Long-run Average Total Cost and Economies of Scale

Summary

This video explains the relationship between a firm's short-run and long-run costs, focusing on the concepts of diminishing marginal returns and economies of scale. It discusses how short-run costs rise as firms add variable resources to fixed capital, while long-run cost reductions are achieved by expanding plant size and acquiring new capital. The video also highlights how firms experience lower per-unit costs through economies of scale, benefiting from bulk buying and improved productivity. However, as firms grow too large, they may face diseconomies of scale, where costs rise due to inefficiencies. Real-world examples, like General Motors' breakup and the duopoly of Boeing and Airbus, illustrate these principles in action.

Takeaways

• 😀 The law of diminishing marginal returns explains how increasing a variable resource to a fixed resource leads to decreased productivity and rising costs beyond a certain point.
• 😀 A firm's short-run cost structure, including marginal cost (MC), average variable cost (AVC), and average total cost (ATC), is influenced by diminishing marginal returns.
• 😀 As production increases beyond a certain point (e.g., beyond 3 units), average total costs rise, making it less economical to produce additional units.
• 😀 To reduce rising costs in the short run, a firm may need to invest in expanding its plant size and capital, which allows for a shift to the long run.
• 😀 In the long run, firms can adjust capital and land resources, unlike in the short run where only labor can be varied, which impacts cost structure.
• 😀 When a firm opens additional factories, it can achieve economies of scale, reducing average total costs due to improved bargaining power, bulk purchasing, better technology, and improved labor productivity.
• 😀 Economies of scale allow firms to lower average total costs as they increase in size, benefiting from factors like better specialization and more favorable financial terms.
• 😀 As firms grow and open new factories, they experience decreasing average total costs until a certain point, after which they may encounter constant or even rising costs due to diseconomies of scale.
• 😀 Diseconomies of scale occur when a firm becomes too large, leading to inefficiencies in management, communication, and operational logistics, which can cause average total costs to rise again.
• 😀 Firms like Boeing or Airbus, which dominate large industries, benefit from economies of scale that make it nearly impossible for new entrants to compete effectively on cost, due to their large-scale operations.
• 😀 The optimal firm size, in terms of minimizing average total costs, occurs when the firm has reached the lowest point on its long-run average total cost curve, balancing economies of scale and the risk of diseconomies of scale.

Q & A

What is the law of diminishing marginal returns and how does it affect a firm's costs?

The law of diminishing marginal returns states that as a firm adds more of a variable resource (like labor) to a fixed resource (like capital), beyond a certain point, the productivity of the variable resource decreases. This causes the marginal cost of production to rise, which in turn increases average total costs.

How do marginal costs and average total costs behave in the short run as output increases?

In the short run, as output increases, marginal costs initially rise due to diminishing returns, causing average total costs to also increase after a certain output level. The firm experiences higher costs for each additional unit produced.

Why does a firm experience higher costs when producing beyond a certain level in the short run?

When a firm produces beyond a certain output level, it encounters diminishing marginal returns, which means that additional units of output require more and more labor or resources to produce, driving up the per unit costs and making production less economical.

What strategies can a firm use in the long run to lower its average total costs?

In the long run, a firm can reduce its average total costs by increasing its capital, such as opening new factories, improving technology, expanding land, and increasing productivity. These changes allow the firm to scale its operations efficiently.

What are economies of scale, and how do they affect a firm's cost structure?

Economies of scale refer to the cost advantages that a firm gains as it increases its production. As a firm grows larger and opens additional factories, its average total costs decrease due to factors like bulk purchasing, better bargaining power, specialized labor, and increased efficiency from more capital.

How does opening a second factory impact a firm's average total cost?

When a firm opens a second factory, it benefits from economies of scale, leading to a reduction in average total costs. The firm can now produce more units at a lower cost per unit due to the ability to utilize capital and labor more efficiently.

What is the relationship between firm size and average total cost in the long run?

In the long run, as a firm grows larger, it may initially experience decreasing average total costs due to economies of scale. However, after a certain point, the firm may experience constant returns to scale, where costs stabilize, or even dis economies of scale, where costs start to rise as the firm becomes too large and inefficient.

What are constant returns to scale, and how do they differ from economies of scale?

Constant returns to scale occur when increasing production does not affect average total costs. This happens when a firm has reached an optimal size and can no longer lower costs by expanding further. This is different from economies of scale, where costs decrease as the firm increases production.

What are dis economies of scale, and what causes them?

Dis economies of scale occur when a firm's average total costs increase as it grows too large. Factors like management inefficiencies, communication problems, and operational complexities can lead to dis economies of scale, making the firm less efficient at producing goods.

How can economies of scale act as a barrier to entry for new firms in an industry?

Economies of scale create a barrier to entry for new firms because larger firms, due to their ability to produce at a lower cost per unit, can offer lower prices and outcompete smaller entrants. For example, in industries requiring significant capital investment like airplane manufacturing, new firms struggle to compete with established firms like Boeing and Airbus.