Production And Cost in the Long Run
• In the long run, costs behave differently
– Firm can adjust all of its inputs in any way it wants
• In the long run, there are no ___ inputs or ___ costs
– All inputs and all costs are ______
– Firm must decide what combination of inputs to use in
producing any level of output
• The firm’s goal is to ___________
– To do this, it must follow ______________
• To produce any given level of output the firm will choose the
input mix with the lowest cost
Different ways to wash 196 cars per day
Capital cost =$75 per day
Labor cost = $60 per unit per day
Method
Quantity of Quantity of Cost
Capital
Labor
A
0
9
B
1
6
C
2
4
D
3
3
Production And Cost in the Long
Run
• Long-run total cost
– The cost of producing each quantity of output when
the least-cost input mix is chosen in the long run
• Long-run average total cost
– The cost per unit of output in the long run, when all
inputs are variable
• The long-run average total cost (LRATC)
– Cost per unit of output in the long-run
LRTC
LRATC 
Q
Long-Run and Short-Run Costs for Spotless Car Wash
Output
TC($)
LRTC($)
0
30
90
130
161
184
196
250
300
75
135
195
255
315
375
435
0
100
195
255
315
360
390
650
1,200
LRATC($)
The Relationship Between LongRun And Short-Run Costs
• For some output levels, LRTC is ______ than
TC
• Long-run total cost of producing a given level of
output can be less than or equal to, but never
greater than, short-run total cost (LRTC ≤ TC)
• Long-run average cost of producing a given
level of output can be less than or equal to, but
never greater than, short–run average total cost
(LRATC ≤ ATC)
Average Cost And Plant Size
• Plant
– Collection of fixed inputs at a firm’s disposal
• Can distinguish between the long run and the short run
– In the long run, the firm can change the size of its plant
– In the short run, it is stuck with its current plant size
• ATC curve tells us how average cost behaves in the
short run, when the firm uses a plant of a given size
• To produce any level of output, it will always choose that
ATC curve—among all of the ATC curves available—that
enables it to produce at lowest possible average total
cost
– This insight tells us how we can graph the firm’s LRATC curve
Figure 7: Long-Run Average Total
Cost
Dollars
ATC1
$4.00
ATC0
ATC2
3.00
C
D
B
A
2.00
LRATC
ATC3
E
1.00
0
30
Use 0
automated
lines
90
130
161 184
175 196
Use 1
automated
lines
250
Use 2
automated
lines
300
Use 3
automated
lines
Units of Output
Graphing the LRATC Curve
• A firm’s LRATC curve combines portions of each
ATC curve available to firm in the long run
– For each output level, firm will always choose to
operate on the ATC curve with ________________
• In the short run, a firm can only move along its
current ATC curve
• However, in the long run it can move from one
ATC curve to another by varying the size of its
plant
– Will also be moving along its LRATC curve
Economics of Scale
• Economics of scale
– Long-run average total cost _____ as output
increases
• When an increase in output causes LRATC to
decrease, we say that the firm is enjoying
economics of scale
– The more output produced, the lower the cost per unit
• When long-run total cost rises proportionately
less than output, production is characterized by
economies of scale
– LRATC curve slopes ________
Figure 8: The Shape Of LRATC
Dollars
$4.00
3.00
LRATC
2.00
1.00
130
0
Economies of Scale
184
Constant
Returns to
Scale
Diseconomies of Scale
Units of Output
Gains From Specialization
• One reason for economies of scale is
gains from specialization
• The greatest opportunities for increased
specialization occur when a firm is
producing at a relatively low level of output
– With a relatively small plant and small
workforce
• Thus, economies of scale are more likely
to occur at lower levels of output
More Efficient Use of Lumpy Inputs
• Another explanation for economies of scale involves the
“lumpy” nature of many types of plant and equipment
– Some types of inputs cannot be increased in tiny increments, but
rather must be increased in large jumps
• Plant and equipment must be purchased in large lumps
– Low cost per unit is achieved only at high levels of output
• Making more efficient use of lumpy inputs will have more
impact on LRATC at low levels of output
