Module 15 1 Costs in the Long Run. ObjectivesObjectives Define long run average cost. 2

Module 15Module 15Module 15Module 15

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Costs in the Long RunCosts in the Long Run

ObjectivesObjectivesObjectivesObjectives

DefineDefine long run average cost. long run average cost.

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DefineDefine long run average cost.long run average cost.

Understand how toUnderstand how to constructconstruct the long run average the long run average cost curve. cost curve.

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Understand how to Understand how to constructconstruct the long run average the long run average cost curve.cost curve.

Define the concept of Define the concept of returns to scalereturns to scale, and , and understand how it affects the shape of the long run understand how it affects the shape of the long run average cost curve.average cost curve.

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Understand how to Understand how to constructconstruct the long run average the long run average cost curve.cost curve.

Define the concept of Define the concept of returns to scalereturns to scale, and , and understand how it affects the shape of the long understand how it affects the shape of the long run average cost curve.run average cost curve.

Define Define minimum efficient scaleminimum efficient scale (MES) and be able (MES) and be able

to identify the MES on a graph.to identify the MES on a graph.

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Objective 1: Define long run average cost curve Objective 1: Define long run average cost curve Objective 1: Define long run average cost curve Objective 1: Define long run average cost curve

The long run is defined as the time period during which all factors of production are variable.

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The relevant cost in the long runrelevant cost in the long run is the total cost of production or average total cost (ATC) if we are interested in cost per unit.

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ATC or simply average cost (AC) is calculated by:

Total Cost ÷ QuantityTotal Cost ÷ Quantity

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ATC or simply average cost (AC) is calculated by:

Total Cost ÷ QuantityTotal Cost ÷ Quantity

The long run average costlong run average cost curve shows the lowest cost at which a firm is able to produce a given quantity of output in the long run when all inputs are variable.

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In the long run, a firm has much greater flexibility to meet its production needs. It can adjust all its inputs.

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Understand how to construct a Understand how to construct a long run average cost curve long run average cost curve


Objective 2Objective 2Objective 2Objective 2


Here, we will focus on variations in plant size.

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Here, we will focus on variations in plant size.

For example, suppose the Acme Box Company faces three different choices of plant size in the long run:

(1) a small plant, (2) a medium-sized plant, and (3) a large plant.

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SRATCSRATC11 represents the short run average total cost

curve associated with a smallsmall plant.

Objective 2: …constructing a long run average Objective 2: …constructing a long run average cost curvecost curve Objective 2: …constructing a long run average Objective 2: …constructing a long run average cost curvecost curve

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SRATCSRATC11 represents the short run average total cost

curve associated with a smallsmall plant.

Once Acme builds a plant, it is locked into that specific plant size which is why the average total cost curves are labeled short run average total cost.


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SRATCSRATC22 represents the short run average total

cost curve associated with a medium-sized plant.


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SRATCSRATC33 is the short run average total cost

curve associated with a large plant.


Which of the three plant sizes will Acme select?

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Objective 2: …constructing a long run Objective 2: …constructing a long run average cost curveaverage cost curve Objective 2: …constructing a long run Objective 2: …constructing a long run average cost curveaverage cost curve


Well, that depends on the anticipated normal sustained rate of output per period.

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Well, that depends on the anticipated normal sustained rate of output per period.

If the expected rate of output per period is QQ11 then it will select the smallsmall plant to achieve the lowest average cost.

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If the expected rate of output per period is QQ22 then it will select the medium-sizedmedium-sized plant.

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Objective 2: …constructing a long run Objective 2: …constructing a long run average cost curveaverage cost curveObjective 2: …constructing a long run Objective 2: …constructing a long run average cost curveaverage cost curve

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Objective 2: …constructing a long run Objective 2: …constructing a long run average cost curveaverage cost curveObjective 2: …constructing a long run Objective 2: …constructing a long run average cost curveaverage cost curve

If the expected rate of output per period is QQ33 then it will select the largelarge plant.

The long run average cost curvelong run average cost curve is derived by tracing the points that represent the lowest per-unit cost for each level of output.

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The long run average cost curvelong run average cost curve is derived by tracing the points that represent the lowest per-unit cost for each level of output.

In the diagram below, the LRAC curve is the red scalloped curve.

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Now, if there is an innumerable number of plant sizes, and if it is possible for the firm to build any plant size that generates the lowest short run average total cost for any output level, then we will arrive at a smoothsmooth LRAC curve like the red curve below.

