Skip to main content

Microeconomics: Long run costs and economies of scale

We have explored the concept of the costs in the short run, it is now time to determine the costs in the long run. But first, let's define the term long run. In economics, the long run occurs when all variables are not fixed. In other words, the long run for a firm is when a firm can change all of its inputs. Then, all costs are variable in the long run. In this time frame a firm is not only able to change the number of workers but also the size of its factories and the number of machines (also known as capital).

In the graph below, you can see a number of different short run average total cost (SRATC) curves that depend on the different levels of fixed inputs. At first, the SRATC curves get lower as the firm increases its size, then it flattens out. Finally,  the SRATC curves get higher. These three effects are caused by different economies of scale.
  • The leftward region on the graph represents the economy of scale, where by increasing each input by a constant increases the production function more than by multiplying the whole production function by the same constant (alpha>1).
  •  The middle region shows the constant return to scale, a firm increases its size but it's average total cost stays the same (alpha>0). 
  • The rightward region is where the long run ATC (LRATC) experiences diseconomy of scale. This is the opposite of the economy of scale, where by increasing each input by a constant results in the production function being smaller than by multiplying the whole production function by the same constant (alpha>1).

In order to obtain the LRATC, one must build a curve that envelopes the SRATC curves. Where the LRATC is tangent to some of the vertices (or minimum) of the SRATC curves.



Note that the graph above is more of a representation of what a LRATC curve with all of the different economies of scale would look like. In reality, the LRATC in the graph is just a quadratic curve, and therefore does not experience constant return to scale, though it comes close to it around its vertex. Furthermore, as you can see, some SRATC curves are not tangent the LRATC, so the latter isn't an envelope either.

Cost-Minimization Formula:

As firms try to earn as much profit as possible, one method to achieve this objective is by lowering the cost of production by decreasing the quantity produced.
  • In order to minimize the cost firms have to follow this rule: the marginal product of labor (MLP) divided by its price (Pl) must be equal to the marginal product of capital (MPK) divided by its price (Pk). Often Pl is represented by the letter w which stands for "wage" and Pk by the letter r which stands for "rent".


As a general rule, the MPL and MPK are decreasing as firms increase the number of labor and capital. Then, if




The firm should increase its labor (hire more workers) and use less capital (machines), in order to minimize its SRATC, the LRATC becomes tangent to the short run average total cost curve. If


The firm should hire less workers and employ more capital, in order to minimize its SRATC.

Reference: Mayer,David. AP Microeconomics Crash Course. Research & Education Association (2014). p 83-86. 


Labels:

Comments

Post a Comment

Popular posts from this blog

Macroeconomics: equilibrium in the AD/AS model

Real output and price level in the AD/AS model: The short run equilibrium in the AD/AS model, is when the  intersection between the short run aggregate supply curve and the aggregate demand curve determines the level of output and price level.          This short equilibrium output can be compared to the full-employment (i.e long run equilibrium) output by adding the long run aggregate supply curve in the graph.  If the difference between the short run equilibrium output and full employment output is negative than we have a recessionary gap. This could be caused by a decrease in households' consumption, a fall in private investments, or a decrease in government spending. If the difference is positive, we have an inflationary gap, where the short run equilibrium output is bigger than its full employment output. This can be caused by an increase in households expenditures, expansionary fiscal policy, etc... If the gap is zero, this means that t...
Post a Comment
Read more

Microeconomics: Firms and cost in the short run

In Economics, the term short run refers to a time period where at least one variable of interest does not change . In our case, the short run for a firm is when at least one input  (labor, land, capital) stays fixed. Usually land and capital are considered fixed in the short run.  If an input is fixed during a period time, no matter how much the total product a firm produces, its cost stays the same. This cost is commonly known as fixed cost (FC). Examples of fixed costs: rent, property taxes, loan payments. Labor is often considered to be a part of the  variable cost (VC) . Variable cost can be defined as the cost a firm has control over during the short run. Unlike fixed cost, variable cost increases (decreases) as a firm's total product increases (decreases). Examples of variable costs include: utility bills, wages, raw materials A firm's total cost (TC) is the sum of its variable and fixed costs. As you can see, the fixed cost...
Post a Comment
Read more

Macroeconomics: balance of payments accounts

Balance of payment is the sum of three separate accounts and must always be equal to 0 (given no statistical error): Current account: the net flow of funds exchanged for goods and services, and monetary gifts  that flow in and out of a country. This is often used as an indicator for net export. Financial account: also known as the capital account, is the net flow of funds for investment in real assets (direct investments) or financial assets (stocks or bonds) into a nation. Official reserves: in order to balance the two accounts above, a country must have a reserve of foreign money. It measures the net effect of all money flows from the other accounts. If the current account is positive, it must be the case that the sum of the financial account and official reserves is negative. Current account (CA) components: Balance of trade in goods: spending by consumers and firms on imported and exported goods. Exported goods have a positive effect on the current account, whereas importe...
Post a Comment
Read more