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8/8/2019 Chap010 Long Run Production and Costs Analysis
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McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., AllRights Reserved.
Production andProduction and
Cost Analysis IICost Analysis II
Chapter 10
8/8/2019 Chap010 Long Run Production and Costs Analysis
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McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., AllRights Reserved.
Laugher CurveLaugher Curve
Economists have forecasted nine out ofthe last 15 recessions.
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Making Long-RunMaking Long-Run
Production DecisionsProduction Decisionss To make their long-run decisions:
q Firms look at costs of various inputs and
the technologies available for combiningthese inputs.
qThen decide which combination offers
the lowest cost.
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Making Long-RunMaking Long-Run
Production DecisionsProduction Decisionss The firm makes long-run decisions on the
basis of the expected costs and expected
usefulness of inputs.
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Technical Efficiency andTechnical Efficiency and
Economic EfficiencyEconomic Efficiencys Technical efficiency as few inputs as
possible are used to produce a given
output.s Technical efficiency is efficiency that does
not consider cost of inputs.
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Technical Efficiency andTechnical Efficiency and
Economic EfficiencyEconomic Efficiencys Economically efficient the method that
produces a given level of output at the
lowest possible cost.s It is the least-cost technically efficient
process.
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Rights Reserved.
Determinants of theDeterminants of theShape of the Long-RunShape of the Long-RunCost CurveCost Curves The law of diminishing marginal
productivity does not hold in the long run.
s All inputs are variable in the long run.
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Rights Reserved.
Determinants of theDeterminants of theShape of the Long-RunShape of the Long-RunCost CurveCost Curves The shape of the long-run cost curve is
due to the existence of economies and
diseconomies of scale.
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A Typical Long-RunA Typical Long-Run
Average Total Cost TableAverage Total Cost TableQuantity
Total Costsof Labor
Total Costof Machines
Total Costs =TC
L+ TC
M
Average TotalCosts = TC/Q
11121314151617181920
$381390402420450480510549600666
$254260268280300320340366400444
$635650670700750800850915
1,0001,110
$58545250505050515356
McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., AllRights Reserved.
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Averagetotal cost
C
ostsperu n
it
$6462
60585654525048
11 12 13 14 15 16 17 18 19 20 Quantity
Minimum efficientlevel of production
A Typical Long-RunA Typical Long-Run
Average Total Cost CurveAverage Total Cost Curve
McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., AllRights Reserved.
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Economies of ScaleEconomies of Scale
s Economies of scale long run averagetotal costs decrease as output increases.
s In real-world production processes,economies of scale are extremelyimportant at low levels of production.
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Economies of ScaleEconomies of Scale
s An indivisible setup costis the cost of anindivisible input for which a certain
minimum amount of production must beundertaken before the input becomeseconomically feasible to use.
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Economies of ScaleEconomies of Scale
s Indivisible setup costs create many real-world economies of scale.
s The cost of a blast furnace or an oilrefinery is an example of an indivisiblesetup cost.
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Economies of ScaleEconomies of Scale
s In the longer run all inputs are variable, soonly economies of scale can influence the
shape of the long-run cost curve.
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Economies of ScaleEconomies of Scale
s Because of the importance of economiesof scale, business people often talk of a
minimum efficient level of production.
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Economies of ScaleEconomies of Scale
s The minimum efficient level ofproduction is the amount of production
that spreads setup costs out sufficiently forfirms to undertake production profitably.
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Economies of ScaleEconomies of Scale
s The minimum efficient level of productionis reached once the size of the market
expands to a size large enough so thatfirms can take advantage of all economiesof scale.
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Diseconomies of ScaleDiseconomies of Scale
s Diminishing marginal productivityrefersto the decline in productivity caused by
increasing units of a variable input beingadded to a fixed input.
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Diseconomies of ScaleDiseconomies of Scale
s Diseconomies of scale refer to decreasesin productivity which occur when there are
equal increases of all inputs (no input isfixed).qDiseconomies of scale occur on the right
side of the long-run average cost curvewhere it is upward sloping, meaning thataverage cost is increasing.
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Diseconomies of ScaleDiseconomies of Scale
s As the size of the firm increases,monitoring costs generally increase.
s Monitoring costs are those incurred by theorganizer of production in seeing to it thatthe employees do what they are supposed
to do.
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s Team spiritis the feelings of friendshipand being part of a team that brings outpeoples best effort
Diseconomies of ScaleDiseconomies of Scale
s As the size of the firm increases, teamspirit or morale generally decreases.
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Constant Returns toConstant Returns to
ScaleScales Constant returns to scale is where long-
run average total costs do not change as
output increases.s It is shown by the flat portion of the LRATC
curve.
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Averagetotal cost
C
ostsperu n
it
$6462
60585654525048
11 12 13 14 15 16 17 18 19 20 Quantity
Economies andEconomies and
Diseconomies of ScaleDiseconomies of ScaleEconomies
of ScaleDiseconomies
of ScaleConstantreturns
to Scale
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Importance of EconomiesImportance of Economiesand Diseconomies ofand Diseconomies ofScaleScales Economies and diseconomies of scale
play important roles in real-world long-run
production decisions.
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Importance of EconomiesImportance of Economiesand Diseconomies ofand Diseconomies ofScaleScales The long-run and the short-run average
cost curves have the same U-shape, but
the underlying causes of these shapesdiffer.
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Importance of EconomiesImportance of Economiesand Diseconomies ofand Diseconomies ofScaleScales Economies and diseconomies of scale
account for the shape of the long-run total
cost curve.
