Study Notes on Production and Cost in Short Run vs Long Run

Examination of the Firm's Production and Costs

Context of Short Run vs Long Run

• The analysis begins with the examination of the firm’s production and costs within the context of the short run. In this context:

  • At least one input is fixed.

• Transitioning to the long run, all costs are variable:

  • This allows a firm to adjust all its inputs and planning as necessary.

Long Run Cost and Economies of Scale

• Key Focus: Understanding why costs differ between the short run and the long run.

• The concept of economies of scale is introduced, defined as the long-run phenomenon regarding cost behaviors associated with increased output levels.

Short Run Limitations

• In the short run:

  • Fixed costs are beyond the firm's control.

  • Production organization can still lead to all costs being variable when transitioning to the long run.

Firm Size Considerations

• Firm size influences average total cost across production output levels:

  • Small-sized firm (Curve m)

  • Medium-sized firm (Cost representation not provided clearly but mentioned as lower than average costs at larger sizes)

  • Large-sized firm (Average Total Cost referred to as l m prime)

• Profit Maximization:

  • The firm strives to maximize profits under varying sizes.

  • Depending on output (denoted quantity q) and chosen size options, there are different average costs linked to production outputs:

  • For example, for quantity q, a medium-sized firm has higher average costs than a small one if producing the same quantity while maximizing profits.

  • Between the quantities qa and qb, costs remain unchanged because output remains constant within planned projections in the long run.

Reaction to Increased Demand

• If demand causes the required output to rise to q prime:

  • The firm is able to transition from a small to a medium-sized firm due to the costs associated with the increased output.

  • Initially, the average cost for q prime is higher, prompting a change in production status up three cases.

Long Run Average Total Cost Curve (LRATC)

• The LRATC reflects how production levels affect average total cost under variable conditions, enabling the firm to adapt its size systematically based on output levels.

• The LRATC is a planning curve where:

  • The relationship between output and average total cost is managed effectively by varying factors of production.

Empirical Example: Celine's Salsa Production

• A practical example discusses the production of salsa:

  • Short-run average total costs depend on the number of cases produced:

  • 3 cases: specific average total cost associated with that output

  • 6 cases: another average total cost curve

  • 9 cases: a further curve representing another level of output.

  • As output increases, the long-run average total cost includes an infinite number of short-run average total cost curves, thus affecting choice based on minimizing average cost.

Returns to Scale Defined

• Increasing Returns to Scale:

  • Long run average total cost declines as output increases, leading to

  • Economies of Scale defined as cost declines when output increases, often explained by specialization allowing for efficiencies.

• Decreasing Returns to Scale:

  • Occurs when the average total cost increases as output increases. This could manifest in larger firms' operations requiring complex managerial structures leading to higher costs.

• Constant Returns to Scale:

  • Average cost remains unchanged as output increases, suggesting stability in production costs despite scaling operations.

Long Run vs Short Run Characteristics

• Long Run:

  • Economies of scale (cost decline with increased output) is a long run aspect.

• Short Run:

  • Diminishing Returns (cost increases with output) is primarily a short run phenomenon and revealed through opportunity costs derived from economic profit.

Understanding Sunk Costs

• Sunk costs become crucial when considering decisions that have already incurred costs that cannot be recovered, influencing future choices:

  • Example:

  • Choosing between fixing a car or buying a new one based on past expenses should focus on current and future costs, ignoring unrecoverable sunk costs (previously spent dollars).

  • For example:

    • Replacing brake pads costs $250.

    • New defective brake system costs $1,500..]\\]

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    • Selling the car would entail additional costs but decisions should only account for recoverable costs moving forward.

• Financial decision impacts involving sunk costs illustrate the error in basing ongoing decisions on irretrievable past expenses, hence advocating for future-oriented economic reasoning.

Wrap-up

• The module wraps up by indicating the need to complete the associated worksheet on production and costs, reinforcing the topics discussed previously through practical examples involving total product schedules and cost structures.

• Final footnote: Ensure all concepts have been understood thoroughly as they form a critical part of the examination of firm operational costs in both long and short run contexts.