Long Run Cost Analysis

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Long Run Cost Analysis

• Recall that the long run is when all factors are
  variable, including capital.
• Lets put this in plain terms by going back to
  your Back to the Business Future auto plant.

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As Demand Expands

• Then, as demand expanded, you built more plant
  capacity.
• Now suppose that this pattern kept repeating
  itself and that you kept building larger and
  larger plants.
• What do you think would happen to your firms
  average cost as plant scale increased?

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The Long Run Average Cost Curve
The long run average cost curve is the envelope
of the short run average cost curves.
LATC
Costs per unit
Quantity
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The Long Run Average Cost Curve
Costs per unit

• Capital inputs are fixed in the short run and
  there is a point on the ATC curve where average
  cost is minimized.

Quantity
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The Long Run Average Cost Curve
Costs per unit
Quantity
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The Long Run Average Cost Curve
LATC
SATC6
Costs per unit
SATC5
SATC3

• If the number of possible plant sizes is very
  large,the long run average cost curve
  approximates a smooth curve.

SATC4
Quantity
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The Long Run Average Cost Curve
higher unit costs
lower unit costs
LATC
SATC6
Costs per unit
SATC5
SATC3

• Economies of scale
• Diseconomies of scale
• Constant returns to scale

SATC4
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Quantity
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Economies Of Scale

• Exist when the per-unit output cost of all inputs
  decreases as output increases.
• If producing 40,000 VCRs costs the firm 16,000
  or 400 each but producing 200,000 VCRs costs the
  firm 40,000 or 200 each, there are significant
  economies of scale associated with the higher
  output level.
• The question, of course, is what accounts for
  these economies.
• Try jotting down a few reasons.

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Related Factors

• Labor specialization
• Managerial specialization
• Efficient capital
• By-products
• Other such factors

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Labor Specialization

• Increased labor specialization means dividing and
  sub-dividing jobs as plant size increases.
• Instead of performing five or six jobs, a worker
  can focus on one.
• In a small plant, a skilled machinist might spend
  half the time performing unskilled tasks leading
  to higher production costs.
• Greater specialization also eliminates the loss
  of time that occurs when workers shift between
  jobs.

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Managerial Specialization

• With managerial specialization, a supervisor who
  can handle twenty workers will be under-used in a
  small plant as will a sales specialist who may
  have to divide his or her time between other
  managerial functions such as marketing,
  personnel, and finance.

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Efficient Capital Use

• Larger plant size also facilitates the most
  efficient capital use.
• In the auto industry, the most efficient
  production method involves robotics and
  sophisticated assembly line equipment.
• But effective use of such machinery and equipment
  requires an output of at least 200,000 cars.

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By-Products

• Larger scale production also allows better use of
  by-products.
• For example, a large meat packing plant will also
  make glue, fertilizer, and pharmaceuticals from
  animal remains which would be otherwise be
  discarded by smaller producers.

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Other Factors

• Finally, there are other factors such as design,
  development, and certain other start-up costs
  that must be incurred irrespective of sales.
• These costs per unit decline as output increases.

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The B-2 or "Stealth Bomber"

• The Pentagon originally wanted to build 132 of
  the planes at a cost of 580 million per plane.
  
• But the Secretary of Defense slashed the
  Pentagons request to only 75 bombers.
• The result The cost per plane soared to over
  800 million due to the loss of scale economies.

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Diseconomies Of Scale
LATC
Costs per unit
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Quantity
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Causes of Diseconomies of scale

• Managerial problems efficiently controlling and
  coordinating a firms operations as it becomes a
  large-scale producer.
• At some point, a plant just gets too big for
  effective management.
• In massive production facilities, workers may
  begin to feel alienated from their jobs and
  efficiency may suffer.

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The US Auto Industry

• In recent years, GM the worlds largest
  corporation has found itself with both a
  declining market share and a substantial cost
  disadvantage.
• In fact, GMs labor costs per car are nearly 800
  more than Fords and 500 more than Chryslers.

