2. ©2001ClaudiaGarcia-Szekely1 Costs in the Long Run When the firm can expand or contract the plant size

3. 2 In the Long Run all inputs are variable There are no fixed costs in the long run. Firms PRODUCE in the short run Restricted by the size of the plant. Firms PLAN in the long run Any plant size is available. When firms are planning

4. ATC Plant 1 With this plant, we can produce any amount from zero units to 5,000. 5,000 The minimum ATC occurs at 2500 units 2,500 0 0 $2 12,000 5,000 $1 ATC Plant 2 With this plant, we can produce any amount from zero units to 12,000. The minimum ATC occurs at 5,000 units ATC Plant 3 With this plant, we can produce any amount from zero units to 15,000. 15,000 The minimum ATC occurs at 10,000 units 10,000 $0.5

5. In the long run firms choose a plant size… We identify the plant size with the Average Total Cost Curve. There is no single “best” plant size… Which plant is “best” depends on the volume of production.

6. 5 Building the Long Run Average Total Cost Curve (LRATC) Match the lowest SRATC with each output level The LRATC shows the minimum ATC for each output level.

7. SRATC1 To produce 100 units, ATC =$4 100 6 To produce 100 units, ATC =$6 SRATC2 SRATC3 To produce 100 units, ATC =$7 4 Plant1 has the lowest cost to produce 100 units: LRATC = $4 7 4 2 5.7 200 2 5.7 200 4 Plant 1 has the lowest ATC from Zero to Q 0 Q0Q0 Plant1 has the lowest cost to produce 200 units: LRATC = $2

8. SRATC1 To produce 300 units, the per unit cost using plant 1 is $3 300 2 To produce 300 units, the per unit cost using plant 2 is $2 SRATC2 SRATC3 To produce 300 units, the per unit cost using plant 3 is $3 33 1 5 2.5 400 5 2.5 400 1 Plant 2 has the lowest from Q 0 to Q 1 Q1Q1 SRATC2 has the lowest cost of producing 300 400 Q0Q0

9. SRATC2 SRATC3 Q1Q1 Q0Q0 SRATC2 has the lowest cost between Q 0 and Q 1 LRATC SRATC1 SRATC3 has the lowest cost above Q 1 SRATC1 has the lowest cost between 0 and Q 0 Long Run ATC 0

10. LRATC The LRATC is an envelope of SRATC curves 3 different plant sizes Each point of the LRATC tells you the lowest cost of producing a given output level when you can change the size of the plant

11. The larger the number of plant size options… The smoother the LRATC

12. Building the LRATC Plant 1 has lowest cost for volumes up to 400. Plant 2 has lowest cost between 400 and 900. Plant 3 has lowest cost above 900. LRATC Output

13. Building the LRATC OUTPUTPLANT 1PLANT 2PLANT 3 OUTPUTLRATC 100909699 10090 200849093 20084 300788487 30078 400727881 40072 500666078 50060 600725475 60054 700784872 70048 800844260 80042 900903657 90036 1000963027 100027 11001023621 110021 12001084215 120015 1300114489 13009 1400120543 14003 1500126606 15006

14. 13 Increasing Returns to Scale Economies of Scale ATC drops as Plant Size increase

15. Per unit costs decrease because Fixed costs are spread out over more units of output. Variable costs decrease with the use of mass production technologies which increase labor productivity. 14

16. 15 ATC = TC Q Q Double Inputs Four times as much output Four times as much output ATC decreases ATC decreases 2TC 4Q Double Costs 4 times Output 200 10 20 400 40 10 Economies of Scale: add more to the “bottom line” Q increase by 10% Costs increase by less than 10% Q increase by 20% Costs increase by less than 20% 20 10 40 10 Economies of Scale ATC

17. SRATC1 SRATC2 SRATC4 SRATC7 SRATC8 SRATC3 output LRATC SRATC5 SRATC6 Economies of scale or Increasing Returns to Scale $8 $7 $6 $5 $4 $3 $2 $1 Output increases by a larger percentage than costs Output increases by a larger percentage than costs ATC Drops

18. 17 Constant Returns to Scale The benefits of expanding the plant size eventually end.. Further expansion leaves per unit costs the same Output increases by the SAME percentage as costs.

19. 18 ATC = TC Q Q Double Inputs Twice as much output Twice as much output ATC Remains the same ATC Remains the same 2TC 2Q Double Costs Double Output 200 20 10 400 20 Constant Returns to Scale 20 10 20 ATC

20. 19 Constant Returns to Scale Horizontal LRATC As the plant size increase ATC remains the same ATC Q $2

21. 20

22. ATC = TC Q Q Twice as much output Twice as much output ATC increases 3TC 2Q Triple Costs 200 20 10 600 20 30 Diseconomies of to Scale 20 10 20 30 ATC Triple Inputs Double Output

23. SRATC1 SRATC2 SRATC4 SRATC3 SRATC7 SRATC8 SRATC6 output LRATC 3 1 2 4 SRATC5 As the plant size increase, per unit costs increase Diseconomies of scale

24. A typical LRATC Units of output LRATC ATC Constant Returns to Scale Diseconomies of Scale ATC decrease ATC same ATC Increase Economies of Scale

25. SRATC1 SRATC2 SRATC3 SRATC4 SRATC5 SRATC6 SRATC7 LRATC Increasing, Constant and Decreasing returns to scale

26. LRATC 25 OUTPUTLRATC 10090 20084 30078 40072 50060 60054 70048 80042 90036 100027 110021 120021 130021 140028 150037 160043 170050 Increasing Returns to scale Constant Returns to scale Decreasing Returns to scale

27. SMALLEST PLANT WITH LOWEST ATC IN THE LONG RUN Only firms with plants with the lowest cost will survive in the long run. 26 MINIMUM EFFICIENT SCALE (MES)

28. 500,000 SRATC1 SRATC2 SRATC3 SRATC4 SRATC5 SRATC6 SRATC7 LRATC Total Market Demand = 3,000,000 150,000 # of Firms = 3,000,000/500,000 = 6 firms each selling 500,000 # of Firms = 3,000,000/150,000 = 20 firms each one sells 150,000 10,000 # of Firms = 3,000,000/10,000 = 300 firms each sells 10,000 The smaller the size of the MES, the more competitive the industry is. The larger the size of the MES, the more concentrated the industry is. The smaller the size of the MES, the larger the number of firms MES