– When these inputs make up a greater proportion of the firm’s
total costs
• At high levels of output, the impact is smaller
Diseconomies of Scale
• Long-run average total cost _______ as output
increases
• As output continues to increase, most firms will reach a
point where bigness begins to cause problems
– True even in the long run, when the firm is free to increase its
plant size as well as its workforce
• When long-run total cost rises more than in proportion to
output, there are diseconomies of scale
– LRATC curve slopes ________________
• While economies of scale are more likely at low levels of
output
– Diseconomies of scale are more likely at higher output levels
Constant Returns To Scale
• Long-run average total cost is ______ as output
increases
• When both output and long-run total cost rise by the
same proportion, production is characterized by constant
returns to scale
– LRATC curve is ___
• In sum, when we look at the behavior of LRATC, we
often expect a pattern like the following
– Economies of scale (decreasing LRATC) at relatively low levels
of output
– Constant returns to scale (constant LRATC) at some
intermediate levels of output
– Diseconomies of scale (increasing LRATC) at relatively high
levels of output
• This is why LRATC curves are typically U-shaped
Using the Theory: Long Run Costs,
Market Structure and Mergers
• The number of firms in a market is an
important aspect of market structure—a
general term for the environment in which
trading takes place
• What accounts for these differences in the
number of sellers in the market?
– Shape of the LRATC curve plays an important
role in the answer
LRATC and the Size of Firms
• The output level at which the LRATC first hits bottom is known as
the minimum efficient scale (MES) for the firm
– Lowest level of output at which it can achieve minimum cost per unit
• Can also determine the maximum possible total quantity demanded
by using market demand curve
• Applying these two curves—the LRATC for the typical firm, and the
demand curve for the entire market—to market structure
– When the MES is small relative to the maximum potential market
• Firms that are relatively small will have a cost advantage over relatively large
firms
• Market should be populated by many small firms, each producing for only a
tiny share of the market
LRATC and the Size of Firms
• There are significant economies of scale that continue as
output increases
– Even to the point where a typical firm is supplying the maximum
possible quantity demanded
• This market will gravitate naturally toward monopoly
• In some cases the MES occurs at 25% of the maximum
potential market
– In this type of market, expect to see a few large competitors
• There are significant lumpy inputs that create economies
of scale
– Until each firm has expanded to produce for a large share of the
market
Figure 9: How LRATC Helps
Explain Market Structure
LRATCTypical Firm
Dollars
F
$160
E
80
DMarket
0
1,000
3,000
100,000
Units per Month
Figure 9: How LRATC Helps
Explain Market Structure
LRATCTypical Firm
Dollars
$160
80
DMarket
0
100,000
Units per Month
Figure 9: How LRATC Helps
Explain Market Structure
Dollars
LRATCTypical Firm
H
$200
F
E
80
DMarket
0
25,000
100,000
Units per Month
Figure 9: How LRATC Helps
Explain Market Structure
LRATCTypical Firm
Dollars
$160
E
F
80
DMarket
0
1,000
10,000
100,000
Units per Month
LRATC and the Size of Firms
• The MES of the typical firm in this market
is 1,000 units
– Lowest output level at which it reaches
minimum cost per unit
– For firms in this market, diseconomies of
scale don’t set in until output exceeds 10,000
units
• Since both small and large firms can have
equally low average costs with neither
having any advantage over the other
– Firms of varying sizes can coexist
The Urge To Merge
• If by doubling their output, firms could slide down
the LRATC curve in Figure 9, and enjoy a
significant cost advantage over any other, stillsmaller firm, they would
– This is a market that is ripe for a merger wave
• A sudden merger wave is usually set off by
some change in the market
• Market structure in general—and mergers and
acquisitions in particular—raise many important
issues for public policy
– Low-cost production can benefit consumers—if it
results in lower prices