The Theory of Production. Production in the Long Run (LR). Lesson Objectives. Understand the theory that explains the short run Appreciate that different sized firms have different levels of productive efficiency Understand the theory of long-run costs
Production in the Long Run (LR)
Increasing marginal returns
Diminishing marginal returns
Law of diminishing marginal returns
Average fixed cost
Average variable cost
Average total cost
Marginal costConnectorWhat might the following terms mean?
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1 & 2
No economies of scale for Proton without global partner
However some firm, typically smaller ones, may decide that expansion is not an option and will remain at their size and overwork their fixed factors.
This may be for reason such as a lack of available finance, little likelihood of a planning application being granted, or fears that market growth may
be temporary. Such firms are not reducing their costs to the lowest but may ignore this fact as long as profits are adequate.
Firstly, the increase in demand may be temporary (e.g. demand for Christmas wrapping paper in December) so if the amount of capital was increased, it wouldn’t be used in the future.
Secondly, firms need funds, either from profit or from borrowed money, in order to pay for the investment; many small firms don’t have this option or don’t want to pay high interest rates on loans.
a) Average costs of generating electricity by nuclear methods have been lower. Fixed costs associated with nuclear are high. External costs associated with nuclear are generally lower. Data shows nuclear power costs 3.2euros per kWh, compared to an average cost for gas of 3.65 and coal of 4.19.
b) Define minimum efficient scale. Show MES on a diagram. Firms benefit from producing at the MES because lower costs are likely to lead to higher profits. Consumers may benefit because lower costs often translate into lower prices, thus increasing consumer surplus. Firms need to ensure however that they don’t surpass the MES, and end up with rising LRATC. Additionally, consumers may not benefit if firms don’t pass on the cost reductions in terms of lower prices.
Explain what is meant by the short-run.
Explain that diminishing returns are caused by increasing the level of output by using more labour, whilst maintaining other fixed factors of production; thus in the short-run diminishing returns are not eliminated by increasing output. Use LRATC/SRATC envelope curve.
Explain what is meant by the long-run. Explain how firms can eliminate diminishing returns by increasing the scale of production in order to increase output i.e. increasing the amount of capital, and not just increasing the amount of labour.
Comment that increasing capital is not necessarily easy, owing to finance constraints, planning permissions, legal barriers (e.g. prevention of monopoly power, patents etc) and so firms cannot guarantee that they can eliminate diminishing returns.
Factors affecting fixed costs could include: salary demands of permanent employees (e.g. public sector workers demanding wage increases in line with inflation), rent prices (dependent on area of country etc).
Factors affecting variable costs could be: price of fuel (more expensive in winter as demand increases, more expensive if there’s uncertainty in the Middle East etc), changes to the National Minimum Wage affecting non-salaried employees, cost of raw materials (e.g. price of gelatine increased following BSE outbreaks).
Reasons for firms having similar costs:
Reasons why they might not face similar costs: