Chap010 Long Run Production and Costs Analysis

8/8/2019 Chap010 Long Run Production and Costs Analysis

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McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., AllRights Reserved.

Production andProduction and

Cost Analysis IICost Analysis II

Chapter 10


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Laugher CurveLaugher Curve

Economists have forecasted nine out ofthe last 15 recessions.


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Making Long-RunMaking Long-Run

Production DecisionsProduction Decisionss To make their long-run decisions:

q Firms look at costs of various inputs and

the technologies available for combiningthese inputs.

qThen decide which combination offers

the lowest cost.


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Making Long-RunMaking Long-Run

Production DecisionsProduction Decisionss The firm makes long-run decisions on the

basis of the expected costs and expected

usefulness of inputs.


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Technical Efficiency andTechnical Efficiency and

Economic EfficiencyEconomic Efficiencys Technical efficiency as few inputs as

possible are used to produce a given

output.s Technical efficiency is efficiency that does

not consider cost of inputs.


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Technical Efficiency andTechnical Efficiency and

Economic EfficiencyEconomic Efficiencys Economically efficient the method that

produces a given level of output at the

lowest possible cost.s It is the least-cost technically efficient

process.


7/57McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All

Rights Reserved.

Determinants of theDeterminants of theShape of the Long-RunShape of the Long-RunCost CurveCost Curves The law of diminishing marginal

productivity does not hold in the long run.

s All inputs are variable in the long run.


8/57McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All

Rights Reserved.

Determinants of theDeterminants of theShape of the Long-RunShape of the Long-RunCost CurveCost Curves The shape of the long-run cost curve is

due to the existence of economies and

diseconomies of scale.


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A Typical Long-RunA Typical Long-Run

Average Total Cost TableAverage Total Cost TableQuantity

Total Costsof Labor

Total Costof Machines

Total Costs =TC

L+ TC

M

Average TotalCosts = TC/Q

11121314151617181920

$381390402420450480510549600666

$254260268280300320340366400444

$635650670700750800850915

1,0001,110

$58545250505050515356



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Averagetotal cost

C

ostsperu n

it

$6462

60585654525048

11 12 13 14 15 16 17 18 19 20 Quantity

Minimum efficientlevel of production

A Typical Long-RunA Typical Long-Run

Average Total Cost CurveAverage Total Cost Curve



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Economies of ScaleEconomies of Scale

s Economies of scale long run averagetotal costs decrease as output increases.

s In real-world production processes,economies of scale are extremelyimportant at low levels of production.


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s An indivisible setup costis the cost of anindivisible input for which a certain

minimum amount of production must beundertaken before the input becomeseconomically feasible to use.


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s Indivisible setup costs create many real-world economies of scale.

s The cost of a blast furnace or an oilrefinery is an example of an indivisiblesetup cost.


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s In the longer run all inputs are variable, soonly economies of scale can influence the

shape of the long-run cost curve.


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s Because of the importance of economiesof scale, business people often talk of a

minimum efficient level of production.


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s The minimum efficient level ofproduction is the amount of production

that spreads setup costs out sufficiently forfirms to undertake production profitably.


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s The minimum efficient level of productionis reached once the size of the market

expands to a size large enough so thatfirms can take advantage of all economiesof scale.


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Diseconomies of ScaleDiseconomies of Scale

s Diminishing marginal productivityrefersto the decline in productivity caused by

increasing units of a variable input beingadded to a fixed input.


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s Diseconomies of scale refer to decreasesin productivity which occur when there are

equal increases of all inputs (no input isfixed).qDiseconomies of scale occur on the right

side of the long-run average cost curvewhere it is upward sloping, meaning thataverage cost is increasing.


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s As the size of the firm increases,monitoring costs generally increase.

s Monitoring costs are those incurred by theorganizer of production in seeing to it thatthe employees do what they are supposed

to do.


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s Team spiritis the feelings of friendshipand being part of a team that brings outpeoples best effort


s As the size of the firm increases, teamspirit or morale generally decreases.


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Constant Returns toConstant Returns to

ScaleScales Constant returns to scale is where long-

run average total costs do not change as

output increases.s It is shown by the flat portion of the LRATC

curve.


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Averagetotal cost

C

ostsperu n

it

$6462

60585654525048

11 12 13 14 15 16 17 18 19 20 Quantity

Economies andEconomies and

Diseconomies of ScaleDiseconomies of ScaleEconomies

of ScaleDiseconomies

of ScaleConstantreturns

to Scale


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Importance of EconomiesImportance of Economiesand Diseconomies ofand Diseconomies ofScaleScales Economies and diseconomies of scale

play important roles in real-world long-run

production decisions.


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Importance of EconomiesImportance of Economiesand Diseconomies ofand Diseconomies ofScaleScales The long-run and the short-run average

cost curves have the same U-shape, but

the underlying causes of these shapesdiffer.


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Importance of EconomiesImportance of Economiesand Diseconomies ofand Diseconomies ofScaleScales Economies and diseconomies of scale

account for the shape of the long-run total

cost curve.


