Production and Cost Analysis:
Part II
Chapter 10
Making Long-Run Production
Decisions
• To make their long-run decisions, firms
look at costs of various inputs and the
technologies available for combining
these inputs, and then decide which
combination offers the lowest cost.
Making Long-Run Production
Decisions
• The firm makes long-run decisions on the
basis of the expected costs, and
expected usefulness, of inputs.
Technical Efficiency and
Economic Efficiency
• Technical efficiency is a situation in
which as few inputs as possible are used
to produce a given output.
• Technical efficiency is efficiency that
does not consider cost of inputs.
Technical Efficiency and
Economic Efficiency
• The economically efficient method of
production is that method that produces
a given level of output at the lowest
possible cost.
• It is the least-cost technically
efficient process.
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 in the long
run.
Determinants of the Shape of
the Long-Run Cost Curve
• The shape of the long-run cost curve is
due to the existence of economies and
diseconomies of scale.
A Typical Long-Run Average
Total Cost Table
Total Costs
Quantity of Labor
11
12
13
14
15
16
17
18
19
20
$381
390
402
420
450
480
510
549
600
666
Total Cost Total Costs = Average Total
of Machines TCL + TCM Costs = TC/Q
$254
260
268
280
300
320
340
366
400
444
$635
650
670
700
750
800
850
915
1,000
1,110
$58
54
52
50
50
50
50
51
53
56
A Typical Long-Run Average
Total Cost Curve
Costs per unit
$64
62
60
58
56
54
52
50
48
Average
total cost
Minimum efficient
level of production
11 12 13 14 15 16 17 18 19 20 Quantity
Economies of Scale
• There are economies of scale in
production when the per-unit output cost
decreases as output increases when all
inputs are changeable.
• In real-world production processes,
economies of scale are extremely
important at low levels of production.
Economies of Scale
• An indivisible setup cost is the cost of an
indivisible input for which a certain
minimum amount of production must be
undertaken before the input becomes
economically feasible to use.
Economies of Scale
• Indivisible setup costs create many realworld economies of scale.
• The cost of a blast furnace or an oil
refinery is an example of an
indivisible setup cost.
Economies of Scale
• Because of the importance of economies
of scale, business people often talk of a
minimum efficient level of production.
Economies of Scale
• The minimum efficient level of
production is the amount of production
that spreads setup costs out sufficiently
for firms to undertake production
profitably.
Economies of Scale
• The minimum efficient level of production
will be at the beginning of the constant
returns portion of the average cost
curve—where average total costs are at a
minimum.
Economies of Scale
• The minimum efficient level 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.
Diseconomies of Scale
• Diminishing marginal productivity refers
to the decline in productivity caused by
increasing units of a variable input being
added to a fixed input.
Diseconomies of Scale
• Diseconomies of scale refer to
decreases in productivity which occur
when there are equal increases of all
inputs (no input is fixed).
– Diseconomies of scale occur on the right
side of the graph of the long-run
average cost curve where it is upward
sloping, meaning that average cost is
increasing.
Diseconomies of Scale
• As the size of the firm increases,
monitoring costs generally increase.
• Monitoring costs are those incurred
by the organizer of production in
seeing to it that the employees do
what they are supposed to do.
Diseconomies of Scale
• Loss of team spirit can contribute to
diseconomies of scale.
• As the size of the firm increases,
team spirit or morale generally
decreases.
• Team spirit is the feelings of
friendship and being part of a team
that brings out peoples’ best effort
Constant Returns to Scale
• Constant returns to scale is where longrun average total costs do not change as
output increases.
• It is shown by the flat portion of the
LRATC curve.
Economies and Diseconomies of
Scale
Costs per unit
$64
62
60
58
56
54
52
50
48
Economies
of Scale
Constant
returns
to Scale
Diseconomies
of Scale
Average
total cost
11 12 13 14 15 16 17 18 19 20 Quantity
Importance of Economies and
Diseconomies of Scale
• Economies and diseconomies of scale play
important roles in real-world long-run
production decisions.
Importance of Economies and
Diseconomies 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.
Importance of Economies and
Diseconomies of Scale
• Economies and diseconomies of scale
account for the shape of the long-run
total cost curve.
Importance of Economies and
Diseconomies of Scale
• The assumption of 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 cost curve.
The 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.
The Envelope Relationship
• In the short run the firm faces an
additional constraint: all expansion must
proceed using only the variable input.
• These additional constraints increase
cost.
The 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 longrun average total cost.
Envelope of Short-Run Average
Total Cost Curves
Costs per unit
LRATC
0
SRMC1
SRATC4
SRATC1
SRMC2
SRMC4
SRATC2 SRATC3
SRMC3
Q2
Q3
Quantity
Entrepreneurial Activity and
the Supply Decision
• Profit is what underlies the dynamics of
production in a market economy.
• The expected profit per unit must exceed
the opportunity cost of supplying the
good for a good to be supplied.
Entrepreneurial Activity and
the Supply Decision
• The supplier’s expected economic profit
per unit is the difference between the
expected price of a good and the
expected average total cost of producing
it.
