Average Cost Analysis for Manufacturing Plants

Costs in the Long Run

• The long run is the period where all inputs are variable.
• Firms plan as if they are operating in the long run, but in reality, operate in the short run.
• Diminishing marginal productivity applies in the short run, but not in the long run where all costs are variable.
• Long run average cost curves show the per-unit costs of production in the long run.

Learning Objectives

• Distinguish between the short run and the long run.
• Explain why medium-sized firms can be just as efficient as larger firms.
• Explain why larger firms sometimes have great cost advantages.
• Explain why firms can sometimes be too big.
• Explain the concept of the "right size" of a firm.
• Explain how input price and technology changes affect a firm's costs.
• Explain why markets can sometimes be too small.

LO1: The Short and Long Run

• The long run is when all inputs are variable.
• Firms can plan as if they are operating in the long run, but they always operate in the short run in the present.
• Short-run production processes experience diminishing marginal productivity.

LO2: Constant Returns to Scale

• Constant returns to scale occurs when a proportionate increase in all inputs results in an equal proportionate increase in output.
• The lowest average cost remains the same for all sizes of a firm's plant.
• The long-run average cost curve (LRAC) is horizontal when constant returns to scale prevail.

The Long Run Average Cost Curve

• A graphical representation of a firm's per-unit costs of production in the long run.
• A firm can plan as if it's in the long run, but it always operates in the short run.

Constant Returns to Scale

• A concept where output increases by the same percentage as inputs.
• For each plant size, the lowest average cost is the same.
• The result is a horizontal LRAC curve.

Average Cost of Production in Four Plant Sizes

• Connecting minimum average costs for each plant size creates the long-run average cost curve.
• Firms producing larger scales have the same long-run average cost.

Plant Size Alternatives

• A table illustrating how average costs differ with different plant sizes, given various output levels.

Test Your Understanding (Table 1)

• Determining the best plant suited to produce 4 units based on average costs from different plant sizes.

Test Your Understanding (Table 2)

• Determining the best plant suited to produce 4 units based on average costs.

Test Your Understanding (Table 3)

• Determining the value of long-run average cost from average costs for different plant sizes at various outputs.

LO3: Economies of Scale

• Economies of scale are cost savings resulting from large-scale operations.
• Manufacturing industries often utilize assembly lines for standardized products.
• Long-run average costs typically decrease as the size of operations increases.

The LRAC Curve Under Economies of Scale

• Economies of scale (increasing returns) occur when the growth in size lowers the minimum average cost of production for each plant.
• The larger-scale firm might produce at a lower long-run average cost.

Reasons for Economies of Scale

• Technical economies : Division of labor, management specialization, machine specialization
• Pecuniary economies : Cost reduced from lower costs of borrowing, bulk buying, selling by-products, lower ads costs.

Test Your Understanding (Sets 1 and 2)

• Determining if economies or constant returns exist in sets of data using total cost and output.

LO4: Diseconomies of Scale

• Diseconomies of scale result from bureaucratic inefficiencies in management.
• Average costs of production increase with increased plant size.
• Diseconomies of scale are also known as decreasing returns.

The LRAC Curve Under Diseconomies of Scale

• A firm producing at a larger scale (i.e., 1600 vs. 1000) potentially experiences higher long-run average costs.

Reasons for Diseconomies of Scale

• Increased lines of communication.
• Increased cost of communication
• Misinterpretation of communication (particularly technical).
• Lines of responsibility and decision making become blurred.

At a Glance

• Diagrams illustrating how various scales of production affect costs and output.

Test Your Understanding (Cases A-D)

• Determining if constant, economies, or diseconomies of scale exist in different sets of data based on Inputs 1 & 2 and output.

LO5: What is the Right Size of a Firm

• Firms often experience constant returns at a range of output levels.
• The right size of a firm is when economies of scale are maximized, but diseconomies are not yet in effect.
• The right size is called the Minimum Efficient Scale (MES).

The Right Size of a Firm

• A firm is considered the right size if it's large enough to achieve economies of scale, but not so large that it experiences diseconomies of scale.

Minimum Efficient Scale

• The smallest plant size that achieves the lowest long-run average cost.

LO6: Changes in Short and Long-Run Costs

• Both short-run and long-run average costs can decrease if input prices decrease, technological improvements occur, or merges reduce fixed costs.

Changes in Short-Run and Long-Run Costs

• A drop in factor input prices or improved technology often shifts cost curves downwards—decreasing average costs.

LO7: Can a Market Be Too Small?

• Yes, a market can be too small if it limits the output level of a firm below its economic capacity and/ or its minimum efficient scale.

Can a Market Be Too Small?

• A small market may limit a firm's output to a level where average cost is too high due to failing to achieve economies of scale.

Key Concepts to Remember

• Firms always operate in the short run but plan for the long run.
• The conditions for economies, constant returns, and diseconomies;and how they relate to costs.
• The impact of technological changes on costs.
• The best size for a firm depends on the industry.
• Some markets might be too small for efficient production.