The Theory of
Production
Production in the
Long Run (LR)
1
Lesson Objectives
• Understand the theory that explains the short
run
• Appreciate that different sized firms have
different levels of productive efficiency
• Understand the theory of long-run costs
• Appreciate the relationship between the short
run and the long run
2
Connector
What might the following terms mean?
•
•
•
•
•
•
•
•
•
•
Total costs
Fixed costs
Variable costs
Short run
Long run
Marginal Product
Average product
Increasing marginal returns
Diminishing marginal returns
Law of diminishing marginal
returns
•
•
•
•
•
•
•
•
Optimum output
Productive efficiency
Depreciation
Semi-variable costs
Average fixed cost
Average variable cost
Average total cost
Marginal cost
3
The Big Picture
• We will look at the costs of production faced by the
individual firm and we will analyse them in more depth
than you experienced at AS.
• We will look at marginal and average costs and
revenues and use numerical examples to explain firms’
behaviour.
• You will become aware of the diagrammatic presentation
of costs curves which we use at A2 and the effect of time
on the firms’ costs in terms of short-run and long-run
behaviour.
4
Big Picture
• To arrive at the learning outcomes you will do the
following:
• Listen to teacher demonstrations on PPP
• Draw graphs
• Watch VIDEO
• ‘Stretch and challenge’ Questions
• Group work
• Independent work
• Class discussion
• Debate economic issues
• Short presentation
• Demonstration on the board
• Pair marking
• Advise on examiner’s tip
5
Lesson Outcome
• Understand the difference between the short
and long run and the theories that underpin
them
• Be able to use short-run (SR) and long-run (LR)
concepts to answer questions
• Be able to explain the relationship between
average and marginal costs both in words and
graphically
• Understand the importance of firms achieving
the minimum efficient scale and what it implies.
6
Key Terms
•
•
•
•
•
•
Increasing returns to scale
Decreasing returns to scale
Constant returns to scale
Minimum efficient scale
Economies of scale
Diseconomies of scale
7
Production in the
Long Run (LR)
8
Production in the Long Run (LR)
• In the LR the firm can temporarily overcome the problem of
diminishing returns as it can vary its fixed factors.
• In the case of the furniture manufacturer it could move to
larger premises.
• But the problem of diminishing returns re-emerges as soon
as the fixed factor becomes overloaded, and though
specialisation can delay diminishing returns setting in, they
will eventually reappear as the firm increases output beyond
optimal output – the ideal combination of fixed and variable
factors
• The furniture manufacturer could move to larger premises.9
Production in the Long Run (LR)
• In Table 1.1 the ATC per unit
is at its lowest at 6 workers
where 60 units are produced
(ATC must be at its lowest
point as the average product is
at its maximum).
• If the firm wants to produce 63
units without diminishing
returns setting in, it will need a
different combination of fixed
and variable factors and this
will be true of all different
levels of output.
• This can be shown in Figure
1.5 where there is a separate
short-run ATC curve for every
level of output.
10
11
12
Production in the Long Run (LR)
• The firm producing the output 0A is producing
at the lowest point on the curve labelled ATC,
• While the firm with the higher level of output
faces a cost structure which is shown by curve
ATC3.
• Each short-run average total cost (SRATC)
represents the particular short-run size or the
scale of the firm
• And we assume that increasing returns to
scale are taking place as the trend of the costs
is downwards as output increases.
13
Production in the Long Run (LR)
• We have seen that in the SR the firm’s productively efficient
level occurs at the lowest point of the ATC curve.
• In the LR we assume that firms can vary the scale of production
and that it can vary all its factors of production.
• In the LR the furniture manufacturer will be able to increase the
size of, or move to, larger premises and employ more capital
equipment.
• Thus in the LR there are no fixed factors and we expect that
increasing size will lead to economies of scale.
• The LR ATC curve is constructed from the optimum output
levels of the SR curves as shown in Figure 1.7.
14
15
http://www.youtube.com/watch?v=p
cNtFWuw78Q
16
Production in the Long Run (LR)
• Figure 1.7 shows that the long-run average total cost (LRATC)
facing the firm
• And we assume that as the firm’s scale of operations increases
it will face falling costs as it receives increasing returns to
scale.
• The LRATC reflects that due to economies of scale as an
increase in factor inputs will result in a more than proportionate
increase in output.
• However, this can only continue up to a certain level of output
and then diseconomies of scale set in.
• This can be illustrated in Table 1.4 below:
17
Production in the Long Run (LR)
• Table 1.4 shows that the change in total output increases by a
greater percentage as the firm increases its scale of production in
years 1 to 3.
• The firm is experiencing increasing returns to scale and so its
average cost per unit falls, indicating economies of scale.
18
Production in the Long Run (LR)
• In years 3 and 4 output rise by the same percentage when inputs
rise from 150 to 200.
• The firm has experienced constant returns to scale and average
costs remain unchanged.
