long run average total costs chapter 22

LONG-RUN AVERAGE

COSTCHAPTER 22

LONG-RUN COSTS

• Remember: All costs in the long run are variable!

• The behavior of long-run cost depends on the firm’s production function which is the relationship between the maximum output attainable and the quantities of both labor and capital.

DIMINISHING RETURNS

Diminishing returns occur at all the quantities of capital as the quantity of labor increases. The marginal product of labor eventually diminishes.

DIMINISHING PRODUCT OF CAPITAL

The marginal product of capital is the change in total output divided by the change in capital when the quantity of labor is constant (the change in output that results from a one unit increase in the quantity of capital)

TWO IMPORTANT THINGS:

1. Each short-run ATC curve is U-shaped.

2. For each short run ATC curve, the larger the plant, the greater is the output at which average total cost is a minimum.

LONG-RUN AVERAGE COST CURVE

The long-run average total cost curve is the relationship between the lowest attainable average total cost and output when both the plant size and labor are varied.

LONG-RUN AVERAGE COST CURVE

• The long-run ATC curve is a planning curve.

• It tells the firm the plant size and the quantity of labor to use at each output to minimize cost.

• Once the plant size is chosen, the firm operates on the short-run curves that apply to that plant size.

LONG-RUN AVERAGE COST CURVE

• The long-run ATC curve is a planning curve.

• It tells the firm the plant size and the quantity of labor to use at each output to minimize cost.

• Once the plant size is chosen, the firm operates on the short-run curves that apply to that plant size.

ECONOMIES OF SCALE

Economies of Scale result from features of a firm’s technology that lead to falling long-run average cost as output increases. The main source of economies of scales is greater specialization of both labor and capital.

ECONOMIES OF SCALE

With given input prices, economies of scale occur if the percentage increase in output exceeds the percentage increase in all inputs.

DISECONOMIES OF SCALEDiseconomies of Scale lead to rising long-run average cost as output increases. The main source of diseconomies of scale is the difficulty of managing a very large enterprise. The larger the firm, the greater the challenge of organizing it and the communicating both up and down the management levels and among managers. Eventually, management complexity brings rising average cost.

CONSTANT RETURNS TO SCALE

Constant returns to scale are features of a firm’s technology that lead to constant long-run average cost as output increases.

When constant returns to scale are present, LRAC curve is horizontal.

MINIMUM EFFICIENT SCALE

Minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level. A firm experiences economies of scale up to some output level. Beyond that level, it moves into constant returns to scale or to diseconomies of scale.The MES plays a role in determining market structure, as you will soon learn in the next three chapters…

EXAMPLE

We’ll do exercise 10 from your worksheet here in class together, in your notebook, and determine both graphically and algebraically, where Cathy encounters economies of scale!