Costs in the Long Run - YouTube

Oh, hi guys. I didn't know the camera was going. Do you like this new board I just got? Yea. I just bought it and spent

like 90% of my life savings on it. But I think in the end it will pay off for

more than what it cost. Wait. What's this writing up here? I just can't explain it. I'll get somebody who can,

Professor Mark McNeill from Irvine Valley College. Why thank you, I'm prepared to explain this.

At the McNeil International headquarters in beautiful Baja Tustin, today we're talking about

costs in the long run. In the long run all factors of production are variable. In the short run there is one fixed factor

but in the long run, everything can be changed. Here we are talking about scale issues. What does scale mean here?

Scale in economics means...? [Disinterested voice: " Big stuff.] Yea, little stuff, big stuff, that's what it means.

Economies of scale: assume the firm increases all the factors of production

by some percent, say 10%. The firm buys 10% more land, labor, capital and entrepreneurship, So now it can

produce more of everything. But how much additional output does it get if it's experiencing

economies of scale? It will get more than a 10% increase in production. So, 10% increase

in resource costs causes an output increase of more than 10% which means

your cost for each unit is going down.

So average costs decrease. Diseconomies of scale are the opposite. A firm buys some

percent more of all resources and output increases by less than that percent. So

if they get 10% more resources it costs them 10% more to buy the resources, they get less than a

10% increase in output, that means their cost for each unit is going up.

Then there are good old constant returns to scale and that's if you buy 10 percent more

resources to get 10% more output. So in that case the costs are constant. Let's show the picture. Quantity

produced - horizontal axis; dollars on the vertical axis. And let's say --- this is talking about

all the various possible scales of production. By scales, we could mean

large-scale production or small-scale production or everything in between.

So we talk about a bakery for instance. Let's say that a small bakery starts out with

a small plant. You understand, the capital of the bakery itself is very small

and its costs are relatively high, $4 a loaf. It can produce about this many loaves a day, say

100 per day. But the costs are high. What if

the firm is able somehow to build a bigger scale plant. What that means is

now that plant can produce 200 loaves a day and the costs of production go down to $3.75 per loaf.

How is that possible? Because of economies of scale. Economies of scale mean that as the plane

gets larger, the cost per unit unit go down. Why do economies of scale exist?

Because of specialization --

specialization of both labor and capital. You can get more specialized machines that are more

productive and are only justified when you produce lots more units with them.

If you have any issues about economies of scale just watch "How It's Made" - these astounding

machines that spit things out. They are incredibly efficient and cost per unit

is very low but you have to run hundreds of thousands or millions of units across

these each year in order to

justify the costs of the equipment. So there is specialization of capital and

specialization of labor as well. As a firm gets bigger it can get specialized

workers. With a little bakery,

there's one person or two people running it; the baker, the salesperson, the

marketing person, businessperson, the account - it's all the same person.

But as the firm gets bigger it can get people to do each of these jobs and

specialized in them and they're better off. So that's the first reason why economies of

scale exist, because of

specialization. A second has to do with by-products. When the scale of production gets

bigger, by-products oftentimes turn from an economic liability to an economic asset.

An example - old lumber mills used to have sawdust that became a hazard and cost to get

rid of. But as they got bigger and bigger it became beneficial for them to use these

by-products as inputs into the production of something else. And all of a

sudden what used to be an economic liability can turn into n economic

asset. When that happens, cost per unit goes down as the scale of the plant gets bigger. A third is

external economies of scale. As the scale of the plant gets bigger and bigger then resource

suppliers oftentimes have an incentive to get bigger themselves and that they

can afford to supply resources cheaper. So, the plant gets bigger, bigger, bigger.

Each one of these red lines is a

short run average cost curve and you can see that the costs are getting smaller (sorry) as

the quantity produced gets larger and larger. So bigger, bigger, bigger, and then

at some point economies of scale are exhausted. They build the bigger and bigger

scales of plan and there is no further decrease in costs because there are no

opportunities for additional economies of scale. This is constant returns to scale.

And then, finally - often industries have never found this point, but theoretically it exists

that they build a bigger and bigger scale and all of a sudden their costs start increasing.

This is diseconomies of scale. Diseconomies of scale come about because of

information and organization problems. The firm becomes so large that cannot be

managed and so costs increase because of this management and coordination problem. So that's economies

of scale diseconomies of scale, and constant returns to scale. And the long run average cost curve

is what is known as the envelope curve of all short run scale possibilities.

It's really the outside tangency points of every possible short run scale of plant.

So this green envelope curve, the outside tangency points, is the long run

average cost curve. The long run average cost curve is U-shaped as well as the short run average cost curve. The

The short run average cost curve is U-shaped because of the law

of diminishing returns but the long run average cost curve is U-shaped because of economies

and diseconomics of scale. Excuse me, put it that away.

Pay attention please. [Sleepy voice responds: "I'm sorry."]

Yes, alright. Alright, there's one other term, the minimum efficient plant scale and that is the first plant scale

at which all economies of scale are exhausted.

It's basically the smallest size or scale of a firm that you can build and be as efficient as

any other producer. So in this, it is really the first scale where the LRAC hits bottom.

So I would say that is probably right in here someplace. This would be the

minimum efficient plant scale, which you can call "MEPS" if you like. So those are the terms associated with long run costs.

And finally, different firms have different long run average cost curves because the technology is different

in all industries. Industries are classified as groups of firms producing similar

products. There is a whole list of industry types. But in some industries the

technology is such that there's this extended range of economies of scale and to be

efficient in this industry you've got to produce this quantity. Now this is an

enormous quantity; this very large plant. This is large-scale production and since

this is the minimum efficient plant scale, you have to be big in order to be

efficient. So in this industry you're going to see a few large firms competing

because small firms cannot compete, their costs are too high. So this may be like

a monopoly on oligopoly. In other industries, the technology is such that there are no

opportunities for large-scale production. You get to a certain size and if you try to produce more than

that quantity, your costs increase rapidly and you're not competitive any more. So the minimum efficient plant scale is

relatively small and in this industry you will see a lot of small firms. Then this LRAC

is possible as well where the minimum efficient scale is fairly small and then

there's extensive constant returns to scale so if you're a small scale firm,

a medium scale firm or a large scale firm, you all have a similar cost footing and one cannot

chase the other out of the market. The other possibility, of course, is the medium one where the minimum efficient plant scale

is medium-sized so you will see medium sized firms in this industry. The point is that the longer average

cost has to has to do with economies and diseconomies of scale and that has to

do with the technologies that exist for producing that product and because of

these differences in technology in long run average cost curves, this leads to

different industries that have different competitive structures. So that's it

costs in the long run.

Hast la vista.