• In year 5, output rises by a smaller percentage than inputs and the
firm experiences decreasing returns to scale and the average cost
per unit increases, which indicates diseconomies of scale.
• These differing returns to scale are shown in Figures 1.7 and 1.8. 19
Production in the Long Run (LR)
These differing returns to scale are shown in Figures 1.7 and 1.8
• Both diagrams show a situation where unit costs fall as output
increases and the firm receives increasing returns to scale.
• But beyond a certain level of output costs begin to increase and
the firm suffers decreasing returns to scale.
• Both diagrams tend to be stylised as different industries will have
different cost structures.
• In some, all economies of scale will be reached very quickly, while in
others the level of output required to exploit all available economies
20
of scale may be huge.
Production in the Long Run (LR)
These differing returns to scale are shown in Figures 1.7 and 1.8
• In the left diagram, cost savings are exhausted quickly
and unit costs rise rapidly after a certain level of output.
• Firms in this industry do not have a great deal of choice
about their level of output and are likely to be of similar
size.
• All Economies of scale will be reached very quickly.
21
Production in the Long Run (LR)
These differing returns to scale are shown in Figures 1.7 and 1.8
•
•
•
•
•
•
The right diagram shows another possible shape of the LRATC.
Over the range of output 0 to A the LRATC falls and the firm receives
increasing returns to scale.
Over the range of output A to B, the curve is flat, and the firm
experiences constant returns to scale.
When output exceeds 0B decreasing returns to scale sets in.
Firms in this industry are likely to be of different sizes as once they
have reached 0A they may have the opportunity to be able to produce
thousands more units of output before decreasing returns to scale set in
at B.
22
This flat part of the curve shows constant returns to scale.
Production in the Long Run (LR)
These differing returns to scale are shown in Figures 1.7 and 1.8
• The optimum level of LR production for a firm occurs at
the point of productive efficiency – at the lowest part of
the LRATC.
• If the LRATC is saucer shaped, as in right diagram, this
will occur at the bottom of the curve, between A and B,
23
where constant returns to scale exist.
Production in the Long Run (LR)
These differing returns to scale are shown in Figures 1.7 and 1.8
• Both diagrams also indicate diseconomies of
scale where a less than proportionate increase
in output occurs as a result of factor inputs.
• The LRATC shows the cheapest possible cost
of producing any level of output.
24
Returns to Scale in Long run Production
• Increasing returns to scale
– When the % change in output > %
change in inputs
– E.g. a 30% rise in factor inputs leads to
a 50% rise in output
– Long run average cost will be falling
25
Returns to Scale in Long run Production
• Decreasing returns to scale
– When the % change in output < %
change in inputs
– E.g when a 60% rise in factor inputs
raises output by only 20%
– Long run average cost will be rising
26
Returns to Scale in Long run Production
• Constant returns to scale
– When the % change in output = %
change in inputs
– E.g when a 10% increase in all factor
inputs leads to a 10% rise in total output
– Long run average cost will be constant
27
28
Case Study – page 11
The new face of hunger
29
30
31
Production in the Long Run (LR)
The Minimum Efficient Scale
•
In Figure 1.9 at output OA the firm has grown large
enough to have exploited benefits of the internal
economics of scale – it has reached the minimum
efficient scale (MES).
•
This corresponds to the lower point of the LRATC
curve and it also known as the output of long-run
productive efficiency.
•
While the minimum efficient scale is defined to be
the first, lower point on the LRATC,
–
in reality there is unlikely to be a single level of output;
rather there will a range of output, as indicated in the
figure 1.9 between OA and OB, where costs are
minimised.
•
Firms are unable to reach the minimum efficient scale
are unlikely to be competitive with other firm.
•
If is produces an output below OA its unit costs will
increase and render it uncompetitive with larger firms
whose unit costs are lower as they have reached the
MES.
32
Production in the Long Run (LR)
The Minimum Efficient Scale
• The output required to reach the MES will depend on the
nature of the industry and its costs structure, and when
fixed costs are extremely large compared to variable
costs, expanding output will lead to decreasing average
costs.
• The relationship between the MES and the size of the
domestic market may mean that an economy may only
be able to support one firm in the industry if the MES is
to be achieved.
• A domestic firm wanting to reach the MES with only a
small home market may need to export its products to
increase the size of the potential market and the
authorities may have to accept that a monopolistic
structure is likely to be the most efficient.
33
34
Answers
1&2
•
The minimum efficient scale varies between different
industries because different industries have different
levels of fixed costs. For example, a company
providing rail network services (such as Network Rail)
has very high fixed costs, and therefore the minimum
efficient scale is only achieved at a very high level of
output. Some companies, such as a local bakery, have
fairly low fixed costs (but high variable costs) and
therefore the minimum efficient scale is low.
