Microeconomics: Costs in the Long Run

Learning Objectives

  • Distinguish between the short run and the long run: Understand the differences in production capabilities over time.
  • Medium-sized firms vs. large firms: Analyze efficiency in firms of different sizes.
  • Cost advantages of big firms: Discuss situations where larger firms benefit economically.
  • Consequences of excessive firm size: Explain potential inefficiencies in very large firms.
  • Optimal firm size: Define what constitutes the right size for a firm in the market.
  • Impact of technological change on costs: Assess how advancements affect production costs.
  • Size limitations of markets: Identify scenarios where a market may not be large enough for efficient production.

The Short and Long Run

  • Long Run:
    • All inputs are variable.
    • Firms can adjust all factors of production.
    • Operates under the premise that long run decisions have long term impacts—diminishing marginal productivity does not apply as it does in the short run.
  • Short Run:
    • Some inputs are fixed; firms can only make changes within those constraints.
    • Diminishing marginal productivity is at play, impacting costs.

Long Run Average Cost Curve (LRAC)

  • Graphical Representation:
    • Shows per unit costs of production when all inputs are variable.
    • Connects minimum average costs of various plant sizes to illustrate efficiency at scale.
  • Constant Returns to Scale:
    • Concept that output increases by the same percentage as inputs.
    • Results in horizontal LRAC—indicative of stable average costs across different scales.

Economies of Scale

  • Definition:
    • Cost reductions as firm size increases.
  • Characteristics:
    • Seen primarily in manufacturing with standardized production.
    • Large firms often achieve lower average costs due to larger operations yielding more output per unit cost.
  • Reasons for Economies of Scale:
    • Technical Economies: Division of labor, machine specialization.
    • Pecuniary Economies: Lower borrowing costs, bulk purchasing advantages.

Diseconomies of Scale

  • Definition:
    • Cost increases that arise from bureaucratic inefficiencies as firms grow too large.
  • Implications:
    • Average costs rise with increased output, known as decreasing returns to scale.
  • Causes:
    • Complex communication structures, increased decision-making layers, misinterpretations in large teams.

Determining the Right Size of a Firm

  • Scale Considerations:
    • Balance between capturing economies of scale without moving into diseconomies.
    • Firm size variation across industries can lead to different efficiency outcomes.
  • Minimum Efficient Scale:
    • The smallest operational scale that allows the lowest long-run average cost.

Changes in Costs

  • Short-run vs. Long-run Adjustments:
    • Costs can decrease due to reductions in input prices or technological advancements.
    • Mergers may also lower average fixed costs, allowing more efficient production.
  • Impact on Cost Curves:
    • Improved technology and lower input costs shift down the long-run average cost curve (LRAC).

Market Size Limitations

  • Small Market Issues:
    • Markets that are too small can inhibit firm growth below optimal production levels.
    • Minimum Efficient Scale (MES): The threshold production level needed for efficiency in a firm.

Key Concepts to Remember

  1. Firms function primarily in the short run but can strategize long-term.
  2. Understanding economies, constant returns, and diseconomies of scale is essential for cost management.
  3. Technological advancements can drastically alter production costs and efficiency.
  4. Optimal size varies by industry—context is key.
  5. Some market sizes may restrict effective production, leading to inefficiencies.