of equities to the capital market
Larger companies are also likely to pay a lower rate of interest on new company bonds because of a better credit rating.

28. Learning economies
Learning reduces unit cost (LRAC) through the benefits of industry experience
Businesses learn through experience the most productive processes
Workers may become more adapt at their job and their speed increases.
Managers learn to schedule the production process more effectively.
Engineers improve design tolerances and learn to develop better and more specialised tools and plant organisation.
Suppliers learn how to process materials required more effectively

29. Learning Economies B LRAC1 Economies of Scale Cost (per unit
of output)
LRAC1 B
Economies of Scale
Output

30. Learning Economies A B LRAC1 C LRAC2 Economies of Scale Learning
Cost
(per unit
of output)
LRAC1 B
Economies of Scale
LRAC2
Learning
economies C A
Output

31. Network Economies of Scale
Some networks and services have huge potential for economies of scale
As they are more widely used (or adopted), they become more valuable to the business that provides them
The classic examples are the expansion of a common language, a common currency, online auctions and air transport networks
The marginal cost of adding one more user to the network is close to zero, but the resulting financial benefits may be huge

32. Network economies in aviation
Consider a long haul flight from Sydney to London or Amsterdam
Virtually every city in Europe is just a short connecting flight away
Networks allow consumers to move quickly between many different centres of population
Network economies also important for producers – their production and distribution systems need to be in easy reach of both their suppliers and their customers

33. Single routes
5 Aircraft A B C D E F G H I J
5 Routes

34. 5 Aircraft – 55 connectionsB J C I D H E G F
55 Connections

35. 2 Networks and an Alliance
2 Networks / Alliances A B C D E F G H I J A B C D E F G H I J
= 210 Connections

36. The Minimum Efficient Scale
The minimum efficient scale (MES) is the long run output where a business fully exploits the available internal economies of scale
It corresponds to the minimum point of the long run average total cost curve
This is also the output where a business achieves productive efficiency
The minimum efficient scale will vary from industry to industry

37. External Economies of Scale
When the long-term expansion of an industry leads to the development of ancillary services which benefit all or the majority of suppliers in the industry
A labour force skilled in the crafts of the industry
Components suppliers re-locate close to production centres – reducing transportation costs
Concentration of the food processing industry around ports
Trade magazines in which all firms can advertise cheaply and disseminate information
Development research capabilities in local universities
External economies partially explain the tendency for firms to cluster geographically

38. Economies of Scope
Economies of scope occur where it is cheaper to produce a range of products rather than specialize in just a handful of products.
A company’s management structure, administration systems and marketing departments are capable of carrying out these functions for more than one product
Expanding the product range to exploit the value of existing brands is a good way of exploiting economies of scope.

39. Different shaped LRAC curves
U-Shaped LAC: average costs decline over low levels of output, but increase at higher levels of output
LRAC2
LRAC1
L-Shaped LAC: Average costs declining over all levels of output.
Output

40. Causes of Diseconomies
Control – costs and limitations of monitoring productivity and the quality of output from thousands of employees in big corporations – possible stakeholder conflicts
Co-ordination - difficult to co-ordinate complicated production processes across several plants in different locations and countries
Co-operation - workers in large firms may feel a sense of alienation and subsequent loss of morale. Possible failures of human resource management