Short Run and Long Run Costs

1
Short Run and Long Run Costs

• Edit 7 Ch. 5 Pages 175-186
• Edit 6 Ch. 5 Pages 178-191

2
Production Processes

• X-Box Production
• http//www.youtube.com/watch?vdzJUSFr5EvQfeatur
  erelated
• UQM Technologies
• http//www.youtube.com/watch?vUvnHQz6lDQ8feature
  related
• Scorpion Factory
• http//www.youtube.com/watch?vhMCyqyyh5MA
• KTM Factory
• http//www.youtube.com/watch?vhMCyqyyh5MA
• 1955 Factory Management
• http//www.youtube.com/watch?vgtZVtANG924feature
  fvwpNR1

3
What would you need to start a Panera?

• http//www.panerabread.com/about/franchise/

4
Short Run versus Long Run?

• short run - a period of time where some inputs
  are fixed (capital building, equipment, etc.)
• long run - a period of time in which all inputs
  can be varied (no inputs are fixed)

5
Short Run Cost Function

• Definition
• A function that defines the minimum possible cost
  of producing each output level when variable
  factors are employed in the cost-minimizing
  fashion. (Based on the inability to change the
  fixed factors)

6
In this case, what is your total product/output
(Q)?

• Number of Paninis (for simplicity assume that
  Panera only produces a single product).
• In general a firm uses capital, labor and
  materials to produce the product/output where
  capital is often fixed in the short run.

7
In Short Run, how does the number of Paninis
produced change as you change the number of
workers?
of workers of paninis
0 0
1 5
2 12
3 20
4 25
5 28
8
How does output change if you hire one more
person?

• Depends on how many workers you currently have.
  Output increases by 5 paninis when you hire the
  1st worker, increases by 7 paninis when you hire
  the 2nd worker, ., and increases 3 paninis when
  you hire the 5th worker.

9
What happens to productivity as the first few
employees are hired?

• Specialize and marginal product increases.
• Marginal Product is the change in total output
  attributable to the last unit of an input.

10
What would happen to productivity if you
continued to hire more and more workers?

• Marginal product would start to fall because some
  inputs are fixed in the short run.
• Law of diminishing marginal returns OR Law of
  diminishing marginal product.

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What costs would you have to pay even if you
didnt produce a single panini?

• Fixed Costs, FC (or Total Fixed Costs, TFC)
• (often involves building and equipment)
• Fixed Costs Costs that do not change with
  changes in output

12
What costs would you have to pay only if you
produced paninis?

• Variable Costs, VC (or Total Variable Costs, TVC)
  
• (often assumed to be labor and material)
• Variable Costs Costs that change with changes
  in output

13
What costs would increase if we wanted to produce
one more panini?

• Variable Costs (such as labor and materials)

14
If you hired more and more employees

• and the store became more and more crowded until
  the marginal product of a worker started to fall,
  what would happen to the cost of producing one
  more panini (marginal cost)?
• Marginal cost cost of producing an additional
  unit of output

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Costs
Q FC VC TC AFC AVC ATC MC
0 100 0 100 - - -
    50
1 100 50 150 100 50 150
    30
2 100 80 180 50 40 90
    20
3 100 100 200 33.3 33.33 66.7
    10
4 100 110 210 25 27.5 52.5
    20
5 100 130 230 20 26 46
Fixed costs do not vary with output
(150-100)/1
Variable costs increase by 50 from 0 to 1 unit of
output and increases by 30 from 1 to 2 units.
Average Variable Costs (AVC) Variable Costs/Q
so at an output of 2, AVC80/240.
Average Fixed Costs (AFC) Fixed Costs/Q so at
an output of 2, AFC100/250.
Average Total Costs (ATC) Total Costs/Q so at
an output of 2, ATC180/290 or AFCATC.
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Costs
Q FC VC TC AFC AVC ATC MC
5 100 130 230 20 26 46
    30
6 100 160 260 16.7 26.67 43.3
    40
7 100 200 300 14.3 28.57 42.9
    50
8 100 250 350 12.5 31.25 43.8
    60
9 100 310 410 11.1 34.44 45.6
    70
10 100 380 480 10 38 48  
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TC ATCQ
What is happening to TC as Q increases?
Increases!
150
180
480
18
What are total fixed costs in this example?
AFCQ
1001100
19
Spreading a fixed number out over a larger and
larger Q
Why are AFC diminishing?
20
Why is AVC getting closer to ATC?
Because ATC AVCAFC and AFC is getting close to
0
21
Where does the law of diminishing marginal
product set in and how do you know?
Where MC starts increasing!
Why does this happen?
An input is fixed in the short run!
22
Where does MC cross ATC?Where does MC cross AVC?
At their minimums
What is the relationship between MC and ATC?
MC and AVC?
If MCltATC, ATC is decreasing If MCgtATC, ATC is
increasing Same for AVC
23
How do you know this is the short run?
There are fixed costs
24
Fixed Cost versus Sunk Cost

