CHAPTER 8 Production and Costs 193 1. Wdentfy two ways to compute average total cost 3. What happens to unit costs as marginal costs rise? Explain (aro, your answer, 2, Would a business ever sll its product for less than cost? 4. Do changes in marginal physical product influence unit costs! Explain your answer Explain your answer. PRODUCTION AND COSTS IN THE LONG RUN ‘This section discusses production and long,run costs. As noted, in the long run, there are no fixed inputs and no fixed costs. Consequently, the firm has greuterflvibilty inthe long, run than in the shore run. (Because we discuss both short-run and long-run average total cost curves, we distinguish between them with prefixes: SR for short run and LR for long run.) Long-Run Average Total Cost Curve In the short run, because there are fixed costs and variable costs, total cost isthe sum of the to. But inthe long run, there are no Fixed casts 50 variable cost are toal cost. This section focuses on (1) the long,-run average total cost (ERAT) curve and (2) what it looks tke. Consider the manager of firm that produces bedroom furniture. When all inputs are variable, the manager must decide what the situation of the firm should be in the upcom- ing short-run period. For example, he might need to determine the size of the plant— small, medium, or large. Once this decision is made, the firm is locked into a specific plant sine for the short run, Associated with each of the three different plant sizes is a short-run average total cost (SRATO) curve as illustrated in Exhibit 8 (a). a Long-Run Average Total Cort Curve she ony pint szes the loigrun average total LAATC care in) ent sealoped because tie (rare) con (4) There are three short-run average total cost UN.) Te long-ran average total cost cure the LRATC cune touches each SRATC cieclortree diferent port sees Wthew ae the heavy shaded ble smooth cune The only one port sve ste heaviy shaded. bie sealoped sesumetthat thee ae so many plant ses that, snare, share; saaro, SRATC, a z La 8 SAATD, sparc, Ae fo fe cA a z ' ' oa Economies AT Constant 1 Disaconamies ! eS ofcale Rens | ofScale toScaie ‘i 2 7 ° i Quanto ouput uanty of ouput Minimarn eflient scale @ oEee 194 PART 2 International Economies Long-Run Average Total Cost (RATC) Curve A cave that shows the lowest (nt) cost at which the fn can produce any given eel oF output Economies of Seale Econom that exit when pute are increased by some percentage and output increas by a greater percentage, causing unt costs to fal Constant Returns to Scale The candtion when meus are increased by some percentage and uiputiereases by an equal percent age, causing nit cos to remain Diseconomies of Seale The condition when meus re increaved by some percentage ard output creases bya amir per centage, causing unt coss to rie Minimum Efficient Seale The lowest output level at which sverage total cons ae minimized Suppose the manager of the firm wants to produce output level Q., Obviously, he will choose the plant size represented by SRATC,. This gives lower unit cost of producing Q, than che plant size represented by SRATC,, which has a higher unit cost of producing Q, (86 as opposed to $5). However, ifthe manager chooses to produce Q, he will choose the plant size repre sented by SRATC, because the unit cost of producing Q, is lower with that plant size than it is with the plant size represented by SRATC, Tf'we were to ask the same question for every (posible) ourput level, we would derive the long-run average total cost (LRATC) curve, The LRATC curve shows the lowest unit cost at which the firm can produce any given level of output. In Exhibit 8(a), the LRATC con- sists ofthe portions of the three SRATC curves that are tangential to the blue curve itis the scalloped blue curve Exhibic 8(b) shows a host of SRATC curves and one LRATC curve. In this case, the LRATC curve is not scalloped, as in part (a). The LRATC curve is smooth in part (b) because we assume there are many plant sizes in addition to the thece represented in (a) In other words, although they have not been drawn, short-run average total cost eurves rep resenting different plant sizes exist in (b) between SRATC, and SRATC,, between SRATC, and SRATC, and so on, In this case, the LRAT eurveis smooth and touches each SRATC curve at one point. Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale Suppose two inputs, labor and capital, are used together to produce a good. IF inputs are increased by some percentage (sy, 100 percent) and if output increases by a greater percentage (more than 100 percent), then unit costs fll and economies of scale are sai to exist. For example, suppose good X is made with two inputs, ¥ and Z, and ic takes 20 Y and 10 Z to produce 5 units of X. The cost of each unit of inpur Y is $1, and the cost ofeach unit of input Z is $1. Thus, a total cost of $30 is required to produce 5 units of X. The unit cost (average total cost) of good X is $6 (ATC = TCIQ). Now consider a doubling of inputs Y and Z to 40 Y and 20 Z and a more than doubling in ousput, say, 0 15 units of X. This means a cotal cost of $60 is required to produce 15 units of X, and the unit cost (average total cost) of good X is $4. ‘An increase in inputs can have two other results. IFinputs are increased by some per- centage and output increases by an equal percentage, then unit costs remain constant, and constant returns to scale are said to exist. IF inputs are increased by some percentage and output increases by a smaller percentage, then unit cost rise, and diseconomles of scale are said t0 exist The three conditions can easily be seen in the ZRATC curve in Exhibie 8(b): i mies of scale are present, the LRATC curve is fallings if constant returns to scale are present, the curve is flat: if discconomies of scale are present, the curve is rising. Economies of scale -> LRATC is falling Constant retums to scale > LRATCis constant Diseconamies of scale -> LRATC is ising Iii the production of a good, economies of scale give way to constant returns to sale or to diseconomies of scale, as in Exhibit 8(b), the point at which this occurs is refered to as the minimum efficient scale, The minimum efficient scale is the lowest output level at which average total costs are minimized, Point A represents the minimum efficient scale in Exhibit 8(b). ‘The significance of the minimum efficient scale of output can be seen by looking at the long-run average total cost curve becween points A and B in Exhibic 8(b). Berween e