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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Economic Costs

   Goods or resources have price because they are scarce and may have alternative uses. When a society uses resources to produce a specific good, it loses (forgoes) the opportunity to use this good for any other purpose. Economic cost or opportunity costs measure the value or worth of a good that would have in its best alternative use.

Explicit and Implicit Costs
   Now let’s consider costs from a business viewpoint. Keeping opportunity costs in mind, we may say that economic costs are payments that a business must make or income it must provide, to attract resources it needs from alternative uses. These payments to resource providers may be explicit (expressed) or implicit (present but not obvious). So firms have both implicit and explicit costs while they are producing goods:

• A firm’s explicit costs are payments that it makes for labor force, resources, transportation of goods and so on.
• A firm’s implicit costs are the opportunity cost for the goods it owns and it produces. They are the monetary payments that those resources could have earned if they were used in their best alternative uses.

       Normal Profit
            Normal profit (an implicit cost for firms) is the monetary payment that a firm must make to obtain and retain entrepreneurial ability also we may call it as minimum payment entrepreneurial ability must receive to perform the entrepreneurial activity for a firm. For example if you are entrepreneur and you didn’t receive this minimum payment for your effort you could easily withdraw from a business and move to a more attractive one.
   Economists include as costs of production all payments- implicit (including normal profit) and explicit, which are required to attract resources in a specific economic unit.

Economic Profit
     To economists, economic profit is the difference between total revenue (TR) and total costs (TC) (implicit and explicit). So when it is said that a firm receives normal profit, it means that it receives the money needed to cover it costs (implicit and explicit) and the entrepreneur is receiving payments large enough to retain his abilities in this production line.

 

Economic profit is not a cost, better said it is excess revenue offered to entrepreneur in his line of production.

Short Run and Long Run
   When firm’s demand changes its profit may depend how quickly it can adjusts to various amount of resources it employs. It can quickly adjust the quantity of resources employed of labor, fuel, resources. However, to adjust plant capacity (size of factory, amount of equipment and machinery and other capital resources) more time it’s needed. For example in heavy industries time needed to increase plant capacity can be very long. That’s why economists distinguish two conceptual periods: long run and short run.
Short Run
       In short run plant capacity is assumed to be fixed because period of time is too short; however it is enough to perform several changes in the method how the fixed plant is used. For example, firm may vary the quantity output by applying different amount of labor force, materials and other resources needed to that plant.

Long Run
      Long run is a period long enough to adjust all quantities of resources that a firm needs even a change in plant’s capacity can occur. For industry, long-run is the period of time in which firms can also leave or enter the industry. While short run determines “fixed-plant” period, long run determines “variable-plant” period.

Elasticity of Supply

   Supply also can be determined by price elasticity. If producers are responsive to a change in price then supply is elastic. If they are insensitive to price change then the supply is inelastic.
   In economics elasticity of supply is denoted by E_s, but there is a change in our elasticity of demand formula:

    Like E_d, if E_s is smaller than one, then the supply is inelastic. However, if E_s is smaller than one then the supply is inelastic.
   The main determinant of elasticity of supply is time they have to respond to an increase in demand. Shifting resources takes time, more time available- greater ability to shift resources. The impact that time can have on elasticity of supply is distinguished among the immediate market period, short run, and the long run.

   Market Period
        Market period is that amount of time in which suppliers are unable to respond to an increase in demand and in price of a good. Suppose an owner of a small goat farm has 100 liter produced in the whole week and he bring all this quantity of milk to the market to sell. The supply curve is perfectly inelastic (vertical). This farmer will sell all his milk whether the price is high or low. Why? Because the farmer can offer only this quantity of milk in this milk even if the price is very high. Another week in needed to collect more milk, so he needs some time to respond to the increase in demand. Also, because the product is perishable he can’t keep it away for some time from the market. If the price is smaller than anticipated this farmer also has to sell all this quantity of milk.
   As we can see farmer’s cost of production, won’t enter into decision to sell, because he has to sell all his production in order to avoid total loss. During market period our farmer’s quantity of supplied milk is fixed, no matter how high or low the price can be.
   However, not all supply curves are perfectly inelastic immediately after a price change. If the good is not perishable and price rises, then the producers may choose to increase quantity supplied by drawing down their inventory unsold, stored goods causing market supply to get more quantity of that good.
         For our farmer this market period can be one week, however, for producers of some goods that can be inexpensively stored, there may be no market period at all.
  The Short Run
         In short run, the plant capacity of some producers or of the entire industry is fixed. In the short run, our farmer’s farm is fixed, but he may give more food and more nutrients for his goats which may result in a somewhat higher output. In this case, an increase in demand is met with an increase in supply, which results in a smaller price adjustment than in the market period.
The Long Run
   The long Run is period long enough for firms to adjust their plant size and new firms to enter the industry. In milk industry for example our farmer can buy more land, more goats and more labor force. Moreover, other farmers may be attracted by high revenue possible to get in milk industry and to enter it. Such adjustments make a higher supply in response to an increase in demand.

Cross Elasticity of Demand
      The cross elasticity of demand measures how sensitive consumer purchases of the products let’s say “A” are to a change in price of the good “B”.

 

 
  This formula helps us understand easier the concepts of complementary and supplementary goods.
 Substitute Goods
   If cross-elasticity of demand is positive, meaning that sales of A move in the same direction as a change of B, then A and B are substitute goods. Example: An increase in price of X causes consumers to purchase more Y.
Complementary Goods
   When cross-elasticity is negative, we know that X and Y are complementary, an increase in price of one cause demand for another to decrease.
Independent Good
   A zero or near-zero cross elasticity shows that two products are unrelated also called independent good.  Example: wristwatches and apples, glasses and walnuts.

Income elasticity Demand
       Income elasticity demand measures how demand of a product is affected by an increase of income. The coefficient of income elasticity demand, E_{i ,}  can be found by following formula:

Normal goods
    For most goods, the income elasticity coefficient E_i is positive, meaning more of them are demanded as income increases. Such goods are called normal or superior goods.
Inferior goods
   Negative income elasticity shows an inferior good. Ex: used clothes, long-distance bus tickets.
Table at Cross and Income Elasticity of Demand: