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Firm and Its Long-term Costs

Analysis

By:Group 6Astha Singh 2010057Hitesh Babbar 2010079

Jaya Dadlani 2010084Jhanvi Thakkar 2010086Nirmal Modh 2010099

Prateek Chaturvedi 2010295

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COST

Total Cost - the sum of all costs incurred in productionTC = FC + VC

Average Cost the cost per unitof output

AC = TC/OutputMarginal Cost the cost of one more or one fewer units of

productionMC= TC n TC n-1 units

Short run P eriod of time for which some production factorsare fixed and some can vary.

Long run P eriod of time for which all the production factorscan vary.

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Analyzing the Long RunT he long run is a period of time for which following

conditions hold:1. T he firm is operating for a significant amount of

time taken to vary all factors of production.2. Firms can enter or exit an industry.

3. With long-term decline in demand, firms will prevalently cut fixed costs.4. With long-term rise in demand, firms will

prevalently choose innovations that allow them toreduce variable costs.5. T he period of time varies according to the firmand the industry

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Analyzing the Long Run

typical firm.

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Ec onomies of S c ale E

conomies of scale refers to the phenomena of decreased per unit cost as the number of units of production increase.It is a Long run concept

Types : Internal E conomies of Scale E xternal E conomies of Scale

Why it is Important?

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Real world LA C s in Manufa c turing

In the example shown when the business increases the scale of productionfrom P lant 1 (with 10 units of labour and 10 units of capital) to P lant 2 (adoubling of the inputs used), total output quadruples. T his shows increasingreturns to scale leading to a fall in the average total cost of production. Afurther increase in scale to P lant 3 demonstrates constant returns to scale where

both inputs and output have increased by 50% and a further expansion of scaleto P lant 4 illustrates decreasing returns to scale where inputs have grown by

33% but output has grown by just 15%. When a firm experiences decreasingreturns to scale, then average total cost will rise in other words diseconomiesof scale exist.

I nput Plant 1 Plant 2 Plant 3 Plant 4

10 40 100 130 150

20 100 160 180 210

30 130 180 240 250

40 150 200 255 275

50 160 210 270 290

Capital I nput 10 20 30 40

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Real world LA C s in Manufa c turing

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Real world LA C s in Manufa c turing

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C aselet 1: T he long run average c ostc urve in E le c tric ity Generation

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LAC c urve in E le c tric ity GenerationLAC is L shaped be c ause of in c reasing &

de c reasing returns to s c ale operatetogether.Power c ompanies buying more power

from independent produc

ers to minimizec ost of produ c tion that would be in c urredin produ c ing more power.Deregulation and end of monopoly power.

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Ec onomies of S c aleIncreasing returns to Scale

O utputs c hange by larger proportion thaninputsProfic ien c y of workers and avoidan c e of timelostMore spe c ialized and produ c tive ma c hinery

c an be usedFirms need smaller inventory as s c ale of operation in c reasesPrevails at smaller levels of output

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Ec onomies of S c aleD ecreasing returns to Scale:

O utputs c hanges by lower proportionthan inputsArises as s c ale of operation in c reases, it

be c omes diffi c ult to manage firmseffe c tivelyPrevails at larger levels of output

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L shaped LA C

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W hy L-shaped LA C c urve?Ec onomies of s c ale are rather qui c kly

exhausted and c onstant or near c onstant returns to s c ale prevail over a c onsiderable range of outputs.Lowest point of c urve o cc urs when thefor c es of in c reasing and de c reasingreturns to s c ale just balan c e ea c hother.

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Introdu c tion Like servi c e firms many manufa c tures

foc us on c ustomer inquiry system ,produ c treliability, quality c hara c teristi c s like brandloyalty and te c hnologi c al innovations.

T o c apture large c hunk of market share

quality c hara c teristi c s and support servi c esbeyond physi c al unit of produ c tion arerequired.

W ith innovation and advan c ement inte c hnology in c reasing returns persist.

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Innovationsa) Produ c t Innovation - new produ c ts or

improvements on produ c ts eg:- newmodels of mobile phones and so on.b) Pro c ess Innovation - where some part

of the pro c ess is improved to bring benefit.Just in T ime applied by wall mart is a goodexample.

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C on c lusionIn long run as market share in c reases

c osts su c h as promotional andmarketing c osts are lower to trigger another adoption.

T he only limitation in the adoption of su c h innovations is that one needs togo for these new adoptions again andagain.

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C aselet 3: How exa c tly has the informationte c hnology lowered c osts at C hevron and

Mer c k?

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T e c hnology at C hevronC hevron spent 2-4 million ea c h drilling 10-

12 exploratory wells before finding oil.Introdu c tion of new te c hnology: 3Dgraphs, c al c ulation intensive simulationmodeling resulted in making mu c h morea cc urate lo c ation of se c ondary wells or known oil fields.O verall produ c tion c ost shrunk by 16%.

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T e c hnology at Mer c kE xperimenting on known a c tive c ompoundsinvolved lot of time c onsuming c hemi c al trials.T otal time to introdu c tion of new pharma c euti c alwas often longer than a de c ade.After te c hnologi c al upgrade mi c ro c hip c ontrolled

and automated mac

hines performed thousandsof rea c tions at on c e and tally the results.2/3rd redu c tion in time c onsumed and attendants

c osts have de c lined a cc ordingly.

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T e c hnologi c al Advan c ements

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Inc reasing Returns to S c aleInc reasingreturns tos c ale due toT e c hnologi c aladvan c es

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C aselet 4: GM de c ides small is better

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INT RO DUCT IO NGeneral Motors, the largest

c orporation and c armaker in theworld had a turbulent de c ade in1990s.

It inc urred huge losses and toover c ome that GM c losed some of the plants and redu c ed theworkfor c e,but this was not suffi c ient.

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De c reasing returns to s c aleT he firms are fa c ed with de c reasing returns to s c alewhen a c ertain proportionate c hange in inputs, lead to

less than proportionatec

hange in output.

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C auses of Diminishing return tos c ale

T he de c reasing returns to s c ale areattributed to the dise c onomies of s c ale.T he most important fa c tor c ausing this isthe diminishing return to management.

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C on c lusionHenc e it restru c tured its strategy by

redu c ing the no. of models, c uttingaverage manufa c turingtime, c entralised its vast sales and

servic

es and marketing system.Henc e to sustain GM need togenerate ex c itement over its newmodels and c oax buyers.

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T hank you