Chapter 9: Production and Cost Analysis II

1. Chapter 9: Production and Cost Analysis II Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

2. Long Run Production Decisions • To make their long run decisions: • Firms look at costs of various inputs and the technologies available for combining these inputs. • Then decide which combination offers the lowest cost. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

3. Technical Efficiency and Economic Efficiency • Technical efficiency – as few inputs as possible are used to produce a given output. • Technical efficiency is efficiency that does not consider cost of inputs. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

4. Technical Efficiency and Economic Efficiency • Economic efficiency – the method produces a given level of output at the lowest possible cost. • It is the least-cost technically efficient process. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

5. Long Run Cost Curve • The law of diminishing marginal productivity does not hold in the long run. • All inputs are variable in the long run. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

6. Long Run Cost Curve • The shape of the long run cost curve is due to the existence of economies and diseconomies of scale. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

7. $64 62 60 Average total cost 58 56 Costs per unit Minimum efficient level of production 54 52 50 48 1 1 12 13 14 15 16 17 18 19 20 Quantity Typical Long Run Average Total Cost Curve © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

8. Economies of Scale • There are economies of scale in production when the long run average cost decreases as output increases. • Economies of scale (increasing returns to scale) are cost savings associated with larger scale of production. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

9. Individual Setup Costs • An indivisible setup costis the cost of an indivisible input for which a certain minimum amount of production must be undertaken before the input becomes economically feasible to use. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

10. Individual Setup Costs • Indivisible setup costs are the source of many real-world economies of scale. • The cost of a blast furnace or an oil refinery is an example of an indivisible setup cost. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

11. Economies of Scale • In the longer run all inputs are variable, so only economies of scale can influence the shape of the long run cost curve. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

12. Economies of Scale • Economies of scale occur whenever inputs do not need to be increased in proportion to the increase in output. • As output increases, cost per unit falls in the long run, so this can also be seen as an increase in productivity. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

13. Economies of Scale • Doubling the inputs more than doubles the output, when there are economies of scale. • Firms can economize on management cost, or they can take advantage of specialized labour and specialized capital. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

14. Economies of Scale • Because of the importance of economies of scale, business people often talk of a minimum efficient scale of production. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

15. Minimum Efficient Scale • The minimum efficient scale of production is the amount of production that spreads setup costs out sufficiently for firms to undertake production profitably. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

16. Minimum Efficient Scale • The minimum efficient scale (MES) of production is reached once the size of the market expands to a size large enough so that firms can take advantage of all economies of scale. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

17. $64 62 60 Long run average total cost 58 56 Minimum efficient scale of production 54 52 50 48 1 1 12 13 14 15 16 17 18 19 20 Quantity Typical Long Run Average Total Cost Curve Costs per unit Economies of scale Constant returns to scale Diseconomies of scale © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

18. Economies of Scale • The minimum efficient scale of production will be at the beginning of the constant returns portion of the average cost curve—where average total costs are at a minimum. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

19. Economies of Scale • The implication of economies of scale is that in some industries firms must be of a certain size to be able to compete successfully. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

20. Increasing Returns to Scale (IRTS) • Increasing returns to scale is where long run average total costs fall as output increases. • It is shown by the decreasing portion of the LRAC curve. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

21. Constant Returns to Scale (CRTS) • Constant returns to scale is where long run average total costs do not change as output increases. • It is shown by the flat portion of the LRAC curve. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

22. Decreasing Returns to Scale (DRTS) • Decreasing returns to scale or diseconomies of scale refer to decreases in productivity which occur when there are equal increases of all inputs. • Decreasing returns to scale occur where the long run average cost curve is upward sloping, meaning that average cost is increasing. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

23. Monitoring Costs • As the size of the firm increases, monitoring costs generally increase. • Monitoring costs are those incurred by the organizer of production in seeing to it that the employees do what they are supposed to do. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

