Long Run Cost and Economies of Scale

1. Long Run Cost and Economies of Scale

2. Long run average total cost curve (LRATCC) • Shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output. • If there are many possible choices of fixed cost the long-run average total cost curve will have the U-shape.

3. Distinction between long and short run • In the long run a producer has had time to choose the fixed cost appropriate for its desired level of output, the producer will be at some point on the long-run average total cost curve. • If output level is altered, the firm will no longer be on the LRATCC and will instead be moving along its current short run average total cost curve. • It will not be on LRATCC until it readjusts its fixed costs for its new output level.

4. Returns to scale • What gives the LRATCC its shape? • It is the influence of scale (the size of a firm’s operations) on its long-run average total cost of production. • Firms that experience scale effects in production find that their long-run average total cost changes substantially depending on the quantity of output they produce.

5. Economies of Scale • When long-run average total cost declines as output increases

6. Increasing returns to scale • When output increase more than in proportion to an increase in all inputs • Diseconomies of scale • When long-run average total cost increases as output increase.

7. Decreasing returns to scale • When output increases less than in proportion to an increase in all inputs • Constant returns of scale • When output increases directly in proportion to an increase in all inputs.

8. Sunk Costs • When making decisions knowing what to ignore is important. • Sunk costs are costs that have already been incurred and are nonrecoverable. • They should be ignored in a decision about future actions.