1. Module 15 Costs in the Long Run 1

2. Objectives: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. 2

3. 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. relevant cost in the long run  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 long run average cost  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. 3

4.  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 sizes in the long run: (1) a small plant, (2) a medium-sized plant, and (3) a large plant. 4 Understand how to construct a long run average cost curve Understand how to construct a long run average cost curve Objective 2

5. 5  SRATC 1 represents 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. Objective 2: …constructing a long run average cost curve

6. 6  SRATC 2  SRATC 2 represents the short run average total cost curve associated with a medium-sized plant. Objective 2: …constructing a long run average cost curve

7. 7  SRATC 3 is the short run average total cost curve associated with a large plant. Objective 2: …constructing a long run average cost curve

8.  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 Q 1 then it will select the small plant to achieve the lowest average cost. 8 Objective 2: …constructing a long run average cost curve

9.  If the expected rate of output per period is Q 2 then it will select the medium-sized plant. 9 Objective 2: …constructing a long run average cost curve

10. 10 Objective 2: …constructing a long run average cost curve  If the expected rate of output per period is Q 3 then it will select the large plant.

11. 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. 11 Objective 2: …constructing a long run average cost curve

12. 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. 12 Objective 2: …constructing a long run average cost curve

13.  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. 13 Objective 2: …constructing a long run average cost curve

14. 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. 14 Objective 3

15. increasing returns to scaleeconomies of 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. average cost falls as output increases downward sloping.  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. 15 Objective 3: …the concept of returns to scale

16. constant 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. long-run average costs are constant as output increases horizontal  Constant returns to scale occur when long-run average costs are constant as output increases resulting in a horizontal long run average cost curve. 16 Objective 3: …the concept of returns to scale

17. diseconomies of scaledecreasing returns to scale  As firms continue to expand, they eventually experience diseconomies of scale or decreasing returns to scale. slopes upwards  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. 17 Objective 3: …the concept of returns to scale

18. 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. 18 Objective 4  At the output level where economies of scale ends and constant returns to scale start, the firm encounters its minimum efficient scale.

19.  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. 19 Objective 4: ….and be able to identify the minimum efficient scale on a graph.