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Importance of EconomiesImportance of Economiesand Diseconomies ofand Diseconomies ofScaleScales 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-runcost curve.


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The EnvelopeThe Envelope

RelationshipRelationships In the long run all inputs are flexible, while

in the short run some inputs are not

flexible.s As a result, long-run cost will always be

less than or equal to short-run cost.


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RelationshipRelationships In the short run the firm faces an additional

constraint all expansion must proceed

using only the variable input.s These additional constraints increase

cost.


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RelationshipRelationships The envelope relationship explains that:

qAt the planned output level, short-run

average total cost equals long-runaverage total cost.

qAt all other levels of output, short-runaverage total cost is higher than long-runaverage total cost.


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Costs

perunit

0Quantity

SRATC2SRATC3

SRATC4

LRATC

SRATC1SRMC

1

SRMC2

SRMC3

SRMC4

Q2

Q3

Envelope of Short-RunEnvelope of Short-RunAverage Total CostAverage Total CostCurvesCurves


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Entrepreneurial ActivityEntrepreneurial Activity

and the Supply Decisionand the Supply Decisions Profit is what underlies the dynamics of

production in a market economy.

s The expected price must exceed theopportunity cost of supplying the good fora good to be supplied.


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and the Supply Decisionand the Supply Decisions Suppliersexpected economic profit per

unit the difference between the expected

price of a good and the expected averagetotal cost of producing it.


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and the Supply Decisionand the Supply Decisions An entrepreneuris an individual who see

an opportunity to sell an item at a price

higher than the average cost of producingit.


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and the Supply Decisionand the Supply Decisions Entrepreneurs organize production.

s They visualize the demand and convince the

individuals who own the factors ofproduction that they want to produce thosegoods.


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Using Cost Analysis inUsing Cost Analysis in

the Real Worldthe Real Worlds Some of the problems of using cost

analysis in the real world include the

following:q Economies of scope.q Learning by doing and technological

change.

qMany dimensions.qUnmeasured costs.


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Economies of ScopeEconomies of Scope

s The cost of production of one product oftendepends on what other products a firm is

producing.


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s There are economies of scope when thecosts of producing goods are

interdependent so that it is less costly for afirm to produce one good when it isalready producing another.


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s Firms look for both economies of scopeand economies of scale.

s Economies of scope play an important rolein firms decisions of what combination ofgoods to produce.


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s Globalization has made economies ofscope even more important to firms in their

production decisions.


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Learning by Doing andLearning by Doing and

Technological ChangeTechnological Changes Production techniques available to real-

world firms are constantly changing

because of learning by doing andtechnological change.

s These changes occur over time and

cannot be accurately predicted.


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Technological ChangeTechnological Changes Learning by doingmeans that as we do

something, we learn what works and

doesnt, and over time we become moreproficient at it.


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Technological ChangeTechnological Changes Many firms estimate worker productivity to

grow 1 to 2 percent a year because of

learning by doing.


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Technological ChangeTechnological Changes Technological change is an increase in

the range of production techniques that

provides new ways to producing goods.


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Technological ChangeTechnological Changes Technological change can fundamentally

alter the nature of production costs.


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Technological ChangeTechnological Changes Technological change occurs in all

industries, not only high-tech industries.


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Technological ChangeTechnological Changes In many businesses, the effect of learning

by doing and technological change on

prices is built into the firm's pricingstructure.


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Technological ChangeTechnological Changes Technological change and learning by

doing are intricately related.


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Many DimensionsMany Dimensions

s Most decisions that firms make involvemore than one dimension.

s The only dimension in the standard modelis the level of output.

s Good economic decisions take all relevant

marginal costs and benefits into account.


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Many DimensionsMany Dimensions

s The important thing to remember in usingthe standard model is the reasoning, not

the specific model.


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Unmeasured CostsUnmeasured Costs

s The relevant costs as defined byeconomists are not the costs found in a

firms books.s Economists include opportunity costs while

accountants use explicit costs that can be

measured.


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Economists IncludeEconomists Include

Opportunity CostOpportunity Costs Economists insists on including the

business owners opportunity cost.

s The business owners opportunity costincludes forgone income that the ownercould have earned by spending his or her

time in another job.


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Economic VersusEconomic Versus

Accounting DepreciationAccounting Depreciations Economic depreciation differs from

accounting depreciation.


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Accounting DepreciationAccounting Depreciations In measuring the costs of depreciable

assets, accountants insist on using

historical costswhat a depreciable itemcosts in terms of money actually spent foritas the cost basis.


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Accounting DepreciationAccounting Depreciations If the depreciable asset increased in value,

accountants would still use the historical

cost basis while an economist would countits increased value as revenue.


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The Standard Model as aThe Standard Model as a

FrameworkFrameworks Despite its limitations, the standard model

provides a good framework for cost

analysis.s It can be expanded to include real-world

complications.


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Production andProduction and

Cost Analysis IICost Analysis II

End of Chapter 10

Chap010 Long Run Production and Costs Analysis

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Transcript of Chap010 Long Run Production and Costs Analysis