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The long run average cost curvelong run average cost curve is constructed by combining the short run average total cost curves for many, many different plant sizes so as to arrive at the lowest average cost at each level of output when the firm is free to vary its plant size.

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Define the concept of returns to scale and Define the concept of returns to scale and understand how it affects the shape of the long understand how it affects the shape of the long run average cost curverun average cost curve


The long run average cost curve is also U-shapedU-shaped.

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The shape of the long run average cost curve derives from a concept called returns to scalereturns to scale, not from the law of diminishing marginal returns.

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The law of diminishing marginal returns does notnot apply in the long run.

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The law of diminishing marginal returns does notnot apply in the long run.

Returns to scaleReturns to scale examines what happens to average cost when a firm changes its scale of operations.

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Initially, as a firm increases its output, its long run average cost tends to fall. We say that the firm experiences increasing returns to scaleincreasing returns to scale or economies of scale.economies of scale.

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Objective 3: …returns to scaleObjective 3: …returns to scaleObjective 3: …returns to scaleObjective 3: …returns to scale

Initially, as a firm increases its output, its long run average cost tends to fall. We say that the firm experiences increasing returns to scaleincreasing returns to scale or economies of scale.economies of scale.

When production displays economies of scale, its long run average cost falls as output increasesaverage cost falls as output increases and therefore, the long run average cost curve is downward sloping.downward sloping.

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In many industries there is a wide range of output where long run average cost remains constant. We say that production displays constant returns constant returns to scaleto scale.

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In many industries there is a wide range of output where long run average cost remains constant. We say that production displays constant returns constant returns to scaleto scale.

Constant returns to scale occur when long-run long-run average costs are constant as output increasesaverage costs are constant as output increases resulting in a horizontalhorizontal long run average cost curve.

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As firms continue to expand, they eventually experience diseconomies of scalediseconomies of scale or decreasing decreasing returns to scalereturns to scale.

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Diseconomies of scale occur when long-run average costs are rising as output is increasing. Thus, the long-run average cost curve slopes slopes upwardsupwards.

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Diseconomies of scale occur when long-run average costs are rising as output is increasing. Thus, the long-run average cost curve slopes slopes upwardsupwards.

One reason why diseconomies of scale arise is due to managerial inefficiency.

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Define minimum efficient scale ….Define minimum efficient scale ….Define minimum efficient scale ….Define minimum efficient scale …. In many industries, the long run average cost curve displays

a portion of declining average cost, followed by a range of output over which average costs are constant, and ultimately a segment of increasing average cost.

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Define minimum efficient scale ….Define minimum efficient scale ….Define minimum efficient scale ….Define minimum efficient scale …. In many industries, the long run average cost curve displays

a portion of declining average cost, followed by a range of output over which average costs are constant, and ultimately a segment of increasing average cost.

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At the output level where economies of scale ends and constant returns to scale start, the firm encounters its minimum efficient scale.

The minimum efficient scale is denoted by “a” on the graph.

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Objective 4:….and be able to identify the Objective 4:….and be able to identify the minimum efficient scale on a graphminimum efficient scale on a graphObjective 4:….and be able to identify the Objective 4:….and be able to identify the minimum efficient scale on a graphminimum efficient scale on a graph

The minimum efficient scale is denoted by “a” on the graph.

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Objective 4:….and be able to identify the Objective 4:….and be able to identify the minimum efficient scale on a graphminimum efficient scale on a graphObjective 4:….and be able to identify the Objective 4:….and be able to identify the minimum efficient scale on a graphminimum efficient scale on a graph

The minimum efficient scale occurs at the lowestrate of output at which long run average cost is minimized.

The maximum efficient scale is denoted by “b” on the graph.

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Objective 4: ….and be able to identify the Objective 4: ….and be able to identify the minimum efficient scale on a graph.minimum efficient scale on a graph.Objective 4: ….and be able to identify the Objective 4: ….and be able to identify the minimum efficient scale on a graph.minimum efficient scale on a graph.

The maximum efficient scale is denoted by “b” on the graph.

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The maximum efficient scale occurs at the highest rate of output at which long run average cost is minimized.

All firms with outputs between the minimum and maximum efficient scales have identical and minimal average costs. No firm has a cost advantage over other such firms because of its size.

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End of Module 15End of Module 15End of Module 15End of Module 15

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Costs in the Long RunCosts in the Long Run

Song: That’s All Folks (Looney Tunes closing theme)

Documents

Module 15 1 Costs in the Long Run. ObjectivesObjectives Define long run average cost. 2