Long-Run Production Costs

 Economies and Diseconomies of scale
     In the Long Run like in Short Run average total cost (ATC) is U shaped, but why? We can’t explain this by law of diminishing returns, because only in short run plant’s capacity is fixed. In long run all resources are variable. Since prices of the resources are constant we can explain the form of the ATC in terms of economies and diseconomies of scale:
 
   Economies of Scale or economies of production explain the down-sloping part of ATC curve. The following factors may lower ATC of production:
 Management Specialization
     Large-scale production also means the better us and specialization of management. A manager that can supervise 50 people will be used inefficiently when the firm will employ only 20. Small plants won’t use managers to their best advantage, because they will have to divide time among more functions. Greater production means that manager will do his job full time so a higher efficiency will be achieved. This may result in lower product price.
Labor Specialization
     Increased specialization of labor becomes more achievable when factor’s size is increased. Hiring more workers means that tasks can be divided and subdivided, so that each worker has its own function. In this case a worker will perform only one job instead of five. In a small firm some skilled machine operators won’t be used efficient since they will perform unskilled task, leading to higher production costs.
   Workers by performing fewer tasks will become more proficient at them. Also greater labor specialization eliminates the time loss needed for them to switch their job.
Efficient Capital
       Small businesses may not afford to buy the most efficient machineries.  Some of these machineries are available only for mass-production, so a high efficiency is achieved only when there is used a big amount or resources. So a small firm is in dilemma between choosing to produce at inefficient equipment or at efficient one but with small amount of resources, but in both cases output is inefficient and too costly.
Other Factors
   An example of factor that creates economies of scale is advertising. These costs for advertising are decreased as more units are sold. So if there is an increase in quantity of resources ex: 30% followed by a greater increase in quantity of output ex: 50% then this event  declines ATC and may be a factor of economies of scale.

Diseconomies of Scale
   While a firm is expanding, their ATC may increase, so the curve of it becomes up-sloping. The main factor of diseconomies of scale is the difficulty of controlling and operating a bigger firm. In small ones a single manager may make all decisions for plant’s operations.
   But as the firm grows there is need for more managers. One person can’t digest and understand all the information needed for decision making. Expansion of management hierarchy leads to problems of communication and cooperation. So decision making may be slowed down so that they fail to respond immediately to change in consumer’s demand.
   In massive production workers may feel free from their employers so that they care less about working efficiently. So if there is an increase in quantity of resources ex: 30% followed by a smaller increase in quantity of output ex: 20% then this event increases ATC and may be a factor of diseconomies of scale.

Constant Return Scale
     In some industries a wider range of output may exist between the output at which economies of scale end and output at which diseconomies of scale begin. This range is called constant return scale and may exist over a wide part of long-run curve in which average total cost (ATC) doesn’t change. So if there is quantity Q input there will be also quantity Q output.

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Short Run Production Costs

   Production information must contain resource prices in order to determine total and per unit price of diverse amount of output. It’s known that in short run prices are associated with plant’s variable resources. Its capital resources are limited so we shouldn’t consider them. Short run costs can be either variable or fixed. So let’s describe them:
Fixed Cost: these costs don’t vary with changes in output. These costs must be paid even if the firm doesn’t produce anything. Such costs may be: rental payments, interests of firm’s debts, money paid for insurance. These costs are paid even when the firm has zero output, so firm can’t avoid paying these costs.
Variable Cost:
 These costs vary with the change in output. They include payment for raw material, fuel, wages, transportation prices, fuel etc. These payments vary directly with output. As the production begins variable costs will increase by a decreasing amount, but after a point they will rise by an increasing amounts (as a result of law of diminishing marginal returns) also this reason lies in the shape of Marginal Product (MP) curve, which is increasing with smaller and smaller amounts and when diminishing returns are encountered marginal product begin to decline, so larger and larger amounts of variable resources are needed to produce a successive unit of output. Total variable cost then is increasing by an increasing amount.
Total Cost:
Economists call sum of fixed costs and variable costs as total costs. At zero unit of output total costs are equal with fixed costs. Graphically, amount of vertical Total Fixed Cost (TFC) summed with vertical value of Total Variable Cost (TVC) should result in Total Cost (TC).
For business manager these distinctions between fixed and variable costs are very important. Variable costs can be controlled or changed by changing production levels in short-run. However, fixed costs are beyond control of business manager, because they are included in short run and must be paid regardless the output level. In short run firms can’t get out of industry and leave the market.

