Production and Cost

Analysis in the Long Run

Valliry S. Molina
MBA 103
Economic Analysis
LONG-RUN PRODUCTION ANALYSIS
In microeconomic analysis, the long run is concerned with the adjustment of
factory or plant size and is often termed the planning period. In the long run, a firm is
able to change the quantities of ALL resource inputs--labor, material, land and capital.
The central characteristic of long-run production analysis is that all inputs under the
control of the firm are variable. The central principle guiding production in the long run is
returns to scale, which indicates how production responds to proportional changes in all
inputs. A contrasting analysis is short-run production analysis.
The guiding principle for the long run is returns to scale, which indicates how
production changes due to proportional changes in all inputs. Returns to scale can be
either increasing, decreasing, or constant.

LONG-RUN COST ANALYSIS

Long-run total cost is the total cost incurred by a firm in production when all
inputs are variable. In particular, it is the per unit cost that results as a firm increases in
the scale of operations by not only adding more workers to a given factory but also by
building a larger factory.
In the long run, when all inputs under the control of the firm are variable, there is
no fixed cost. As such, there is no need to distinguish between total cost, fixed cost, and
variable cost. In the long run, total cost is merely total cost.
In the long run, there are no fixed inputs. As such, marginal returns and
especially the law of diminishing marginal returns do not operate and thus do not guide
production and cost. Instead long-run total cost is affected by increasing and decreasing
returns to scale, which translates into economies of scale and diseconomies of scale.

Long Run Cost and Its Types

1. Long Run Total Cost
Long run Total Cost (LTC) refers to the minimum cost at which given level
of output can be produced. The long run total cost of production is the least
possible cost of producing any given level of output when all inputs are variable.”
LTC represents the least cost of different quantities of output. LTC is always less
than or equal to short run total cost, but it is never more than short run cost.
2. Long Run Average Cost
 Long run Average Cost (LAC) is equal to long run total costs divided by
the level of output. The derivation of long run average costs is done from the
short run average cost curves. In the short run, plant is fixed and each short run
curve corresponds to a particular plant. The long run average costs curve is also
called planning curve or envelope curve as it helps in making organizational
plans for expanding production and achieving minimum cost.
3. Long Run Marginal Cost
Long run Marginal Cost (LMC) is defined as added cost of producing an
additional unit of a commodity when all inputs are variable. This cost is derived
from short run marginal cost.

Three Returns to Scale

If a firm or producer changes all inputs proportional, the resulting change in
production is guided by returns to scale, which come in three varieties.

1. Constant Return to Scale

 Constant returns to scale occur when the output increases in exactly
the same proportion as the factors of production. In other words, when
inputs (i.e. capital and labor) increase, outputs likewise increase in the
same proportion as a result.
 As an example of constant returns to scale, if the factors of production
are doubled, then the output will also be exactly doubled

2. Increasing Return to Scale

 Increasing returns to scale happen when all the factors of production
are increased; at this point, the output increases at a higher rate.
 For example, if all inputs are doubled, the overall output will increase at
more than twice the rate—this is the increase in output relative to
inputs that “increasing” describes.

3. Decreasing Return to Scale

 Decreasing or decreasing returns to scale are taking place when all the
factors of production increase in a given proportion, but the output
increases at a lesser rate than that of the increase in factors of
production. To compare this to increasing returns to scale: for
decreasing returns to scale, increasing inputs leads to smaller
 increases in output; for increasing returns to scale, increasing inputs
leads to the opposite—larger increases in output.
 For example, if the factors of production are doubled, then the output
will be less than doubled.

Two Scale Cost Alternatives

Long-run production analysis provides the foundation for understanding long-run
cost. In particular, increasing and decreasing returns to scale are behind two important
long-run cost concepts--economies of scale and diseconomies of scale.
1. Economies of Scale
 These occur if a firm experiences a decrease in the long-run average cost
due to proportional increases in all inputs. Economies of scale result, in
part, from increasing returns to scale. If production increases more than
inputs increase, then the average cost of production declines.
 For relatively small levels of production, a firm tends to experience
economies of scale and increasing returns to scale. These result because
an increase in the scale of operations (a proportional increase in all inputs
under the control of the firm) affects the cost of production.
Economies of scale generally occur because of:
a. Specialization
A larger scale of operations allows individual workers to specialize
in a few specific tasks and become highly skilled at them. It will
allow firms to produce output more efficiently.
b. Large initial setup cost
If an industry requires large initial capital expenditure to operate,
firms that can afford the capital expenditure will experience
increasing returns to scale.
c. Network externalities
The network effect is the impact of an additional user of a good or
service on the value of that good or service to others. For example,
if a social media platform only lists a hundred users, likely, it will not
be very valuable for a social media user. Whereas if a social media
platform counts one billion users, the social media service is more
valuable to its users.

2. Diseconomies of Scale
 These occur if a firm experiences an increase in the long-run average cost
due to proportional increases in all inputs. Diseconomies of scale result, in
 part, from decreasing returns to scale. If production increases less than
inputs increase, then the average cost of production increases.
 For relatively large levels of production, a firm tends to experience
diseconomies of scale and decreasing returns to scale. These result
because an increase in the scale of operations affects the cost of
production.

This graph shows that the as the output (production) increases, long run average total
cost decreases in economies of scale. Constant in constant returns to scale and
increases in diseconomies of scale.