Lecture 6 - Production & Cost in the Long Run

1. Lecture 6 - Production & Cost in the Long Run • What is long run Production???? • What is an isoquant????

2. Production & Cost in the Long Run • What are the characteristics of an isoquant??? • Represents different combinations of K & L for producing different outputs • What is Marginal Rate of Technical Substitution????

3. Production & Cost in the Long Run • What is the relationship between MRTS & MP???? • MRTS = - ΔK = MPL = w ΔL MPK r • MPL = w MPK r

4. Production & Cost in the Long Run • MPL = MPK w r • Principle to produce a given level of output at the lowest cost when 2 input K & L are variable and respectively prices of the inputs w & r

5. Output maximization for a given level of cost • Principle In the case of 2 variable inputs K & L the manager of the firm maximises output for a given number of cost by using L & K such that MRTS = w/r. Refer to graph Fig 9.5 Page 204

6. Optimization and Cost • What is the expansion path????? • Refer o fig 9.6

7. Optimization and Cost • What is constant returns to scale??? • What is increasing returns to scale??? • What is decreasing returns to scale???

8. Long Run Costs • What is LR cost or LAC???? • What is LR marginal cost or LMC????

9. Economies of Scale • The advantages of large scale production that result in lower unit (average) costs (cost per unit) • AC = TC / Q • Economies of scale – spreads total costs over a greater range of output

10. Economies of Scale • Internal – advantages that arise as a result of the growth of the firm • Technical • Commercial • Financial • Managerial • Risk Bearing

11. Economies of Scale • External economies of scale – the advantages firms can gain as a result of the growth of the industry – normally associated with a particular area • Supply of skilled labour • Reputation • Local knowledge and skills • Infrastructure • Training facilities

12. Economies of Scale • Assume each unit of capital = £5, Land = £8 and Labour = £2 • Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility • What happens and why?

13. Economies of Scale • Doubling the scale of production (a rise of 100%) has led to an increase in output of 200% - therefore cost of production • PER UNIT has fallen • Don’t get confused between Total Cost and Average Cost • Overall ‘costs’ will rise but unit costscan fall • Why?

14. Economies of Scale • Internal: Technical • Specialisation– large organisations can employ specialised labour • Indivisibility of plant– machines can’t be broken down to do smaller jobs! • Principle of multiples– firms using more than one machine of different capacities - more efficient • Increased dimensions– bigger containers can reduce average cost

15. Economies of Scale • Indivisibility of Plant: • Not viable to produce products like oil, chemicals on small scale – need large amounts of capital • Agriculture – machinery appropriate for large scale work – combines, etc.

16. Economies of Scale • Principle of Multiples: • Some production processes need more than one machine • Different capacities • May need more than one machine to be fully efficient

17. Economies of Scale • Principle of Multiples: e.g. Company A = 1 of each machine, output per hour = 10 Total Cost = £500 AC = £50 per unit Company B = 6 x A, 3 x B, 4 x C, 2 x D – output per hour = 60 Total Cost = £1750 AC = £29.16 per unit

18. Economies of Scale Increased Dimensions: e.g. Transport container = Volume of 20m3 Total Cost: Construction, driver, fuel, maintenance, insurance, road tax = £600 per journey AC = £30m3 2m 2m 5m Total Cost = £1800 per journey AC = £11.25m3 4m 4m 10m Transport Container 2 = Volume 160m3

19. Economies of Scale • Commercial • Large firms can negotiate favourable prices as a result of buying in bulk • Large firms may have advantages in keeping prices higher because of their market power

20. Economies of Scale • Financial • Large firms able to negotiate cheaper finance deals • Large firms able to be more flexible about finance – share options, rights issues, etc. • Large firms able to utilise skills of merchant banks to arrange finance

21. Economies of Scale • Managerial • Use of specialists – accountants, marketing, lawyers, production, human resources, etc.

22. Economies of Scale • Risk Bearing • Diversification • Markets across regions/countries • Product ranges • R&D

23. Economies of Scale Minimum Efficient Scale – the point at which the increase in the scale of production yields no significant unit cost benefits Minimum Efficient Plant Size – the point where increasing the scale of production of an individual plant within the industry yields no significant unit cost benefits

24. Economies of Scale Unit Cost Scale A 82p Scale B 54p LRAC MES Output

25. Diseconomies of Scale • The disadvantages of large scale production that can lead to increasing average costs • Problems of management • Maintaining effective communication • Co-ordinating activities – often across the globe! • De-motivation and alienation of staff • Divorce of ownership and control

26. Long run costs • What are economies of scope???

27. Summary • In the long run inputs are variable. • Isoquants show all possible combinations of labor and capital capable of producing a given level of output. • Isoquants are downward sloping reflecting if larger amounts of labor are used less capital is required to produce same output.

28. Summary • MRTS is the absolute value of the slope of an isoquant and measures the rate at which the 2 inputs can be substituted for one another while maintaining a constant level of output • MRTS = - ΔK = MPL ΔL MPK

29. Summary • Isocost curves the various combinations of inputs that maybe purchased for a given dollar output. • The slope of the isocost is (-w/r) • A manager minimizes the total cost of producing a given level of output by choosing an input combination at point of tangency between isocost and isocurve.

30. Summary • Optimization condition slopes of isocosts and isoquants • MPL = MPK w r • The expansion path shows equilibrium input combination for every level of output.

31. Summary • All points on the expansion path are both cost minimising and output maxising combinations of K & L • LMC lies LAC over range for which LAC is decreasing and vice versa. • When LAC is decreasing there is economies of scale

32. Summary • When LAC is increasing there is diseconomies of scale • LAC gives the lowest possible unit cost of producing various outputs because in the LR all outputs are variable or adjusted optimally.