Firm Costs in the Long-run

Unit 7 - Lesson 4
Learning outcomes:

● Explain economic costs in terms of explicit and implicit costs.

● State the difference between the short-run and long-run.
● State the difference between economies and diseconomies of
scale.
● Explain the reasons for economies and diseconomies of scale.
● Draw a graph representing long-run average cost curve.
Meaning of Economic Costs

We know that the inputs that firms use to produce the output of goods are
referred to as costs of production.
● Includes transactions (money payments) made by firms to purchase the
resources necessary to produce the goods.
● Also refers to anything that is given up by the firm in order to produce the
good.
● Cost of production is the cost of the resources (land, labor, capital and
entrepreneurship) necessary to produce the goods.
Economic costs are made up of:
● Explicit Costs: costs associated with resources the firm does not own.
● Implicit Costs: costs associated with resources the firm does own.
Meaning of Economic Costs
Economic Costs is equal to explicit plus implicit costs

● Explicit Costs: when firms use resources they do not own, they must purchase
those resources from other suppliers/vendors.
○ A firm pays a wage for the labor.
○ A firm purchases resources that are necessary in the production of a good.
■ Think of explicit costs as anything that you receive a receipt when
making a purchase.
● Implicit Costs: sacrificed income that arises when a firm uses a self-owned
resource.
○ The cost incurred from the use of their own resources is the income forgone
(opportunity cost) from the use of their own resources.
■ If an office building is owned by the firm, the implicit cost is the rental
income that could be earned if they chose to rent the office building.
Cost of Production in the Long-Run
Short-Run
● Period of time when at least one input is fixed - cannot be changed.
Long-Run
● Period of time when all inputs are variable - can be changed.
● There are no fixed inputs
The long-run examines how a firm’s average cost - cost per unit of output -
changes as the firm grows larger by increasing all of their factors of production.
The long-run average cost curve is comprised of a series of short-run cost
curves.
In other words, a firm in the short-run decides to increase its factors of
production it will move to the long-run then back to the short-run.
Cost of Production in the Long-Run
The long-run average total cost curve
(LRATC) is comprised of a series of
short-run average total cost curves
(SRATC):
● SRATC - 1, 2, 3 and 4
If a firm is operating on the SRATC - 1
curve decides to increase its factors of
production, it moves to the long-run and
then back to the short-run.
The firm would now be operating at
SRATC - 2 with lower costs and higher
output than SRATC - 1.
Cost of Production in the Long-Run
In summary,

● The LRATC is the result of a series of

SRATC curves.
● As a firm increases its factors of production
they will move from:
○ SRATC - 1 to SRATC - 2.
■ As the firm increases the factors of
production the cost of production
decreases as output increases.
○ SRATC - 2 to SRATC - 3
■ As the firm increases the factor of
production the cost of production
increases as output increases.
Economies and Diseconomies of Scale
The previous graph is important to
understand the LRATC curve is a series
of infinite SRATC curves.
To simplify, we can illustrate the LRATC
curve as shown on the right.
The LRATC illustrates the two following
concepts:
1. Economies of Scale: as output
increases the cost to produce the
output decreases.
2. Diseconomies of Scale: as output
increases cost to produce the output
increases.
Explain the reasons for Economies of Scale
Economies of Scale occur for the following
reasons:

● Specialization of Labour
○ As production increases the need to
hire more workers also increases.
○ This allows a firm to hire workers that
specialize in a specific skill areas.
○ This specialization in labour allows
firms to become more efficient
allowing for more output produced at
a lower cost thus achieving
economies scale.
Explain the reasons for Economies of Scale
● Specialization of Management
○ Larger scales of production allow
for firms to hire more managers.
○ With the increase in hiring of
managers, firms are able to hire
managers that specialize in
certain areas (finance, marketing,
sales and production).
○ The ability to specialize in
management will result in
increased efficiency and lower
costs as output increases.
Explain the reasons for Economies of Scale
● Bulk Buying of Inputs (Factors of
Production)
○ As the amount of output produced
increases, the need for additional
inputs increases.
○ Suppliers of inputs often offer
discounts if the inputs are bought
in larger quantities (bulk).
○ As purchases of inputs increases
(bulk buying) the cost per unit
decreases.
○ This results in firms achieving
economies of scale.
Explain the reasons for Economies of Scale
● Financing Economies
○ Larger firms that have more
resources and sell larger amounts
of output tend to be deemed by
financial institutions (banks) as
less likely to fail or become
insolvent (bankrupt).
○ Because of the view of larger
firms being less likely to fail they
will be offered lower interest rates
on money borrowed.
■ Interest rate is the cost to
buy money
○ Lower interest rates result in
lower costs per unit of output.
Explain the reasons for Economies of Scale
● Spreading Costs Over Larger
Volumes of Output
○ Certain activities that firms
undertake when producing output
results in lower average costs if
spread over larger quantities of
output.
■ These activities include
marketing, advertising, design
and research and
development.
○ This will result in firms achieving
economies of scale - decrease in
cost as output increases.
Explain Diseconomies of Scale.
Diseconomies of Scale

● As output increases cost per unit of output

increases.

Reasons:

● Coordination and Monitoring Difficulties

○ As a firm grows larger and larger, this may
result in firms finding it difficult to
coordination, organization, cooperation and
monitoring of firm’s activities.
○ This results in increased inefficiency within
the firm resulting in costs to increase as
output increases - diseconomies of scale.
Explain Diseconomies of Scale

● Communication Difficulties
○ Larger firms may experience
difficulty communicating
between departments within the
firm.
○ This difficulty of communication
may result in more inefficiency.
■ Increased inefficiency results
in an increase in cost per
unit of output -
diseconomies of scale.
Explain Diseconomies of Scale
● Poor Worker Motivation
○ Sometimes if firms become too
large, workers can feel less
motivated as they do not feel part
of the firm.
○ With less voice and ability to
vocalize their ideas makes
workers less motivated.
○ Decreased motivation leads to
increased inefficiency within a
firm which results in an increase
in cost to produce a unit of output
- diseconomies of scale.