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To Offset Scale Diseconomies

• GM has given each of its five automotive
  divisions Chevrolet, Buick, Pontiac,
  Oldsmobile, and Cadillac much greater autonomy
  with respect to styling, engineering and
  marketing decision.
• The goal is to reduce the layers of managerial
  approval required in decision making so each
  division can respond more rapidly.

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1
2
Long-run ATC
Long-run ATC
Unit costs
Unit costs
Output
Output
4
3
Long-run ATC
Long-run ATC
Unit costs
Unit costs
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Output
Output
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Here, the narrow U-shape indicates that economies
of scale are exhausted quickly.
Long-run ATC
Unit costs
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Output
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Constant Returns To Scale
Long-run ATC
Unit Costs
Output
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Banking Mergers in the 1980s

• Most analysts thought unit costs would fall
  dramatically.
• Banks could close some of their branches and
  combine support services such as computer
  processing, advertising, auditing, and legal
  work.
• Studies found that the mergers did not
  significantly reduce costs.
• One possible explanation is constant returns to
  scale over a broad spectrum of output.

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Increasing Returns To Scale

• This is one of the most famous in economics
  because it is the signature of what is called a
  natural monopoly.

Unit Costs
Long-run ATC
Output
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Increasing Returns To Scale

• Over time, bigger producers will drive out small
  producers until there is only one left.
• The result is that price is set too high and
  output too low.

Unit Costs
Long-run ATC
Output
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Minimum Efficient Scale

• The smallest level of output at which a firm can
  minimize long-run average costs.

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Constant Returns To Scale

• Because of the extended range of constant returns
  to scale, relatively large and small firms can
  coexist and be equally viable.

Long-run ATC
Unit Costs
Output
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Natural Monopoly

• In the case of natural monopolies like the
  railroads and utilities, small firms cannot
  realize the MES so there is only one seller.

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Oligopoly

• A large minimum efficient scale can also give
  rise to another type of industry structure known
  as oligopoly.
• An oligopolistic industry is characterized by a
  small number of large sellers.
• Examples include automobiles, aluminum, steel,
  and cigarettes.

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The Broader Point

• The shape of an industrys long run average cost
  curve has an enormous influence on the structure
  of that industry.
• Will it be competitive, oligopolistic, or
  monopolistic?

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Two More Tasks

• This completes our discussion of short and long
  run cost analysis.
• Now there are just two more tasks we have to
  complete
• the difference between economic profits and
  accounting profits
• and clean up a few things about the supply curve

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The Supply Curve

• In the next lesson, Ill show you how to derive
  that curve from the upward sloping marginal cost
  curve.
• However, for now, lets just point out several
  common traits that the supply curve has with the
  demand curve we learned about in the last
  lecture.

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The Law Of Supply

• First, just as there is a law of demand, there is
  a law of supply.
• When the price of a good increases, the quantity
  of that good supplied will increase.
• This means, of course, that the supply curve is
  upward sloping.

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The Price Elasticity Of Supply

• Second, just as there is a price elasticity of
  demand, there is a price elasticity of supply.
• Knowing what you know about demand elasticity,
  try writing the supply elasticity formula.

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The Elasticity Formula
change in quantity supplied
change in price
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Determinants Of Elasticity

• The most important determinant of the elasticity
  of supply is the number of substitutes for the
  good.
• If substitution is easy, supply will be elastic
• If substitution is difficult, supply will be
  inelastic.
• Try drawing an elastic, inelastic, and unit
  elastic supply curve.

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Elasticity Of Supply
S2 inelastic Egt1
S0 unit elastic E1
S1 elastic Elt1
Price
Quantity
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Economic vs. Accounting Profits

• Lets talk about how an economist measures a
  firms costs and profits versus how an accountant
  measures them.
• In this regard, an economist as opposed to an
  accountant will always count not only explicit
  costs but implicit costs as well.

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Explicit vs. Implicit Costs

• Explicit costs are your monetary payments to
  outsiders for things like labor, materials,
  fuel, transportation and power.
• Implicit costs represent the money payments you
  could have earned by employing your own resources
  in their best alternative use.
• This distinction sheds further light on the
  concept of opportunity costs that we introduced
  in an earlier lecture.

