Production and Cost

Analysis in the Long

Run
Lesson 6
Long-run Production
Function
Relationship between a flow of inputs and
the resulting flow of output where all inputs
are variable:
Q = f(L, K)
Where
Q = quantity of output
L = quantity of labour input (variable)
K = quantity of capital input (variable)
Note: both inputs are variable
Input Substitution

 Labour-intensive method:
 Process that uses large amounts of labour
relative to other inputs
 Capital-intensive method:
 Processthat uses large amounts of
equiptment relative to other inputs
Input Substitution
 Input substitution:
 Degree to which one input can be substituted
for another
 Can occur in a small-scale or large-scale
business
 Some processes may not be conducive to
substitution
 Issue is whether the same quality output is
being produced with input substitution
Factors Influencing Input
Substitution
 Technology
 Prices of inputs
 Incentives facing a given producer
Role of Competitive
Environments
 X-inefficiency:
 Inefficiency
that may result in firms with
market power having fewer incentives to
minimise costs
 Best practices:
 Production techniques adopted by firms
with the highest levels of productivity
 Lean production:
 Streamlines production through strict
scheduling and small-batch production
 Model of Long-run Average
Cost Function
SRAC SRAC 1 SRAC2 5
SRAC4
SRAC3

5 factories
Costs

1 factory
2 factories
3 factories4 factories

O
Outputfig
 Model of Long-run Average
Cost Function
SRAC SRAC
1 SRAC2 5
SRAC4
SRAC3

LRAC
Costs

O
Outputfig
 Model of Long-run Average
Cost Function
Costs

Examples of short-run
average cost curves

O
Outputfig
 Model of Long-run Average
Cost Function

LRAC
Costs

O
Outputfig
Economies of Scale

 Economies of scale:
 The average costs of production are
lowered as the firm produces larger
output levels with an increased scale of
production
 Economies of Scale

Economies of Scale
Costs

LRAC

O Output
Diseconomies of Scale

 Diseconomies of scale:
 Higher unit costs of production results
with larger scale of production
 Diseconomies of Scale

LRAC
Diseconomies of Scale
Costs

O Output
 Factors Creating
Economies of Scale
 Specialisation and division of labour
Combination of
 Technological factors inputs
 Use of automation devices

 Quantity discounts
 Spreading of advertising costs Pecuniary
gains
 Financial factors
Factors Creating
Diseconomies of Scale
 Inefficiencies of managing large-scale
operations
 Increased transportation costs
resulting from concentrating
production in a small number of large
plants
 Important limitation to large-scale
production is the management
function
Other Factors Influencing
LRAC Curve
 Learning by doing:
 Reflects drop in unit costs as total
cumulative production increases because
workers become more efficient as they
learn their tasks
 Transportation costs:
 Ifthese increase with large-scale
production, the LRAC has lower optimum
scale of operation than a curve without
these costs
Minimum Efficient Scale

 MES:
 Scale of operation at which the long-run average
cost curve stops declining or where economies
of scale are exhausted
 Methods for determining minimum efficient
scale:
 Surveys of expert opinion
 Statistical cost estimation
 The survivor approach
Summary of Key Terms

 Best practices
 Capital intensive production
 Diseconomies of scale
 Economies of scale
 Input substitution
 Labour-intensive production
 Lean production
Summary of Key Terms

 Leaning by doing
 Long-run average cost
 Long-run production function
 Minimum efficient scale
 Short-run average total cost
 X-inefficiency