Production and Cost

Analysis

To make their long run decisions:

Firms look at costs of various inputs and the
technologies available for combining these
inputs.
Then decide which combination offers the
lowest cost.

Long Run Production Decisions

2

Technical Efficiency and

Economic Efficiency

Technical efficiency as few inputs as

possible are used to produce a given output.

Economic efficiency the method

produces a given level of output at the
lowest possible cost.

It is the least-cost technically efficient

process.

Technical Efficiency and Economic

Efficiency
4

Long Run Cost Curve

The law of diminishing marginal

productivity does not hold in the
long run.

All inputs are variable in the long

run.

The shape of the long run cost curve is

due to the existence of economies and
diseconomies of scale.

Long Run Cost Curve

6

Costs per unit

$64
62
60
58
56
54
52
50
Typical
48

Average
total cost
Minimum efficient
level of production

Long Run Average Total

Cost Curve
11 12 13 14 15 16 17 18 19 20 Quantity
7

There are economies of scale in

production when the long run average
cost decreases as output increases.

Economies of scale (increasing returns to

scale) are cost savings associated with
larger scale of production.

Economies of Scale
8

Economies of Scale

In the longer run all inputs are

variable, so only economies of scale
can influence the shape of the long
run cost curve.

Economies of Scale

Economies of scale occur whenever

inputs do not need to be increased in
proportion to the increase in output.

As output increases, cost per unit

falls in the long run, so this can also
be seen as an increase in
productivity.
10

Economies of Scale

Doubling the inputs more than

doubles the output, when there are
economies of scale.

Firms can economize on

management cost, or they can take
advantage of specialized labour and
specialized capital.
11

Economies of Scale

Because of the importance of

economies of scale, business people
often talk of a minimum efficient
scale of production.

12

Minimum Efficient Scale

The minimum efficient scale of

production is the amount of
production that spreads setup costs
out sufficiently for firms to undertake
production profitably.

13

Minimum Efficient Scale

The minimum efficient scale (MES) of

production is reached once the size of the
market expands to a size large enough so
that firms can take advantage of all
economies of scale.

14

Typical Long Run Average

Total Cost Curve
Costs per unit
$64
Economies
62
of scale
60
58
56
54
52
50
48

Constant
returns
to scale

Diseconomies
of scale

Minimum efficient scale

of production

Long run
average
total cost

11 12 13 14 15 16 17 18 19 20 Quantity
15

Economies of Scale

The minimum efficient scale of

production will be at the beginning of
the constant returns portion of the
average cost curvewhere average
total costs are at a minimum.

16

Economies of Scale

The implication of economies of scale

is that in some industries firms must
be of a certain size to be able to
compete successfully.

17

Increasing returns to scale is where

long run average total costs fall as output
increases.

It is shown by the decreasing portion of

the LRAC curve.

Increasing Returns to Scale

(IRTS)
18

Constant returns to scale is where long

run average total costs do not change as
output increases.

It is shown by the flat portion of the LRAC

curve.

Constant Returns to Scale (CRTS)

19

Decreasing
returns
to
scale
or
diseconomies
of
scale
refer
to
decreases in productivity which occur
when there are equal increases of all
inputs.

Decreasing returns to scale occur where

the long run average cost curve is upward
sloping, meaning that average cost is
increasing.

Decreasing Returns to Scale

(DRTS)
20

Decreasing Returns to Scale

Diseconomies occur for a number of

reasons as the firm increases its size
Coordination of a large firm is more
difficult
Information costs and communication
costs increase as firm increases
Team spirit may decrease

21

Decreasing Returns to Scale

Team spirit is the feelings of friendship and

being part of a team that brings out peoples
best effort.

22

Returns to scale

Doubling inputs
results in:

Slope of the LRAC

Increasing returns to
scale (IRTS;
economies of scale)

Output more than

doubles.

downward

Constant returns to
scale (CRTS)

Output exactly
doubles.

horizontal

Decreasing returns to Output less than

scale (DRTS;
doubles.
diseconomies of
scale)

upward

Summary of Returns to Scale

23

Economies and Diseconomies of

Scale

Costs per unit

$64
62
60
58
56
54
52
50
48

Increasing
Returns to
Scale

Constant
returns
to Scale

Decreasing
Returns to
Scale
Long run
average
total cost

11 12 13 14 15 16 17 18 19 20 Quantity
24

Importance of Economies of
Scale

Economies and diseconomies of

scale play important roles in realworld long run production decisions.

25

Importance of Economies of
Scale

The long run and the short run

average cost curves have the same
U-shape, but the underlying causes
of these shapes differ.

26

Initially increasing and then eventually

diminishing marginal productivity (as a
variable input is added to a fixed input)
accounts for the shape of the short run
average cost curve.

Short Run Average Cost Curves

27

Long Run Average Cost Curve

Economies and diseconomies of

scale account for the shape of the
long run total cost curve.

28

Envelope Relationship

In the long run all inputs are flexible,

while in the short run some inputs
are not flexible.

As a result, long run cost will always

be less than or equal to short run
cost.

29

In the short run the firm faces an

additional constraint all expansion must
proceed using only the variable input.

These additional constraints increase cost.

Envelope Relationship
30

Envelope Relationship

The envelope relationship explains

that:
At the planned output level, short run
average total cost equals long run
average total cost.
At all other levels of output, short run
average total cost is higher than long run
average total cost.
31

Costs per unit

LRATC
SRMC1

SRATC4

SRATC1
SRMC2

SRMC4
SRATC2 SRATC3
SRMC3

Envelope of Short Run Average

0
Quantity
Total Cost CurvesQ*
32

Industry with Strong Economies of

Scale

33