35
36
Case Study – page 13
No economies of scale for Proton without
global partner
37
38
39
Production in the Long Run (LR)
Relationship between short-run & Long-run costs
•
•
•
•
In Figure 1.7 we saw that any firm that is
producing at the lowest point of the SRATC
curve is on its LRATC and as its scale of
production increases its unit costs are likely
to fall.
In Figure 1.10 a firm is producing at OA
where it is at the lowest point of its shortrun cost curve.
If the firm decide to increase its output
rapidly to OB, perhaps in response to an
unexpected order, its unit costs will
increase up the SRATC as it overworks its
fixed factors and depart from the optimum
factor combination.
If the firm decides to increase its scale of
production then, as the fixed factors
increase and are brought in to use, the firm
moves down SRATC1 until it reaches the
LRATC at the output OB where once again it
has achieved the optimum factor
combination and productive efficiency.
However some firm, typically smaller ones, may decide that expansion is not an option and will remain at their size and overwork their fixed factors.
This may be for reason such as a lack of available finance, little likelihood of a planning application being granted, or fears that market growth may
40
be temporary. Such firms are not reducing their costs to the lowest but may ignore this fact as long as profits are adequate.
41
42
Answers
1.
In the short-run, firms
will produce more in
order to meet growing
demand by simply
employing more
workers. If they employ
many more workers,
then their short-run
average total costs
could begin to rise.
43
Answers
2. To tackle the
problem, the firm
could increase the
amount of capital
i.e. increase its
scale of production.
This would cause
the entire SRATC
curve to shift down
and to the right,
reaching SRATC1.
44
Answers
3. There are a number of reasons why a firm may
not choose to do this.
Firstly, the increase in demand may be
temporary (e.g. demand for Christmas
wrapping paper in December) so if the amount
of capital was increased, it wouldn’t be used in
the future.
Secondly, firms need funds, either from profit
or from borrowed money, in order to pay for
the investment; many small firms don’t have
this option or don’t want to pay high interest
rates on loans.
45
Activity
46
47
48
49
50
51
52
53
54
55
56
AQA Examination-style questions
Data response question 1:
a) Average costs of generating electricity by nuclear
methods have been lower. Fixed costs associated with
nuclear are high. External costs associated with nuclear
are generally lower. Data shows nuclear power costs
3.2euros per kWh, compared to an average cost for gas
of 3.65 and coal of 4.19.
b) Define minimum efficient scale. Show MES on a
diagram. Firms benefit from producing at the MES
because lower costs are likely to lead to higher profits.
Consumers may benefit because lower costs often
translate into lower prices, thus increasing consumer
surplus. Firms need to ensure however that they don’t
surpass the MES, and end up with rising LRATC.
Additionally, consumers may not benefit if firms don’t
pass on the cost reductions in terms of lower prices.
57
AQA Examination-style questions
Data response question 1:
c) Define diminishing returns.
Explain what is meant by the short-run.
Explain that diminishing returns are caused by increasing the level
of output by using more labour, whilst maintaining other fixed
factors of production; thus in the short-run diminishing returns are
not eliminated by increasing output. Use LRATC/SRATC envelope
curve.
Explain what is meant by the long-run. Explain how firms can
eliminate diminishing returns by increasing the scale of production
in order to increase output i.e. increasing the amount of capital, and
not just increasing the amount of labour.
Comment that increasing capital is not necessarily easy, owing to
finance constraints, planning permissions, legal barriers (e.g.
prevention of monopoly power, patents etc) and so firms cannot
guarantee that they can eliminate diminishing returns.
58
AQA Examination-style questions
Essay question 2:
a) Define total costs (i.e. fixed plus variable).
Factors affecting fixed costs could include: salary
demands of permanent employees (e.g. public
sector workers demanding wage increases in line
with inflation), rent prices (dependent on area of
country etc).
Factors affecting variable costs could be: price of
fuel (more expensive in winter as demand
increases, more expensive if there’s uncertainty in
the Middle East etc), changes to the National
Minimum Wage affecting non-salaried employees,
cost of raw materials (e.g. price of gelatine
59
increased following BSE outbreaks).
AQA Examination-style questions
Essay question 2:
b) Explain what is meant by average cost (use diagram).
Reasons for firms having similar costs:
 often face the same changes in variable costs (i.e. they buy the same raw
materials);
 we might expect production to take place in similarly-sized industrial units.
Reasons why they might not face similar costs:
 products are often differentiated (e.g. costs will be very different for a small
company making small batches of cars compared to say, Ford, or boutique
chocolate shops may focus on high-quality handmade chocolates which is
very different to Cadbury’s mass production approach).
 firms may operate in different countries where wages are different (e.g.
many European companies relocated production to China);
 well-established firms can negotiate good bulk-purchasing discounts on raw
materials, or carry out sound negotiations in the futures markets
 the internal structure of companies may be different, leading to different
60
levels of morale (workers with low morale are likely to produce less, leading
to higher average costs)