Long Run Production and Costs Economies of Scale Long Run Production and Costs

In the Long Run In the long-run “But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” John Maynard Keynes, 1936

Long Run Costs Economies of scale are not relevant in the short run production function Economies of scale are the cost advantages that a business can exploit by expanding their scale of production in the long run. The effect of economies of scale is to reduce the long run average costs of production over a range of output.

Long Run Returns to Scale Long Run Output (Units) Total Costs (£s) Long Run Average Cost (£ per unit) 1000 12000 12 2000 20000 10 5000 45000 9 10000 80000 8 144000 7.2 50000 330000 6.6 100000 640000 6.4 500000 3000000 6

Returns to Scale – Work out the total cost for each scale of production Factor Inputs Production Costs (K) (La) (L) (Q) (TC) (TC/Q) Capital Land Labour Output Total Cost Average Cost Scale A 5 3 4 100 Scale B 10 6 8 300 Scale C 15 9 12 500 Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200

Now calculate average cost for each scale Factor Inputs Production Costs (K) (La) (L) (Q) (TC) (TC/Q) Capital Land Labour Output Total Cost Average Cost Scale A 5 3 4 100 3256 Scale B 10 6 8 300 6512 Scale C 15 9 12 500 9768 Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200

Measuring the Returns to Scale Factor Inputs Production Costs (K) (La) (L) (Q) (TC) (TC/Q) Capital Land Labour Output Total Cost Average Cost Scale A 5 3 4 100 3256 32.6 Scale B 10 6 8 300 6512 21.7 Scale C 15 9 12 500 9768 19.5 Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200

The Long Run Average Cost Curve The LRAC curve or ‘envelope curve’ is drawn on the assumption of their being an infinite number of plant sizes – hence its smooth appearance If LRAC is falling when output is increasing then the firm is experiencing economies of scale When LRAC rises, the firm experiences diseconomies of scale If LRAC is constant, then the firm is experiencing constant returns to scale

Drawing the Long Run Average Cost Curve Cost per unit AC1 AC2 AC3 Output

Drawing the Long Run Average Cost Curve Cost per unit AC1 AC2 AC3 LRAC Output

Drawing the Long Run Average Cost Curve Cost per unit AC1 AC2 AC3 LRAC Q1 Q2 Q3 Output

The LRAC as a cost boundary Cost per unit Attainable costs per unit LRAC Output

Cost advantages of economies of scale AC1 AC2 AC3

Scale economies – higher output MC1 AC1 AC2 AC3

Scale economies – higher output MC1 AC1 AC2 AC3 MC3

Scale economies – higher output MC1 AC1 AC2 AC3 MC3 AR MR

Scale economies – higher output MC1 AC1 AC2 AC3 MC3 AR MR

Scale economies – higher output MC1 AC1 AC2 AC3 MC3 AR MR

Scale economies – higher profit MC1 AC1 AC2 AC3 MC3 AR MR

Internal Economies of Scale Internal economies of scale arise from the internal growth of a business as it expands the scale of its operations External economies of scale result from the expansion of the industry as a whole of which the business is a member

Technical Economies of Scale Expensive capital inputs: Large-scale businesses can afford to invest in expensive and specialist capital machinery Specialisation of the workforce: Within larger firms there is the possibility of splitting complex production processes into separate tasks to boost factor productivity The law of increased dimensions or the “container principle Learning by doing: The unit (average) costs of production typically decline in real terms as a result of production experience

Exploiting Size and Scale

The container principle

Scale economies in printing Advances in printing technology and the use of huge printing presses have driven down the costs of publishing Print on demand increases the elasticity of supply for many publishing businesses

Marketing Economies of Scale A large firm can spread its advertising and marketing budget over a much larger output It can purchase its factor inputs in bulk at negotiated discounted prices if it has monopsony (buying) power in the market

Managerial Economies of Scale This is a form of division of labour For example, large-scale manufacturers employ specialists to supervise production systems Increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication

Financial Economies of Scale Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and have access to credit facilities, with favourable rates of borrowing Businesses quoted on the stock market can normally raise fresh money (extra financial capital) more cheaply through the sale (issue) of equities to the capital market Larger companies are also likely to pay a lower rate of interest on new company bonds because of a better credit rating.

Learning economies Learning reduces unit cost (LRAC) through the benefits of industry experience Businesses learn through experience the most productive processes Workers may become more adapt at their job and their speed increases. Managers learn to schedule the production process more effectively. Engineers improve design tolerances and learn to develop better and more specialised tools and plant organisation. Suppliers learn how to process materials required more effectively

Learning Economies B LRAC1 Economies of Scale Cost (per unit of output) LRAC1 B Economies of Scale Output

Learning Economies A B LRAC1 C LRAC2 Economies of Scale Learning Cost (per unit of output) LRAC1 B Economies of Scale LRAC2 Learning economies C A Output

Network Economies of Scale Some networks and services have huge potential for economies of scale As they are more widely used (or adopted), they become more valuable to the business that provides them The classic examples are the expansion of a common language, a common currency, online auctions and air transport networks The marginal cost of adding one more user to the network is close to zero, but the resulting financial benefits may be huge

Network economies in aviation Consider a long haul flight from Sydney to London or Amsterdam Virtually every city in Europe is just a short connecting flight away Networks allow consumers to move quickly between many different centres of population Network economies also important for producers – their production and distribution systems need to be in easy reach of both their suppliers and their customers

Single routes 5 Aircraft A B C D E F G H I J 5 Routes

5 Aircraft – 55 connections B J C I D H E G F 55 Connections

2 Networks and an Alliance 2 Networks / Alliances A B C D E F G H I J A B C D E F G H I J = 210 Connections

The Minimum Efficient Scale The minimum efficient scale (MES) is the long run output where a business fully exploits the available internal economies of scale It corresponds to the minimum point of the long run average total cost curve This is also the output where a business achieves productive efficiency The minimum efficient scale will vary from industry to industry

External Economies of Scale When the long-term expansion of an industry leads to the development of ancillary services which benefit all or the majority of suppliers in the industry A labour force skilled in the crafts of the industry Components suppliers re-locate close to production centres – reducing transportation costs Concentration of the food processing industry around ports Trade magazines in which all firms can advertise cheaply and disseminate information Development research capabilities in local universities External economies partially explain the tendency for firms to cluster geographically

Economies of Scope Economies of scope occur where it is cheaper to produce a range of products rather than specialize in just a handful of products. A company’s management structure, administration systems and marketing departments are capable of carrying out these functions for more than one product Expanding the product range to exploit the value of existing brands is a good way of exploiting economies of scope.

Different shaped LRAC curves U-Shaped LAC: average costs decline over low levels of output, but increase at higher levels of output LRAC2 LRAC1 L-Shaped LAC: Average costs declining over all levels of output. Output

Causes of Diseconomies Control – costs and limitations of monitoring productivity and the quality of output from thousands of employees in big corporations – possible stakeholder conflicts Co-ordination - difficult to co-ordinate complicated production processes across several plants in different locations and countries Co-operation - workers in large firms may feel a sense of alienation and subsequent loss of morale. Possible failures of human resource management