 Per-unit and Average Costs:
 Average fixed cost (AFC) is found by dividing total fixed cost by output quantity (Q):

Because Total fixed Cost by definition is the same regardless of output, then AFC curve will decline as output increases,because as output quantity increases Total Fixed Cost (TFC) is spread over a larger output produced. Q≠0.

Average Variable Cost (AVC): for any output quantity (Q≠0) is calculated by dividing Total Variable Cost (TVC) by Quantity output (Q):

As added more variable resources increase output, average variable cost (AVC) declines initially, reach a minimum and then increases again, so AVC curve is U shaped. It can be explained by the fact that AVC (also TVC) curve reflects law of diminishing returns.

  To explain in simple terms, at very low levels of output, production is inefficient because of high-costs and low quantity produced. Initially, since firm is understaffed, average variable cost is relatively high. As output expands greater level of specialization, greater division of labor and better use of firm’s capital occurs. However, when we still add more variable resources, a point is reached when diminishing returns are incurred. Also the firm is being overstaffed so each additional unit of variable resource doesn’t increase marginal product (MP) as before.

ATC
    Average Total Cost (ATC) for any output level is found by dividing Total Cost (TC) by output (Q) or by adding average variable cost (AVC) and average fixed cost (AFC):

Graphically ATC can be found by adding vertically average variable cost (AVC) and average fixed cost (AFC). Q≠0. 

Marginal Cost
  Marginal Cost is the additional cost of producing one more unit of output. Marginal cost can be found by following formula:

Marginal Cost is important for firm’s managers because a firm can control it immediately. It is used to find the cost of production of an additional product, so it helps to save some money if the firm doesn’t produce this unit (because of the loss that may occur at production).

Short-Run labor output realationship, Law of diminishing returns!

Firm’s cost of producing of a specific good or service depends of quantity of resources needed to produce that goods. Price is determined by resource supply and demand. To examine labor-output relationship we should know some terms:

• Total Product (TP) is the total quantity or total output of a specific good or service.
• Marginal Product (MP) is the extra output of a product associated with adding a unit of variable resource, in our case it is labor. Thus we can write the following formula:

 

• Average Product (AP) is output per unit of resource employed (labor in our case):

 

In the short run we can maximize “for a time” the output by adding labor to the fixed plant. But how much will output rise when a firm adds labor?

Law of Diminishing Returns

  Law of diminishing returns also called low of diminishing marginal utility, states that as a successive unit of variable unit(let’s say labor) is added to a fixed resource(capital, land or firm), the marginal product (MP) will eventually decline.  For example if additional workers are hired to work with a constant amount of machineries, the output will rise by smaller and smaller amounts.

Examples:

     Let’s say that a farmer has 100 hectares of planted tomatoes.  If the farmer will cultivate this land once he will get 100kg per hectare, if he cultivates it twice he will get 150 kg per hectare, a third cultivation may result in 170 kg per hectare, the fourth one will rise the output only by 5 kg per hectare, so he will get 175 kg/hectare. So succeeding cultivations add less output. If there wouldn’t be like that then the world’s need for food could be fulfilled by intense cultivation of these 100 hectares.  If diminishing returns wouldn’t occur the world could be fed from 1 m². Just keep adding seeds, fertilizers and harvester.

Another example of law of diminishing returns could be taken from a firm for producing doors for cars. This firm has a fixed number of machineries. So if only 2 or 3 workers are hired then the total output would be very low. Because they will have to do many different jobs and advantage of specialization won’t occur. Workers will lose time for switching from one job to another and machineries may stay a lot of time idle. So the firm will be understaffed and there will be underproduction of goods.

This firm may hire more labor then the equipment will be used efficiently. There won’t be any time lost by switching the jobs. As we add more workers the production will be more efficient and the marginal product will rise.

The rise in marginal product won’t go indefinitely. If still more workers will be added, beyond a point, the firm may be overcrowded. Workers will have to wait to use machineries. Total output will increase at a diminishing rate, because since we have a firm fixed-sized firm, each additional worker will have less additional capital to work with, as more labor is hired.  The marginal product will decline because there will be more labor than the amount of capital available. If we still add more labor then the quantity produced will decline, so the marginal product will get negative and at a point(extreme one) will fall to zero.

Law of diminishing returns assumes that all units of labor are with the same qualities, same innate abilities, education, training and work experience. Marginal product decreases not because the workers whom we add are inferior, but because more workers are used in comparison with the amount of firm and equipment.