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Importance of EconomiesImportance of Economiesand Diseconomies ofand Diseconomies ofScaleScales 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-runcost curve.
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The EnvelopeThe Envelope
RelationshipRelationships In the long run all inputs are flexible, while
in the short run some inputs are not
flexible.s As a result, long-run cost will always be
less than or equal to short-run cost.
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The EnvelopeThe Envelope
RelationshipRelationships In the short run the firm faces an additional
constraint all expansion must proceed
using only the variable input.s These additional constraints increase
cost.
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The EnvelopeThe Envelope
RelationshipRelationships The envelope relationship explains that:
qAt the planned output level, short-run
average total cost equals long-runaverage total cost.
qAt all other levels of output, short-runaverage total cost is higher than long-runaverage total cost.
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Costs
perunit
0Quantity
SRATC2SRATC3
SRATC4
LRATC
SRATC1SRMC
1
SRMC2
SRMC3
SRMC4
Q2
Q3
Envelope of Short-RunEnvelope of Short-RunAverage Total CostAverage Total CostCurvesCurves
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Entrepreneurial ActivityEntrepreneurial Activity
and the Supply Decisionand the Supply Decisions Profit is what underlies the dynamics of
production in a market economy.
s The expected price must exceed theopportunity cost of supplying the good fora good to be supplied.
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Entrepreneurial ActivityEntrepreneurial Activity
and the Supply Decisionand the Supply Decisions Suppliersexpected economic profit per
unit the difference between the expected
price of a good and the expected averagetotal cost of producing it.
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Entrepreneurial ActivityEntrepreneurial Activity
and the Supply Decisionand the Supply Decisions An entrepreneuris an individual who see
an opportunity to sell an item at a price
higher than the average cost of producingit.
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Entrepreneurial ActivityEntrepreneurial Activity
and the Supply Decisionand the Supply Decisions Entrepreneurs organize production.
s They visualize the demand and convince the
individuals who own the factors ofproduction that they want to produce thosegoods.
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Using Cost Analysis inUsing Cost Analysis in
the Real Worldthe Real Worlds Some of the problems of using cost
analysis in the real world include the
following:q Economies of scope.q Learning by doing and technological
change.
qMany dimensions.qUnmeasured costs.
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Economies of ScopeEconomies of Scope
s The cost of production of one product oftendepends on what other products a firm is
producing.
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Economies of ScopeEconomies of Scope
s There are economies of scope when thecosts of producing goods are
interdependent so that it is less costly for afirm to produce one good when it isalready producing another.
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Economies of ScopeEconomies of Scope
s Firms look for both economies of scopeand economies of scale.
s Economies of scope play an important rolein firms decisions of what combination ofgoods to produce.
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Economies of ScopeEconomies of Scope
s Globalization has made economies ofscope even more important to firms in their
production decisions.
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Learning by Doing andLearning by Doing and
Technological ChangeTechnological Changes Production techniques available to real-
world firms are constantly changing
because of learning by doing andtechnological change.
s These changes occur over time and
cannot be accurately predicted.
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Learning by Doing andLearning by Doing and
Technological ChangeTechnological Changes Learning by doingmeans that as we do
something, we learn what works and
doesnt, and over time we become moreproficient at it.
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Learning by Doing andLearning by Doing and
Technological ChangeTechnological Changes Many firms estimate worker productivity to
grow 1 to 2 percent a year because of
learning by doing.
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Learning by Doing andLearning by Doing and
Technological ChangeTechnological Changes Technological change is an increase in
the range of production techniques that
provides new ways to producing goods.
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Learning by Doing andLearning by Doing and
Technological ChangeTechnological Changes Technological change can fundamentally
alter the nature of production costs.
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Learning by Doing andLearning by Doing and
Technological ChangeTechnological Changes Technological change occurs in all
industries, not only high-tech industries.
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Learning by Doing andLearning by Doing and
Technological ChangeTechnological Changes In many businesses, the effect of learning
by doing and technological change on
prices is built into the firm's pricingstructure.
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Learning by Doing andLearning by Doing and
Technological ChangeTechnological Changes Technological change and learning by
doing are intricately related.
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Many DimensionsMany Dimensions
s Most decisions that firms make involvemore than one dimension.
s The only dimension in the standard modelis the level of output.
s Good economic decisions take all relevant
marginal costs and benefits into account.
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Many DimensionsMany Dimensions
s The important thing to remember in usingthe standard model is the reasoning, not
the specific model.
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Unmeasured CostsUnmeasured Costs
s The relevant costs as defined byeconomists are not the costs found in a
firms books.s Economists include opportunity costs while
accountants use explicit costs that can be
measured.
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Economists IncludeEconomists Include
Opportunity CostOpportunity Costs Economists insists on including the
business owners opportunity cost.
s The business owners opportunity costincludes forgone income that the ownercould have earned by spending his or her
time in another job.
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Economic VersusEconomic Versus
Accounting DepreciationAccounting Depreciations Economic depreciation differs from
accounting depreciation.
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Economic VersusEconomic Versus
Accounting DepreciationAccounting Depreciations In measuring the costs of depreciable
assets, accountants insist on using
historical costswhat a depreciable itemcosts in terms of money actually spent foritas the cost basis.
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Economic VersusEconomic Versus
Accounting DepreciationAccounting Depreciations If the depreciable asset increased in value,
accountants would still use the historical
cost basis while an economist would countits increased value as revenue.
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The Standard Model as aThe Standard Model as a
FrameworkFrameworks Despite its limitations, the standard model
provides a good framework for cost
analysis.s It can be expanded to include real-world
complications.
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Production andProduction and
Cost Analysis IICost Analysis II
End of Chapter 10