Long run production and cost theory

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  • 1. Long-run production and cost theory
  • 2. Changing the scale of operations In the short-run, the level of production 1 small plant with can be changed within limits of the 60 workers can fixed factor/s of production (e.g. produce 300 capital). To break these limits, firms units per week. are able to increase the scale of their operations in the long-run by investing in fixed factors (e.g. building bigger factories). 1 medium sized plant with 80 workers can 1 large plant with produce 600 100 workers can units per week. produce 1000 units per week. Note how the output per worker increases as the plant size increases. This effect is known as increasing returns of scale.
  • 3. Returns to scale Increasing returns to scale is when an increase in the scale of the factors of production leads to a more than proportionate increase in output Constant returns to scale is when an increase in the scale of the factors of production leads to a proportionate increase in output Decreasing returns to scale is when an increase in the scale of the factors of production leads to a less than proportionate increase in output
  • 4. A U-shaped long-run average cost curve and its related short- run average cost curves Long-run costsCosts The shape of the LRAC curve SRATC7 SRATC1 LRAC As firms increase the scale of production and experience SRATC2 SRATC6 increasing returns to scale, so the average cost of SRATC3 SRATC5 production falls. However, Economies SRATC4 Dis-economies when the scale reaches a of scale of scale certain level there can be C1 decreasing returns therefore increasing average costs. The long-run average cost curve therefore is often 0 drawn as U-shaped. Q1 Output Economies and dis-economies The falling LRAC is due to economies of scale and the rising LRAC at higher levels of output are due to dis-economies of scale. Short-run curves along the LRAC curve At each point along the LRAC curve the short-run rules of production apply; costs fall due to the division of labour and falling AFC, then rise as diminishing marginal returns kick in. As the scale of production increases the long-run costs fall or increase, but the short-run curve still applies at each scale. It is important not to confuse the short-run reasons for changing costs with the long-run reasons.
  • 5. Economies and Dis-economiesTechnical economies of scale Dis-economies of scaleIncreasing returns to scale lead to economies of When the output of a firm increases it mayscale when the effect is translated into cost experience rising unit costs. This is often due totheory. This reason for falling unit costs is known what are known as managerial dis-economies ofas technical economies of scale. There are other scale.types of economies of scale apart from technicaleconomies. Managerial dis-economies occur as the firm gets larger and it becomes more difficult to manageThe main types of technical economies are: the complexity of the firm. Often, levels of hierarchy are introduced and different functionalIndivisibilities whereby there is a minimum parts of the firm are divided into departments.efficient scale for a piece of equipment Communication problems may increasingly result, both from the top to bottom of the hierarchy, andSpreading of R&D costs over higher production between the departments.levelsVolume economies which occur when theincreasing dimensions lead to proportionallyhigher volume increases. For example, a factoryof twice the height, width and length will have fourtimes the volume.Economies of massed resources e.g. fewerspare parts need to be held if multiple identicalmachines are run.
  • 6. Other LRAC curvesCosts Economies of small-scale production LRAC curves are not always U-shaped. Some firms experience the full economies of scale at LRAC quite a small scale. Personal services, such as hairdressing for instance, are typical examples. A wonky bowl-cut please Hairdressers benefit from bulk buying economies for things like shampoo at quite low 0 levels and experience managerial economies Output with a limited number of salons, perhaps as one manager oversees a few outlets. Chains of hairdressers will experience dis-economies early on as they need a head-office to oversee operations. If they wish to build a national reputation they will also incur marketing costs which a small, local hairdressers wouldnt incur. It is for these reasons that hairdressers are often small, local, independently-owned businesses. The exception which proves the rule is Tony and Guys which can only sustain its national operation by charging high prices as an up-market brand
  • 7. Other LRAC curvesCosts An L-shaped LRAC curve In some industries, such as manufacturing, there are significant economies of scale to be gained but not dis-economies (at least not at the scale of production required by the market). LRAC Driving down costs C1 Car manufacturing requires significant Minimum Efficient Scale investment in equipment and set-up costs are therefore very high. It is simply not cost- 0 Q1 Output effective to spend all that money to only produce a few cars. Large scale production is achievable through the use of technology, such as computer controlled robotics, and although expensive, the average cost falls rapidly as automation replaces labour and speeds up production. Economies can also be gained as firms source cheaper components internationally, or set up their own plants in countries where costs are low. Consumers also want cars which have a recognisable brand and large firms can benefit from mass- market advertising which, if the market is large, can be cost effective.
  • 8. Minimum Efficient Scale Minimum Efficient Scale (MES) is the term used to refer to theCosts quantity of output required to achieve the lowest average production cost. MES is often used to explain the reason for the number of firms in a market. If the MES is at a high level of output then a very large firm is required to produce at an efficient cost. Therefore, the market will likely sustain one (monopoly) or a few LRAC firms (oligopoly). Small firms attempting to enter the market will C1 Minimum Efficient Scale experience very high production costs and be unable to compete with the low unit costs, and therefore potentially low prices, of the 0 Q1 Output dominant, large firms in the market. Outsourcing It is not always cost effective for a firm to undertake all Why has outsourcing become more common? aspects of a production process itself. Firms may outsource (i.e. commission other firms to perform 1. Globalisation means firm can sell to, or buy certain parts of production) as it may be cheaper to buy from, firms across the globe due to improved travel from another firm because: and communication - the other firm may be able to achieve better 2. The removal of trade barriers economies of scale due to supplying a number of firms 3. Countries specialising in the production of certain goods - the firm may be specialists who innovate and adopt the latest practices and technology The UK has become so good at outsourcing that some firms just design and brand a good and - a national firm may take advantage of buying from a commission all the production to oversees firms. foreign firm with lower production costs
  • 9. 10 point summary • In the short-run the level of production can be varied, and in thelong-run the scale of production changed • As the scale of operations increases firms may experienceincreasing, constant or decreasing returns to scale• Increasing returns to scale are associated with decreasingaverage costs, known as economies of scale4. Decreasing returns to scale are associated with increasingaverage cost, known as dis-economies of scale5. The particular type of economies of scale associated with theLRAC curve are technical economies
  • 10. 10 point summary6.The particular type of dis-economies of scale associated with theLRAC curve is managerial dis-economies7.The long-run average cost curve is often depicted as bowl-shaped, with average costs falling due to economies, thenincreasing due to dis-economies8.The long-run average cost curve can also be drawn in differentways to depict the conditions in specific industries e.g. L-shaped,tick-shaped9.The minimum efficient scale is the level of output at which theminimum average cost of production is achieved in the long-run10.It is not always most efficient for a firm to undertake everystage of the production process; contracting out production isknown as outsourcing