Long run Cost Function: Introduction The time periods that we use in Economics can sometimes appear somewhat

arbitrary they help to provide a framework within which we can analyse the behaviour of businesses in different markets and industries, but the length of time that constitutes the short run clearly varies across industries and the reality is that most businesses can vary the amount of capital input in the short run by leasing items of machinery and renting additional commercial property and factory space if it is available. The key point about the long run is that all factors of production are assumed to be variable, in other words a business can vary all of its inputs and change the whole scale of production. How a firms output responds to a change in factor inputs is called returns to scale. The hypothetical returns for a business varying the scale of production is shown in the table below Labour Input 10 20 30 40 50 Capital Input Plant 1 40 100 130 150 160 10 Plant 2 100 160 180 200 210 20 Plant 3 130 180 240 255 270 30 Plant 4 150 210 250 275 290 40

In the example shown when the business increases the scale of production from Plant 1 (with 10 units of labour and 10 units of capital) to Plant 2 (a doubling of the inputs used), total output quadruples. This shows increasing returns to scale leading to a fall in the average total cost of production. A further increase in scale to Plant 3 demonstrates constant returns to scale where both inputs and output have increased by 50% and a further expansion of scale to Plant 4 illustrates decreasing returns to scale where inputs have grown by 33% but output has grown by just 15%. When a firm experiences decreasing returns to scale, then average total cost will rise in other words diseconomies of scale exist. Economies and Diseconomies of Scale In the long run the scale of production can be increased or reduced, because all factors are variable. This allows the firm to move on to new average cost curves. For each size of firm there is an equivalent short run average cost curve. As the firm expands, it moves on to different short run average cost curves. If expanding the scale of output leads to a lower average cost for each level of output then the firm is said to be experiencing economies of scale. The long run average total cost curve (LRAC) shown in the diagram below is the locus of points representing the minimum average total cost of producing any given rate of output, given current technology and resource prices. The LRAC curve or envelope curve is drawn on the assumption of infinite plant sizes. The points of tangency do not occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale (MES) is achieved. MES is the minimum level of output required to fully exploit economies of scale in the long run:

By Ali ur Rehman

G.C.M.S Peshawar

One way of interpreting the minimum efficient scale is to consider the cost disadvantage of producing an output below the estimated MES. Consider the diagram below. The lowest point of the LRAC occurs at an output of 90,000 per month where average total cost = 10 per unit. At an output level of of MES (45,000 per month) the average cost is estimated to be 25 per unit. At an output level of just 1/3 of MES the cost disadvantage is even greater with AC rising to 40 per unit.

The steeper the fall in the LRAC up to the MES, the greater the cost advantage in exploiting economies of scale. The LRAC will tend to fall steeply when the overhead costs of production are high and the marginal costs of producing extra output are low the classic examples of industries

By Ali ur Rehman

G.C.M.S Peshawar

where this occurs are in markets such as steel production, motor car manufacturing, pharmaceuticals and computer software. The long run average total cost curve does not always have to have the shape illustrated in the diagram above. With a natural monopoly, the cost structure is different. For example, in industries where massive networks or national distribution channels are required, the overhead costs relative to the running costs are likely to be high. There is also likely to be great potential to exploit technical economies of scale. As a result the MES will be a high proportion of total market demand. There may be room only for one business to fully exploit the increasing returns to scale available in the industry. We assume for a natural monopoly that the long-run average cost curve falls continuously over a very large range of output. This is shown in the diagram below the average cost per unit declines over the full range of output.

This does not mean that a natural monopoly is an industry with only one supplier. Often a number of firms may operate profitably below MES because the cost disadvantage of doing so is small, or because of product differentiation which allows smaller suppliers to sell their output at a premium price to the market average, taking advantage of the willingness and ability of consumers to pay higher prices to cover the increased cost per unit. Nonetheless when the minimum efficient scale of production is high relative to total market demand, we expect to see a high level of industry concentration. The long run average and marginal cost curves can be summarised as shown in the final diagram below. When LRAC is falling, then LRMC must lie below it but when LRMC is rising and is above LRAC then diseconomies of scale have set in and average costs are rising. The firm has gone beyond the output of productive efficiency in the long run.

By Ali ur Rehman

G.C.M.S Peshawar

By Ali ur Rehman

G.C.M.S Peshawar