Firm and Its Long-term Costs

Analysis

By:Group 6
Astha Singh 2010057
Hitesh Babbar 2010079
Jaya Dadlani 2010084
Jhanvi Thakkar 2010086
Nirmal Modh 2010099
Prateek Chaturvedi 2010295
COST
• Total Cost - the sum of all costs incurred in production
• TC = FC + VC
• Average Cost – the cost per unit
of output
• AC = TC/Output
• Marginal Cost – the cost of one more or one fewer units of
production
• MC = TCn – TCn-1 units

• Short run – Period of time for which some production factors

are fixed and some can vary.

• Long run – Period of time for which all the production factors
can vary.
Analyzing the Long Run
The long run is a period of time for which following
conditions hold:
1. The firm is operating for a significant amount
of time taken to vary all factors of production.
2. Firms can enter or exit an industry.
3. With long-term decline in demand, firms will
prevalently cut fixed costs.
4. With long-term rise in demand, firms will
prevalently choose innovations that allow them to
reduce variable costs.
5. The period of time varies according to the firm
and the industry
Analyzing the Long Run

typical firm.
 Economies of Scale
• Economies of scale refers to the phenomena of
decreased per unit cost as the number of units of
production increase.
• It is a Long run concept
• Types :
– Internal Economies of Scale
– External Economies of Scale

• Why it is Important?
Real world LACs in Manufacturing
Input Plant 1 Plant 2 Plant 3 Plant 4
10 40 100 130 150
20 100 160 180 210
30 130 180 240 250
40 150 200 255 275
50 160 210 270 290
Capital Input 10 20 30 40

• In the example shown when the business increases the scale of production from
Plant 1 (with 10 units of labour and 10 units of capital) to Plant 2 (a doubling
of the inputs used), total output quadruples. This shows increasing returns to
scale leading to a fall in the average total cost of production. A further increase
in scale to Plant 3 demonstrates constant returns to scale where both inputs and
output have increased by 50% and a further expansion of scale to Plant 4
illustrates decreasing returns to scale where inputs have grown by 33% but
output has grown by just 15%. When a firm experiences decreasing returns to
scale, then average total cost will rise – in other words diseconomies of scale
exist.
Real world LACs in Manufacturing
Real world LACs in Manufacturing
Caselet 1: The long run average cost
curve in Electricity Generation
LAC curve in Electricity Generation
• LAC is L shaped because of increasing &
decreasing returns to scale operate
together.
• Power companies buying more power
from independent producers to minimize
cost of production that would be incurred
in producing more power.
• Deregulation and end of monopoly power.
 Economies of Scale
Increasing returns to Scale
• Outputs change by larger proportion than inputs
• Proficiency of workers and avoidance of time lost
• More specialized and productive machinery can
be used
• Firms need smaller inventory as scale of
operation increases
• Prevails at smaller levels of output
 Economies of Scale
Decreasing returns to Scale:
• Outputs changes by lower proportion
than inputs
• Arises as scale of operation increases, it
becomes difficult to manage firms
effectively
• Prevails at larger levels of output
L shaped LAC
Why L-shaped LAC curve?
• Economies of scale are rather quickly
exhausted and constant or near
constant returns to scale prevail over a
considerable range of outputs.
• Lowest point of curve occurs when the
forces of increasing and decreasing
returns to scale just balance each
other.
Caselet 2: Increasing returns at
Sony, Microsoft & Intel
Introduction
– Like service firms many manufactures focus
on customer inquiry system ,product reliability,
quality characteristics like brand loyalty and
technological innovations.
– To capture large chunk of market share quality
characteristics and support services beyond
physical unit of production are required.
– With innovation and advancement in
technology increasing returns persist.
 Innovations
• a) Product Innovation - new products or
improvements on products eg:- new
models of mobile phones and so on.
• b) Process Innovation - where some part
of the process is improved to bring benefit.
Just in Time applied by wall mart is a good
example.
Conclusion
• In long run as market share increases
costs such as promotional and
marketing costs are lower to trigger
another adoption.
• The only limitation in the adoption of
such innovations is that one needs to
go for these new adoptions again and
again.
Caselet 3: How exactly has the information
technology lowered costs at Chevron and
Merck?
 Technology at Chevron
• Chevron spent 2-4 million each drilling 10-
12 exploratory wells before finding oil.
• Introduction of new technology: 3D
graphs, calculation intensive simulation
modeling resulted in making much more
accurate location of secondary wells or
known oil fields.
• Overall production cost shrunk by 16%.
 Technology at Merck
• Experimenting on known active compounds
involved lot of time consuming chemical trials.
• Total time to introduction of new pharmaceutical
was often longer than a decade.
• After technological upgrade microchip controlled
and automated machines performed thousands
of reactions at once and tally the results.
• 2/3rd reduction in time consumed and attendants
costs have declined accordingly.
Technological Advancements
 Increasing Returns to Scale
• Increasing
returns to
scale due to
Technological
advances
Caselet 4: GM decides small is better
INTRODUCTION
• General Motors, the largest
corporation and carmaker in the world
had a turbulent decade in 1990’s.
• It incurred huge losses and to
overcome that GM closed some of the
plants and reduced the workforce,but
this was not sufficient.
 Decreasing returns to scale
• The firms are faced with decreasing returns to scale
when a certain proportionate change in inputs, lead to
less than proportionate change in output.
Causes of Diminishing return to
scale
• The decreasing returns to scale are
attributed to the diseconomies of scale.
• The most important factor causing this is
the diminishing return to management.
Conclusion
• Hence it restructured its strategy by
reducing the no. of models,cutting
average manufacturing
time,centralised its vast sales and
services and marketing system.
• Hence to sustain GM need to
generate excitement over its new
models and coax buyers.
Thank you