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Opportunity Costs

• Includes all consequences, whether they reflect
  explicit monetary transactions or not.
• The immediate dollar cost of going to a movie
  instead of reading your economics textbook is the
  price of the movie ticket.
• The opportunity cost also includes the
  possibility of gaining a better understanding of
  macroeconomics and therefore becoming more
  successful in business.

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• Suppose both you and your spouse earn after tax
  salaries of 45,000 a year as sales
  representatives for a hospital equipment
  distributor, but you want to do better.
• So you both quit your jobs to open your own
  business -- a health food juice bar called Juice
  Me Up Scotty.

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For Startup Capital

• You borrow 20,000 from the bank at 10 interest.
  
• You kick in another 30,000 of your own savings
  that had been earning you 1,500 annually in
  interest income from your portfolio of bond
  investments.
• You also kick out a tenant in the storefront that
  you own who was paying you 800 in rent per
  month.

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Income Statement of Juice Me Up Scotty,
Inc. (January 1,2001, to December 31,
2001) (1) Net sales (after all discounts and
rebates) 255,000 Less cost of goods
sold (2) Materials 30,000 (3) Labor
cost 60,000 (4) Miscellaneous operating costs
(utilities, etc.) 7,000 (5) Less overhead
costs (6) Selling and administrative costs
7,000 (7) Rent for building
4,000 (8) Depreciation 7,000 (9) Operating
expenses 115,000 115,000 (10) Net operating
income 140,000 Less (11) Interest
charges on equipment loan
3,000 (12) State and local taxes
2,000 (13) Net income (or profit) before income
taxes 135,000 (14) Less Corporation income
taxes 44,550 (15) Net income (or profit)
after taxes 90,450 (16) Less Dividends
paid on common stock (17) Addition to
retained earnings
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Income Statement of Juice Me Up Scotty,
Inc. (January 1,2001, to December 31,
2001) (1) Net sales (after all discounts and
rebates) 255,000 Less cost of goods
sold (2) Materials 30,000 (3) Labor
cost 60,000 (4) Miscellaneous operating costs
(utilities, etc.) 7,000 (5) Less overhead
costs (6) Selling and administrative costs
7,000 (7) Rent for building
4,000 (8) Depreciation 7,000 (9) Operating
expenses 115,000 115,000 (10) Net operating
income 140,000 Less (11) Interest
charges on equipment loan
3,000 (12) State and local taxes
2,000 (13) Net income (or profit) before income
taxes 135,000 (14) Less Corporation income
taxes 44,550 (15) Net income (or profit)
after taxes 90,450 (16) Less Dividends
paid on common stock (17) Addition to
retained earnings
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Income Statement of Juice Me Up Scotty,
Inc. (January 1, 2001, to December 31,
2001) (1) Net sales (after all discounts and
rebates) 255,000 Less cost of goods
sold (2) Materials 30,000 (3) Labor
cost 60,000 (4) Miscellaneous operating costs
(utilities, etc.) 7,000 (5) Less overhead
costs (6) Selling and administrative costs
7,000 (7) Rent for building
4,000 (8) Depreciation 7,000 (9) Operating
expenses 115,000 115,000 (10) Net operating
income 140,000 Less (11) Interest
charges on equipment loan
3,000 (12) State and local taxes
2,000 (13) Net income (or profit) before income
taxes 135,000 (14) Less Corporation income
taxes 44,550 (15) Net income (or profit)
after taxes 90,450 (16) Less Dividends
paid on common stock (17) Addition to
retained earnings
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You End Up Being Worse Off
Category Opportunity Cost
Your own financial capital 1,500 Kicking out
your tenant 7,200 After tax salaries
90,000 Total 98,700 Accounting profit
90,450 Economic profit - 8,250
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• People make mistakes like this all the time
  because they base important decisions on
  accounting rather than economic profits.
• Always consider your opportunity costs when you
  make a decision.

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Conclusion
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End Of Lesson
Lecturer Peter Navarro Multimedia Designer Ron
Kahr Female Voiceover Ashley West Leonard