Long-run production and cost theory

Changing the scale of operationsIn the short-run, the level of production can be changed within limits of the fixed factor/s of production (e.g. capital). To break these limits, firms are able to increase the scale of their operations in the long-run by investing in fixed factors (e.g. building bigger factories).

1 small plant with 60 workers can produce 300 units per week.

1 medium sized plant with 80 workers can produce 600 units per week.

1 large plant with 100 workers can produce 1000 units per week.

Note how the output per worker increases as the plant size increases. This effect is known as increasing returns of scale.

Returns to scale

Increasing returns to scale is when an increase in the scale of the factors of production leads to a more than proportionate increase in output

Constant returns to scale is when an increase in the scale of the factors of production leads to a proportionate increase in output

Decreasing returns to scale is when an increase in the scale of the factors of production leads to a less than proportionate increase in output

Long-run costsA U-shaped long-run average cost curve and its related short-run average cost curves

Short-run curves along the LRAC curve

At each point along the LRAC curve the short-run rules of production apply; costs fall due to the division of labour and falling AFC, then rise as diminishing marginal returns kick in. As the scale of production increases the long-run costs fall or increase, but the short-run curve still applies at each scale. It is important not to confuse the short-run reasons for changing costs with the long-run reasons.

Costs

Output0

LRACSRATC1

SRATC2

SRATC3

SRATC4

SRATC5

SRATC6

SRATC7

C1

Q1

Economies of scale

Dis-economies of scale

The shape of the LRAC curve

As firms increase the scale of production and experience increasing returns to scale, so the average cost of production falls. However, when the scale reaches a certain level there can be decreasing returns therefore increasing average costs. The long-run average cost curve therefore is often drawn as U-shaped.

Economies and dis-economies

The falling LRAC is due to economies of scale and the rising LRAC at higher levels of output are due to dis-economies of scale.

Economies and Dis-economiesTechnical economies of scale

Increasing returns to scale lead to economies of scale when the effect is translated into cost theory. This reason for falling unit costs is known as technical economies of scale. There are other types of economies of scale apart from technical economies.

The main types of technical economies are:

Indivisibilities whereby there is a minimum efficient scale for a piece of equipment

Spreading of R&D costs over higher production levels

Volume economies which occur when the increasing dimensions lead to proportionally higher volume increases. For example, a factory of twice the height, width and length will have four times the volume.

Economies of massed resources e.g. fewer spare parts need to be held if multiple identical machines are run.

Dis-economies of scale

When the output of a firm increases it may experience rising unit costs. This is often due to what are known as managerial dis-economies of scale.

Managerial dis-economies occur as the firm gets larger and it becomes more difficult to manage the complexity of the firm. Often, levels of hierarchy are introduced and different functional parts of the firm are divided into departments. Communication problems may increasingly result, both from the top to bottom of the hierarchy, and between the departments.

Other LRAC curves

Output

Costs

0

LRAC

Economies of small-scale production

LRAC curves are not always U-shaped. Some firms experience the full economies of scale at quite a small scale. Personal services, such as hairdressing for instance, are typical examples.

A wonky bowl-cut pleaseHairdressers benefit from bulk buying economies for things like shampoo at quite low levels and experience managerial economies with a limited number of salons, perhaps as one manager oversees a few outlets. Chains of hairdressers will experience dis-economies early on as they need a 'head-office' to oversee operations. If they wish to build a national reputation they will also incur marketing costs which a small, local hairdressers wouldn't incur. It is for these reasons that hairdressers are often small, local, independently-owned businesses. The exception which proves the rule is 'Tony and Guys' which can only sustain its national operation by charging high prices as an 'up-market' brand

Other LRAC curvesCosts

Output0

LRAC

An L-shaped LRAC curve

In some industries, such as manufacturing, there are significant economies of scale to be gained but not dis-economies (at least not at the scale of production required by the market).

Driving down costsCar manufacturing requires significant investment in equipment and set-up costs are therefore very high. It is simply not cost-effective to spend all that money to only produce a few cars. Large scale production is achievable through the use of technology, such as computer controlled robotics, and although expensive, the average cost falls rapidly as automation replaces labour and speeds up production. Economies can also be gained as firms source cheaper components internationally, or set up their own plants in countries where costs are low. Consumers also want cars which have a recognisable brand and large firms can benefit from mass-market advertising which, if the market is large, can be cost effective.

C1

Q1

Minimum Efficient Scale

Minimum Efficient Scale

Outsourcing

Costs

Output0

LRACC1

Q1

Minimum Efficient Scale

Minimum Efficient Scale (MES) is the term used to refer to the quantity of output required to achieve the lowest average production cost.

MES is often used to explain the reason for the number of firms in a market. If the MES is at a high level of output then a very large firm is required to produce at an efficient cost. Therefore, the market will likely sustain one (monopoly) or a few firms (oligopoly). Small firms attempting to enter the market will experience very high production costs and be unable to compete with the low unit costs, and therefore potentially low prices, of the dominant, large firms in the market.

It is not always cost effective for a firm to undertake all aspects of a production process itself. Firms may outsource (i.e. commission other firms to perform certain parts of production) as it may be cheaper to buy from another firm because:

- the other firm may be able to achieve better economies of scale due to supplying a number of firms

- the firm may be 'specialists' who innovate and adopt the latest practices and technology

- a national firm may take advantage of buying from a foreign firm with lower production costs

Why has outsourcing become more common?

1. Globalisation means firm can sell to, or buy from, firms across the globe due to improved travel and communication

2. The removal of trade barriers

3. Countries specialising in the production of certain goods

The UK has become so good at outsourcing that some firms just design and brand a good and commission all the production to oversees firms.

10 point summary

1. In the short-run the level of production can be varied, and in the long-run the scale of production changed

1. As the scale of operations increases firms may experience increasing, constant or decreasing returns to scale

1. Increasing returns to scale are associated with decreasing average costs, known as economies of scale

4. Decreasing returns to scale are associated with increasing average cost, known as dis-economies of scale

5. The particular type of economies of scale associated with the LRAC curve are technical economies

10 point summary

6.The particular type of dis-economies of scale associated with the LRAC curve is managerial dis-economies

7.The long-run average cost curve is often depicted as bowl-shaped, with average costs falling due to economies, then increasing due to dis-economies

8.The long-run average cost curve can also be drawn in different ways to depict the conditions in specific industries e.g. L-shaped, tick-shaped

9.The minimum efficient scale is the level of output at which the minimum average cost of production is achieved in the long-run

10.It is not always most efficient for a firm to undertake every stage of the production process; contracting out production is known as outsourcing