Entrepreneurial Activity and
the Supply Decision
• Cost curves do not become supply curves
through some magic process.
• To move from cost to supply,
entrepreneurial initiative is required.
Entrepreneurial Activity and
the Supply Decision
• An entrepreneur is an individual who see
an opportunity to sell an item at a price
higher than the average cost of producing
it.
Entrepreneurial Activity and
the Supply Decision
• Entrepreneurs organize production.
• They are the ones who visualizes the
demand and convinces the individuals
who own the factors of production
that they want to produce those
goods.
Entrepreneurial Activity and
the Supply Decision
• The entrepreneur also must convince
demanders that what the entrepreneur is
producing is what the demanders want.
Entrepreneurial Activity and
the Supply Decision
• Without entrepreneurs there would be
little supply because there would be no
one to recognize and act on demand
potential.
Entrepreneurial Activity and
the Supply Decision
• By allowing entrepreneurs to earn profit,
market economies encourage people to
channel their drive into supplying material
goods.
Entrepreneurial Activity and
the Supply Decision
• Cost enters into these decisions as a
cutoff since entrepreneurs who do not
cover their costs generally do not stay in
business.
Entrepreneurial Activity and
the Supply Decision
• The greater the difference between
price and average total cost, the greater
the entrepreneur’s incentive to tackle the
organizational problems and supply the
good.
Using Cost Analysis in the Real
World
• Some of the problems of using cost
analysis in the real world include the
following:
–
–
–
–
Economies of scope
Learning by doing and technological change
Many dimensions
Unmeasured costs
Economies of Scope
• The cost of production of one product
often depends on what other products a
firm is producing.
Economies of Scope
• There are economies of scope when the
costs of producing goods are
interdependent so that it is less costly
for a firm to produce one good when it is
already producing another.
Economies of Scope
• Firms look for both economies of scope
and economies of scale.
• Economies of scope play an important
role in firms’ decisions of what
combination of goods to produce.
Economies of Scope
• Globalization, by allowing firms to
segment the production process, has
made economies of scope even more
important to firms in their production
decisions.
Learning by Doing and
Technological Change
• Production techniques available to realworld firms are constantly changing
because of learning by doing and
technological change.
• These changes occur over time and
cannot be accurately predicted.
Learning by Doing and
Technological Change
• Learning by doing means that as we do
something, we learn what works and
doesn’t, and over time we become more
proficient at it.
Learning by Doing and
Technological Change
• The concept of learning by doing
emphasizes the importance of the past in
trying to predict performance.
• The experienced failed manager is
preferable to the rookie.
Learning by Doing and
Technological Change
• Many firms estimate worker productivity
to grow 1 to 2 percent a year because of
learning by doing.
Learning by Doing and
Technological Change
• Technological change is an increase in the
range of production techniques that
provides new ways to producing goods.
Learning by Doing and
Technological Change
• Technological change offers an increase
in the known range of production.
Learning by Doing and
Technological Change
• Whenever learning by doing or
technological change occurs, the cost
curve shifts down since the same output
can be produced at a lower cost.
Learning by Doing and
Technological Change
• In some industries such as the computer
business, technological change is
occurring so fast that it overwhelms all
other cost issues.
• Technological change occurs in lowtech businesses as well.
Learning by Doing and
Technological Change
• Moore's law states that the cost of
computing will fall by half every 18
months.
– As the price of computer chips falls,
other industries are affected as well.
Learning by Doing and
Technological Change
• In many businesses, the effect of
learning by doing and technological change
on prices is built into the firm's pricing
structure.
– Firms may price low in the expectation
of lower costs due to learning by doing
and technological change.
Many Dimensions
• Most decisions that firms make involve
more than one dimension.
• The only dimension in the standard model
is the level of output.
• Good economic decisions take all relevant
marginal costs and benefits into account.
Many Dimensions
• The important thing to remember in using
the standard model is the reasoning, not
the specific model.
Unmeasured Costs
• The relevant costs as defined by
economists are not the costs found in a
firm’s books.
• Economists include opportunity costs
while accountants use explicit costs that
can be measured.
Economists Include Opportunity
Cost
• Economists insists on including the
business owner’s opportunity cost.
• The business owner’s opportunity cost
includes forgone income that the owner
could have earned by spending his or her
time in another job.
Economic Versus Accounting
Depreciation
• Economic depreciation differs from
accounting depreciation.
Economic Versus Accounting
Depreciation
• In measuring the costs of depreciable
assets, accountants (and the IRS) insist
on using historical costs—what a
depreciable item costs in terms of money
actually spent for it—as the cost basis.
Economic Versus Accounting
Depreciation
• If the depreciable asset increased in
value, accountants would still use the
historical cost basis while an economist
would count its increased value as
revenue.
The Standard Model as a
Framework
• Despite its limitations, the standard
model provides a good framework for
cost analysis.
• It can be expanded to include real-world
complications.
Production and Cost Analysis:
Part II
End of Chapter 10