COSTS IN THE LONG RUN. Krzysztof Kołodziejczyk, PhD

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1 COSTS IN THE LONG RUN Krzysztof Kołodziejczyk, PhD

3 Agenda 1. Only variable costs 2. Looking for economies of scale 3. The minimum efficient scale (MES)

4 Costs keywords What are the types of costs in the long term? What does it mean to minimize the cost in the long term? What can be the returns from increasing the scale of production? What is the relationship between long-term costs and the structure of the markets?

5 Only variable costs - micro w theory no fixed production factors = no fixed costs (FC) o all production factors (incl. capital) are adjustable to the market changes in the long term, total costs (TC) = variable costs (VC)

6 Minimizing costs in the long run - micro in theory We set long run average cost (LRAC) looking at the short run average costs (SRAC)

7 Minimizing costs in the long run - micro in theory While in the short run firms are limited to operating on a single AC curve (corresponding to the level of FC they have chosen), in the long run when all costs are variable, they can choose to operate on any AC curve. Thus, the LRAC curve is actually based on a group of short run SRAC s curves, each of which represents one specific level of FC. The LRAC curve will be the least expensive SRAC curve for any level of output.

8 Minimizing costs in the long run - micro in theory Source: Figure shows how the LRAC curve is built from a group of SRAC curves. We ve got five SRAC curves on the diagram. Each SRAC curve represents a different level of fixed costs. For example, you can imagine SRAC1 as a small factory, SRAC2 as a medium factory, SRAC3 as a large factory, and SRAC4 and SRAC5 as very large and ultra-large.

9 Minimizing costs in the long run - micro in theory Although this diagram shows only five SRAC curves, presumably there are an infinite number of other SRAC curves between the ones that are shown. This group of SRAC curves can be thought of as representing different choices for a firm that is planning its level of investment in fixed cost physical capital knowing that different choices about capital investment in the present will cause it to end up with different SRAC curves in the future.

10 Minimizing costs in the long run - micro in theory If the firm plans to produce in the long run at an output of Q3, it should make the set of investments that will lead it to locate on SRAC3, which allows producing at the lowest cost. A firm that intends to produce Q3 would be foolish to choose the level of FC at SRAC2 or SRAC4. o At SRAC2 the level of FC is too low for producing Q3 at lowest possible cost, and producing Q3 would require adding a very high level of VC and make the AC very high. o At SRAC4, the level of FC is too high for producing Q3 at lowest possible cost, and again AC would be very high as a result. The shape of the long-run cost curve, as drawn in Figure, is fairly common for many industries.

11 Economies of scale - micro in theory LRAC determine the so-called production scale effects: o if long term AC decreases as production (scale of production) increases, then we can find so called economies of scale, o If long term AC grows as production (production scale) increases, then we can find diseconomies of scale, o If long term AC does not change as production increases (production scale), we can observe constant returns of scale.

12 Economies of scale - micro in theory Reasons for economies of scale: o indivisibility of the production process - the necessity of incurring a specific minimum of effort necessary to conduct business regardless of the size of production; o specialization - thanks to it it is possible to increase productivity resulting in economies of scale, while largescale production generally pays for better machines; o rule 2/3 - means that the costs of building a factory or constructing a machine increase by only 2/3 in relation to the value of production gain obtained on this account; o stochastic economies of scale - during management, the probability of deviations of various parameters from the norm decreases as production increases.

13 Economies of scale - micro in theory Reasons for diseconomies of scale: o as production increases, management problems arise - many levels of management, problems with the coordination of departments, bureaucracy; o the need to look for further markets; o possible problems with acquiring production factors - the emergence of so-called bottlenecks.

14 The minimum efficient scale (MES) - micro in theory Source: Minimum efficient scale (MES) corresponds to the lowest point on the long run average cost curve and is also known as an output range over which a business achieves productive efficiency.

15 The minimum efficient scale (MES) - micro in theory o MES is not a single output level more likely, the MES is a range of outputs where the firm achieves constant returns to scale and has reached the lowest feasible cost per unit. o MES depends on the nature of costs of production in a specific industry.

16 Applicating MES - micro in practice 1. MES answers the question of how many companies will fit on the market. It depends on the size of the market compared to the size of the minimum efficient scale. 2. in industries where the ratio of fixed to variable costs is high, there is scope for reducing AC by increasing the scale of output. This is likely to result in a concentrated market structure (an oligopoly, a duopoly or a monopoly). 3. if MES represents only a small % of market demand, there might be only limited opportunities for scale economies. It is likely that the market will be competitive with many suppliers able to achieve the MES. An example might be a large number of hotels in a city centre or a cluster of restaurants in a town.

17 Applicating MES - micro in practice Source:

18 Applicating MES - micro in practice INDUS TRY Refrigerators Cigarettes Beer brewing Petro le um refining Paints Shoes MES AS A PERCENTAGE OF U.S. CONS UMPTION 14.1 % SOURCE: F. M. Scherer, Alan Bechens tein, Erich Kaufer, and R. D. Murphy, The Economics of Multiplant Operation (Cambridge, Mas s.: Harvard Univers ity Pres s, 1975), p. 80.

19 Conclusion What a mess if you don't know MES ;-)

Edexcel (A) Economics A-level

Edexcel (A) Economics A-level Theme 3: Business Behaviour & the Labour Market 3.3 Revenue Costs and Profits 3.3.2 Costs Notes Formulae to calculate types of costs Total cost: This is how much it costs