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Module 15

Module 15. Costs in the Long Run. 1. Objectives:. Define long run average cost. Objectives:. Define long run average cost. Understand how to construct the long run average cost curve. 3. Objectives:. Define long run average cost.

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Module 15

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  1. Module 15 Costs in the Long Run 1

  2. Objectives: Define long run average cost.

  3. Objectives: Define long run average cost. Understand how to construct the long run average cost curve. 3

  4. Objectives: Define long run average cost. Understand how to construct the long run average cost curve. Define the concept of returns to scale, and understand how it affects the shape of the long run average cost curve. 4

  5. Objectives: Define long run average cost. Understand how to construct the long run average cost curve. Define the concept of returns to scale, and understand how it affects the shape of the long run average cost curve. Define minimum efficient scale (MES) and be able to identify the MES on a graph. 5

  6. 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.

  7. 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. • The relevant cost in the long run is the total cost of production or average total cost (ATC) if we are interested in cost per unit. 7

  8. 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. • The relevant cost in the long run is the total cost of production or average total cost (ATC) if we are interested in cost per unit. • ATC or simply average cost (AC) is calculate by: Total Cost ÷ Quantity 8

  9. 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. • The relevant cost in the long run is the total cost of production or average total cost (ATC) if we are interested in cost per unit. • ATC or simply average cost (AC) is calculate by: Total Cost ÷ Quantity • The long 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. 9

  10. Objective 2 Understand how to construct a long run average cost curve • In the long run, a firm has much greater flexibility to meet its production needs. It can adjust all its inputs.

  11. Objective 2 Understand how to construct a long run average cost curve • In the long run, a firm has much greater flexibility to meet its production needs. It can adjust all its inputs. • Here, we will focus on variations in plant size. 11

  12. Objective 2 Understand how to construct a long run average cost curve • In the long run, a firm has much greater flexibility to meet its production needs. It can adjust all its inputs. • 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. 12

  13. Objective 2: …constructing a long run average cost curve • SRATC1represents the short run average total cost curve associated with a small plant.

  14. Objective 2: …constructing a long run average cost curve • SRATC1represents the short run average total cost curve associated with a small 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. 14

  15. Objective 2: …constructing a long run average cost curve • SRATC2represents the short run average total cost curve associated with a medium-sized plant. 15

  16. Objective 2: …constructing a long run average cost curve • SRATC3 is the short run average total cost curve associated with a large plant. 16

  17. Objective 2: …constructing a long run average cost curve • Which of the three plant sizes will Acme select?

  18. Objective 2: …constructing a long run average cost curve • Which of the three plant sizes will Acme select? • Well, that depends on the anticipated normal sustained rate of output per period. 18

  19. Objective 2: …constructing a long run average cost curve • Which of the three plant sizes will Acme select? • Well, that depends on the anticipated normal sustained rate of output per period. • If the expected rate of output per period is Q1 then it will select the small plant to achieve the lowest average cost. 19

  20. Objective 2: …constructing a long run average cost curve • If the expected rate of output per period is Q2 then it will select the medium-sized plant. 20

  21. Objective 2: …constructing a long run average cost curve • If the expected rate of output per period is Q3 then it will select the large plant. 21

  22. Objective 2: …constructing a long run average cost curve • The long run average cost curve is derived by tracing the points that represent the lowest per-unit cost for each level of output.

  23. Objective 2: …constructing a long run average cost curve • The long 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. 23

  24. Objective 2: …constructing a long run average cost curve 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 smooth LRAC curve like this.

  25. Objective 2: …constructing a long run average cost curve • The long 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. 25

  26. Objective 3 Define the concept of returns to scale and understand how it affects the shape of the long run average cost curve • The long run average cost curve is also U-shaped.

  27. Objective 3 Define the concept of returns to scale and understand how it affects the shape of the long run average cost curve • The long run average cost curve is also U-shaped. • The shape of the long run average cost curve derives from a concept called returns to scale, not from the law of diminishing marginal returns. 27

  28. Objective 3 Define the concept of returns to scale and understand how it affects the shape of the long run average cost curve • The long run average cost curve is also U-shaped. • The shape of the long run average cost curve derives from a concept called returns to scale, not from the law of diminishing marginal returns. • The law of diminishing marginal returns does not apply in the long run. 28

  29. Objective 3 Define the concept of returns to scale and understand how it affects the shape of the long run average cost curve • The long run average cost curve is also U-shaped. • The shape of the long run average cost curve derives from a concept called returns to scale, not from the law of diminishing marginal returns. • The law of diminishing marginal returns does not apply in the long run. • Returns to scale examines what happens to average cost when a firm changes its scale of operations. 29

  30. Objective 3: …the concept of 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 scale or economies of scale.

  31. Objective 3: …the concept of 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 scale or economies of scale. • When production displays economies of scale, its long run average cost falls as output increases and therefore, the long run average cost curve is downward sloping. 31

  32. Objective 3: …the concept of returns to scale • In many industries there is a wide range of output where long run average cost remains constant. We say that production displays constant returns to scale.

  33. Objective 3: …the concept of returns to scale • In many industries there is a wide range of output where long run average cost remains constant. We say that production displays constant returns to scale. • Constant returns to scale occur when long-run average costs are constant as output increases resulting in a horizontal long run average cost curve. 33

  34. Objective 3: …the concept of returns to scale • As firms continue to expand, they eventually experience diseconomies of scale or decreasing returns to scale.

  35. Objective 3: …the concept of returns to scale • As firms continue to expand, they eventually experience diseconomies of scale or decreasing returns to scale. • Diseconomies of scale occur when long-run average costs are rising as output is increasing. Thus, the long-run average cost curve slopes upwards. 35

  36. Objective 3: …the concept of returns to scale • As firms continue to expand, they eventually experience diseconomies of scale or decreasing returns to scale. • Diseconomies of scale occur when long-run average costs are rising as output is increasing. Thus, the long-run average cost curve slopes upwards. • One reason why diseconomies of scale arise is due to managerial inefficiency. 36

  37. Objective 4 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.

  38. Objective 4 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. • At the output level where economies of scale ends and constant returns to scale start, the firm encounters its minimum efficient scale. 38

  39. Objective 4: ….and be able to identify the minimum efficient scale on a graph. • The minimum efficient scale is denoted by “a” on the graph. 39

  40. Objective 4: ….and be able to identify the minimum efficient scale on a graph. • The minimum efficient scale is denoted by “a” on the graph. • The minimum efficient scale occurs at the lowest rate of output at which long run average cost is minimized.

  41. Objective 4: ….and be able to identify the minimum efficient scale on a graph. • The maximum efficient scale is denoted by “b” on the graph. 41

  42. Objective 4: ….and be able to identify the minimum efficient scale on a graph. • The maximum efficient scale is denoted by “b” on the graph. • The maximum efficient scale occurs at the highest rate of output at which long run average cost is minimized. 42

  43. Objective 4: ….and be able to identify the minimum efficient scale on a graph. • All firms with outputs between the minimum and maximum efficient scales have identical and minimal average costs. No such firm has a cost advantage over other such firms because of its size. 43

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