D.  Production and Cost Analysis in the Long Run

• All inputs variable in the long-run

1.  Production

• Long-run production function

.

.

a.  Input substitution

• Firm can substitute one input for another

• Labor-intensive method of production - large amounts of labor used relative to other inputs

• Capital-intensive method of production - large amounts of capital used relative to other inputs

.

b.  Factors affecting input substitution

(1)  Technology of production process

• Technical feasibility may limit input substitution

.

(2)  Prices of inputs

• If price of one input increases, substitute cheaper inputs for more expensive one

(3)  Incentives facing producer

• Firms substitute cheaper inputs for more expensive ones if they face incentives to minimize costs

.

(a)  Competitive environments

• Competitive markets => more pressure to minimize costs

• X-inefficiency - firms with market power have fewer incentives to minimize costs

.

(b)  Labor issues

• Labor unions may resist cost-cutting strategies that reduce quantity of labor

. 

(c)  Nonprofit organizations

• Lack of profit motive => less incentive to minimize costs

.

(d)  Political and legislative influences

• Legislation may mandate  input combinations

.

2.  Costs

a.  Long-run average cost

.

.

.

.

.

.

.

.

b.  Economies and diseconomies of scale

.

.

.

.

.

.

.

.

.

(1)  Factors leading to economies of scale

(a)  Specialization and division of labor

• People get better when they concentrate on a narrow range of tasks

.

(b)  Technological factors

i)  Indivisible inputs

• Can't be scaled down below a minimum level

• Fixed costs associated with indivisible inputs => fixed costs can be spread out over more units as production increases

• Often the case when production is capital intensive - physical capital is a significant percentage of total costs

Ex. -

.

.

.

ii) Cube-square rule

•  As volume increases by a certain proportion, surface area increases by a lesser proportion

• Economies of scale result when production capacity is proportional to the volume and total cost is proportional to the surface area

Ex. -

.

.

.

(c)  Use of automation devices

• Can use more sophisticated machines when scale is larger

. 

(d)  Quantity discounts

• Price sometimes discounted when inputs are bought in bulk

• Requires one of the following conditions:

-  May be less costly for a supply to sell to a single buyer - avoid repeated fixed costs

-  Bulk purchaser more price sensitive because there is more to gain

- Supplier fears disruption to business if business isn't done with a large customer

.

(e)  Advertising economies

.

.

.

i)  Spread advertising costs

• Ex. -

.

.

.

ii)  Advertising reach

• Ex. -

.

.

.

(f)  Financial factors

• Large firms can obtain loans at more favorable terms than smaller ones

.

(g)  Inventory

• Less inventory needed when scale is larger

• Ex.

.

.

.

(2)  Factors leading to diseconomies of scale

(a)  Inefficiencies of managing large-scale operations

• Management becomes too far removed from day-to-day operations

• More difficulty in monitoring and communicating with workers

.

(b)  Increased transportation costs due to concentration

• Workers drawn from farther away, higher wages have to be paid to cover transportation costs

.

.

.

.

c.  Learn by doing (learning curve)

• Costs decrease as cumulative production decreases

.

.

.

.

.

.

.

.

.

.

d.  Minimum efficient scale

• Scale of operation at which economies of scale are exhausted

.

.

.

.

.

.

.

.

.

.

• Estimation

(1)  Surveys of experts

• Engineering estimates

.

(2)  Statistical cost estimation

• Use data and regression analysis

.

(3)  Survivor approach

• Examine size distribution at which most firms are concentrated

.