Economics 111.3 Winter 14

Economics 111.3 Winter 14 March 12th, 2014 Lecture 22 Ch. 11: Output and costs

Test 3 • Friday, March 14th, 2014 • 8:30 – 9:20 Room 200 STM • Chapters to be tested: 9, 10 (up to p. 231) and 11(short-run costs only) • Format: Multiple-Choice Questions (MCQ): 30 questions – 100% of Test mark Time – 50 minutes

Substitution Effect and Income Effect • Budget line: PA QA+ PB QB = y Y is unchanged A A B B

A recap:

MCequals the increase in total cost divided by the increase in output.

b) “At the current output level, this factory is subject to diminishing returns. Therefore, the firm is operating along the upward-sloping portion of its short-run average total cost curve”.

Study question Consider a firm that experiences constant marginal returns. For example, the first worker is just as productive as the second, who is just as productive as the third, and so on. The same is true for all the firm’s inputs. Draw the firm’s short-run marginal cost curve.

A typical case:

An increase in a component of fixed costs shifts TFC, AFC, and TC upward but AVC, TVC, and MC remain unchanged. • An increase in a component of variable costs shifts TVC, AVC, TC, and MC upward but AFC and TFC remain unchanged. Shifts in the Cost Curves:

In the long run, the firm can vary both its use of labour and of capital. It will vary the use of both factors of production to maximize profits. As a result, long-run cost will always be less or equal to short-run cost. Long Run Cost

Firm Size & Costs ATC-4 ATC-3 ATC-1 ATC-2 ATC-5

The Long-Run Average Cost Curve • The segments of the short-run average total cost curves along which average total cost is the lowestmake up the long-run average total cost curve. • For every plant capacity size, there is a corresponding short-run ATC curve • It shows the least ATC at which any output can be produced after the firm has had time to make all appropriate adjustments in its plant size. • LRAC curve is the firms planning curve

The Long-run Cost Curve the number of possible plant sizes is virtually unlimited

Determinants of the Shape of the Long-Run Cost Curve The law of diminishing marginal productivity does not hold in the long run since all inputs are variable. The shape of the long-run cost curve results from the existence of economies and diseconomies of scale.

Economies of Scale • 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 are based on • labour specialization • managerial specialization • efficient capital • other factors, e.g., expected demand or “learning by doing”:learning by doing means that as we do something, we learn what works and what doesn’t, and over time we become more proficient at it

Economies of Scale and Increasing Returns to Scale • Increasing Returns to Scale occur whenever inputs do not need to be increased in proportion to the increase in output. • Or when a given percentage increase in all the firm’s inputs results in the firm’s output increasing by a larger percentage.

Constant Returns to Scale • Constant returns to scale (CRTS) occur where long-run average total costs do not change as output increases. • It is shown by the flat portion of the long run average total cost curve.

Diseconomies of Scale Diseconomies of scale or decreasing returns to scale refer to the increasing long run average costs as output increases. 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 Monitoring costs increase Team spirit may decrease

Diseconomies of scale in terms of firm’s technology are called

Summary of Returns to Scale

Economics 111.3 Winter 14