24. Decreasing Returns to Scale • Diseconomies occur for a number of reasons as the firm increases its size • Coordination of a large firm is more difficult • Information costs and communication costs increase as firm increases • Monitoring costs increase • Team spirit may decrease © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

25. Decreasing Returns to Scale • Team spirit is the feelings of friendship and being part of a team that brings out people’s best effort. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

26. Summary of Returns to Scale © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

27. $64 62 60 Long run average total cost 58 56 Costs per unit 54 52 50 48 1 1 12 13 14 15 16 17 18 19 20 Quantity Economies and Diseconomies of Scale Increasing Returns to Scale Constant returns to Scale Decreasing Returns to Scale © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

28. Importance of Economies of Scale • Economies and diseconomies of scale play important roles in real-world long run production decisions. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

29. Importance of Economies of Scale • The long run and the short run average cost curves have the same U-shape, but the underlying causes of these shapes differ. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

30. Short Run Average Cost Curves • 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 run average cost curve. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

31. Long Run Average Cost Curve • Economies and diseconomies of scale account for the shape of the long run total cost curve. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

32. Envelope Relationship • In the long run all inputs are flexible, while in the short run some inputs are not flexible. • As a result, long run cost will always be less than or equal to short run cost. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

33. Envelope Relationship • In the short run the firm faces an additional constraint – all expansion must proceed using only the variable input. • These additional constraints increase cost. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

34. Envelope Relationship • The envelope relationship explains that: • At the planned output level, short run average total cost equals long run average total cost. • At all other levels of output, short run average total cost is higher than long run average total cost. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

35. LRATC SRATC4 SRATC1 SRMC1 Costs per unit SRMC2 SRMC4 SRATC2 SRATC3 SRMC3 0 Q* Quantity Envelope of Short Run Average Total Cost Curves © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

36. Industry with Strong Economies of Scale © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

37. Entrepreneurial Activity and the Supply Decision • Profit is what underlies the dynamics of production in a market economy. • The expected price must exceed the opportunity cost of supplying the good for a good to be supplied. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

38. Entrepreneurial Activity and the Supply Decision • The greater the difference between price and average total cost, the greater the entrepreneur’s incentive to tackle the organizational problems and supply the good. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

39. Entrepreneurial Activity and the Supply Decision • An entrepreneuris an individual who sees an opportunity to sell an item at a price higher than the average cost of producing it. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

40. Entrepreneurial Activity and the Supply Decision • Entrepreneurs organize production. • They visualize the demand and convince the individuals who own the factors of production that they want to produce those goods. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

41. Using Cost Analysis in the Real World • Some of the problems of using cost analysis in the real world include the following: • Economies of scope. • Learning by doing and technological change. • Many dimensions. • Unmeasured costs. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

42. Economies of Scope • The cost of production of one product often depends on what other products a firm is producing. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

43. Economies of Scope • There are economies of scope in production when the costs of producing goods are interdependent so that it is less costly for a firm to produce one good when it is already producing another. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

44. Economies of Scope • Firms look for both economies of scope and economies of scale. • Economies of scope play an important role in firms’ decisions of what combination of goods to produce. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

45. Economies of Scope • Globalization has made economies of scope even more important to firms in their production decisions. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

46. Learning by Doing and Technological Change • Production techniques available to real-world firms are constantly changing because of learning by doing and technological change. • These changes occur over time and cannot be accurately predicted. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

47. Learning by Doing and Technological Change • Learning by doing means that as we do something, we learn what works and doesn’t, and over time we become more proficient at it. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

48. Learning by Doing and Technological Change • The concept of learning by doing emphasizes the importance of the past effort in developing cost advantages. • Many firms estimate worker productivity to grow 1 to 2 percent a year because of learning by doing. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

49. Learning by Doing and Technological Change • External economies are present in all industries – those are the external forces at work which are capable of reducing costs for all firms belonging to the industry © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

50. Learning by Doing and Technological Change • Technological change is an increase in the range of production techniques that provides new ways of producing goods. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.