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Lecture notes

Lecture notes. Prepared by Anton Ljutic. CHAPTER SEVEN. Costs in the Long Run. This Chapter Will Enable You to:. Distinguish between the short run and the long run Understand what happens to a firm’s output when it increases its inputs

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Lecture notes

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  1. Lecture notes Prepared by Anton Ljutic

  2. CHAPTER SEVEN Costs in the Long Run

  3. This Chapter Will Enable You to: • Distinguish between the short run and the long run • Understand what happens to a firm’s output when it increases its inputs • Understand why big firms can enjoy great advantages yet small firms can also be successful • Understand why firms can sometimes be too big • Explain what is meant by the right size of firm • Explain why markets can sometimes be too small

  4. Short Run Versus the Long Run (I) • Short run • A period of time in which at least one factor of production is fixed • All production processes operate in the short run • Diminishing marginal productivity is an unavoidable reality

  5. Short Run Versus the Long Run (II) • Long run • The period of time during which all inputs are variable • Diminishing marginal productivity does not apply • A firm can plan in the long run • Long-run average cost curve • A graphical representation of the per unit costs of production in the long run

  6. Constant Returns to Scale • The situation in which a firm’s output increases by the same percentage as the increase in its inputs • This term is used only in the long run • These conditions result in a horizontal long-run average cost curve

  7. Economies of Scale • The situation in which a firm’s output increases by a greater percentage than do its inputs • These conditions result in a decreasing long-run average cost curve • Firms in industries characterized by assembly-line production usually experience increasing returns to scale

  8. Economies of Scale • Cost advantages achieved as a result of large-scale operations (division of labour and specialization) • Technical Economies Of Scale, also referred to as increasing returns to scale • Pecuniary economies of scale • Cost of borrowing is cheaper • High-volume firms may buy inputs in bulk • Previously wasted products can be sold • Advantages in marketing and advertising

  9. LRAC Under Economies of Scale Costs Plant 1 AC1 Plant 2 AC2 Plant 3 AC3 LRAC Figure 7.2 Q1 Q2 Q3 Output/day

  10. Diseconomies of Scale • The situation in which a firm’s output increases by a smaller percentage than its inputs • These conditions result in a rising long-run average cost curve • What causes decreasing returns to scale? • Diseconomies of scale • Bureaucratic inefficiencies in management that result in decreasing returns to scale

  11. Changes in Short and Long-Run Costs • A decrease in input prices • would shift both the short-run and long-run average cost curves downward • Technological improvement • Changes in production techniques that reduce the costs of production • This would also shift both the short-run and long-run average cost curves downward

  12. The Complete Long Run Average Cost Curve Figure 7.4 • Economies of scale for output levels up to Q1. • Constant returns to scale between Q1 and Q2 • Diseconomies of scale for output levels above Q2 Costs LRAC Q1 Q2 Output

  13. What is the Right Size of the Firm (I)? • Is bigger better? • It depends on the industry in question • Appropriately sized firms are able to take advantage of any economies of scale that exist without becoming too big and experiencing diseconomies of scale

  14. Three Possible LRAC Curves A C • A: the firm • would have to be very large. • B: a variety of firm sizes • would be appropriate. • C: only small firms would be appropriate Costs LRAC LRAC . Q Q B LRAC Costs Figure 7.5 Q

  15. What is The Right Size of the Firm (II)? • Can a market be too small? • Minimum efficient scale (MES) • The smallest size plant capable of achieving the lowest long-run average cost of production • The Canadian economy has historically had difficulty achieving minimum efficient scale

  16. Minimum Efficient Scale (MES) • If a small market limits the firm’s output to Q1, then Plant 1 is not able to achieve MES. • A large market that allowed an output of Q2, and thus Plant 2, would enable the firm to achieve its MES. Costs AC1 Plant 1 AC2 AC1 Plant 2 LRAC AC2 Q2 Q1 Figure 7.6

  17. Are the Advantages of Scale Changing ? • Does new technology alter the scale of the firm that uses it? • As production becomes more customized and computers become more sophisticated, will efficient production mean smaller firms? • Are huge corporations finding it cheaper to farm out work to lower-cost specialists? • There is no definitive answer to these questions

  18. Chapter Summary: What to Study and Remember • Distinguish between the short run and the long run • Understand what happens to a firm’s output when it increases its inputs • Understand why big firms can enjoy great advantages yet small firms can also be successful • Understand why firms can sometimes be too big • Explain what is meant by the right size of firm • Explain why markets can sometimes be too small

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