• Fixed Cost costs that do not change with
  changes in output
• Sunk Cost a cost that is forever lost after it
  has been paid
• Does profit maximizing output depend on whether
  cost if fixed or sunk given that you produce
  paninis?
• Does the decision whether to produce any paninis
  depend on whether cost is fixed or sunk?

No
Yes
25
Short Run versus Long Run?

• short run - a period of time where some inputs
  are fixed (capital building, equipment, etc.)
• long run - a period of time in which all inputs
  can be varied (no inputs are fixed)

26
Returns to Scale in Long Run Production

• Is the increase in output proportional to the
  increase in inputs?
• What is the marginal product of changing ALL
  inputs?

27
Economies to Scale

• Exist when long-run average costs decline as
  output is increased.
• Example in other words to double output, you
  dont have to double costs
• Example in other words if you double costs, you
  more than double the output

28
Why does there exist Economies of Scale?

• Specialization in production - get more
  productive if specialize
• Can spread some costs over everything (ex
  advertising, RD, capital investments)
• Can command quantity discounts from suppliers

29
Diseconomies of Scale

• Exist when long-run average costs rise as output
  is increased.
• Example in other words to double output, you
  have to more than double costs
• Example in other words if you double costs, you
  cannot double the output

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Why Diseconomies of Scale?

1. Monitoring
2. Morale

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Constant Returns to Scale

• Exist when long-run average costs remain constant
  as output is increased.
• Example in other words to double output, you
  have to double costs

32
Specific Example Each of the following
represent SATC curves at 3 different factory
sizes that are fixed in the short run

• Short Run -At least one input is fixed.
  Typically assume capital is fixed and
  labor/material is variable.
• Why do the ATC curves have the U-shape?
• Law of diminishing marginal returns to variable
  input
• Long Run - Nothing is fixed.
• Each of the following represents a short run SATC
  curve at different levels of capital (building,
  equipment)

33
Specific Example Each of the following
represent SATC curves at 3 different factory
sizes that are fixed in the short run

• Suppose we initially have a small factory and
  were producing one unit of output. If we want
  to increase output in the short run, how do we
  have to do it?
•  add more variable inputs
• In the long run, is that the only option?
• No, build a bigger factory 

34
Specific Example 3 possible factory sizes

• The least expensive way to produce Q 1 is with
  a ___________ factory.
• The least expensive way to produce Q 2 is with
  a ___________ factory.
• The least expensive way to produce Q 3 is with
  a ___________ factory.
• The least expensive way to produce Q 4 is with
  a ___________ factory.
• The least expensive way to produce Q 5 is with
  a ___________ factory.
• The least expensive way to produce Q 6 is with
  a ___________ factory.

small
small
medium
medium
medium
large
35
In the long run, you can choose any size factory
you want...what is the LATC curve?
LATC Minimum of the SATCs!
LATC SATC
36
Where do Economies of Scale exist?
LATC
Economies of Scale
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Where do Diseconomies of Scale exist?
LATC
Diseconomies of Scale
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General Example many possible levels of fixed
inputs
If these are many SATC, what does the LATC look
like?
LATC - minimum of SATC
Why does the LATC curve have the U-shape?
Minimum Efficient Scale smallest output
where average costs are minimized
Diseconomies of Scale
Economies of Scale
Constant Returns to Scale