Production and Cost Analysis II

1. Production and Cost Analysis II Chapter 10

2. Making Long-Run Production Decisions • To make their long-run decisions, firms look at costs of various inputs and the various production technologies available for combining these inputs, and then decide which combination offers the lowest cost.

3. Technical Efficiency and Economic Efficiency • Technical efficiency means that the fewest possible inputs are used to produce a given output. • Technical efficiency is efficiency that does not consider costs of production.

4. Technical Efficiency and Economic Efficiency • The economically efficient method of production is the method that produces a given level of output at the lowest possible cost.

5. Determinants of the Shape of the Long-Run Cost Curve • The law of diminishing marginal productivity does not hold in the long run since all inputs are variable.

6. Determinants of the Shape of the Long-Run Cost Curve • The shape of the long-run cost curve results from the existence of economies and diseconomies of scale.

7. 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.

8. Economies of Scale • 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.

9. Economies of Scale • Indivisible setup costs are the source of many real-world economies of scale.

10. 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.

11. 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.

12. Total Costs of Labor Total Cost of Machines Total Costs = TCL + TCM Average Total Costs = TC/Q Quantity 11 12 13 14 15 16 17 18 19 20 $381 390 402 420 450 480 510 549 600 666 $254 260 268 280 300 320 340 366 400 444 $635 650 670 700 750 800 850 915 1,000 1,110 $58 54 52 50 50 50 50 51 53 56 A Typical Long-Run Average Total Cost Table, Fig. 10-1a, p 217

13. $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 A Typical Long-Run Average Total Cost Curve, Fig. 10-1b, p 217 Costs per unit Economies of scale Constant returns to scale Diseconomies of scale

14. Economies of Scale • The minimum efficient scale of production is the amount of production that spreads setup costs out sufficiently for firms to undertake production profitably.

15. 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.

16. 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.

17. Diseconomies of Scale • Diseconomies of scale or decreasing returns to scale refer to the increasing long run average costs as output increases.

18. Diseconomies of 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

19. Constant Returns to Scale • Constant returns to scale (CRTS) occur where long-run average total costs do not change as output increases. • It is shown by the flat portion of the long run average total cost curve.

20. Summary of Returns to Scale,Table 10-1, p 219

21. Importance of Economies and Diseconomies of Scale • Economies and diseconomies of scale play important roles in real-world long-run production decisions.

22. Importance of Economies and Diseconomies 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.

23. Importance of Economies and Diseconomies of Scale • Economies and diseconomies of scale account for the shape of the long-run total cost curve.

24. Importance of Economies and Diseconomies of Scale • The assumption of 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 cost curve.

25. The Envelope Relationship • In the long run all inputs are variable, while in the short run some inputs are fixed. • As a result, long-run cost will always be less than or equal to short-run cost.

26. LRAC SRAC4 SRAC1 SRMC1 SRMC2 SRMC4 SRAC2 SRAC3 SRMC3 0 Q1 Q2 Q3 Quantity Envelope of Short-Run Average Total Cost Curves,Fig.10-2, p 220 Costs per unit

27. Economies of Scope • Economies of scope play an important role in firms’ decisions of what combination of goods to produce.

28. Economies of Scope • Globalization, by allowing firms to segment the production process, has made economies of scope even more important to firms in their production decisions.

29. Production and Cost Analysis II End of Chapter 10