WHAT IS LONG RUN COST | FIRM’S COST PRODUCTION

What is Long Run Cost?  We know that the firm to vary only its rate of use of labor and raw materials, not the size of its plant. Because this is a limitation facing actual firms in most of their day-to-day decisions, our findings will be of great assistance to us in explaining behavior in an enterprise economy. However, when given time to make changes, firms may decide to increase or reduce the size of their plants. Also, at the planning stage, before capital is committed to plant and equipment, the manager of the firm is free to select the size of the plant he wishes. This is a very important decision. It may affect the profitability of the firm for many years to come. What considerations should guide the manager? His decision is most likely to be correct if he works out with his engineers and accountants estimates of the fixed and variable cost schedules for plants of various sizes. For each plant size, there will be the lowest ATC figure. For the manager of a firm operating in a purely competitive market, the only proper decision is to settle on the plant size that yields the lowest ATC, since by definition he can sell his entire output at market price, regardless of the size of a plant.

LONG RUN COST  GRAPHIC ILLUSTRATION

The curves shown in Figure may help visualize the problem of determining the proper size of a plant. The curves designated ATCU ATC2 . . . ATC5 show how average total costs will vary from very small to very large outputs for plants of five different sizes. The ATCX plant has the smallest amount of capital tied up in land, buildings, machinery, etc.; the ATC5 plant has the largest amount. An examination of the five curves shows that the larger the plant, the longer the range of output over which the firm will encounter increasing returns on its variable costs, and the larger the output at which ATC will be at a minimum. The important consideration, however, is not the size of the output at which ATC will be at a minimum; rather it is the size of the plant which yields the lowest possible minimum ATC. In this particular case, it is the ATCS plant size that yields this result. This is said to be the optimum-sized plant for this particular management. When a plant of optimum size is operating at the scale at which its ATC is at its minimum, the plant is said to be operating at normal capacity. OQ3 represents the normal capacity of the ATC3 plant and QSC3 is its long-run normal cost of production. We shall show later on that how competition tends to force all purely competitive firms to operate at normal capacity. But we shall also show why, in the short run cost, it may be more profitable for a firm to operate at less or at more than normal capacity.

Does this mean that the optimum size of all firms in a given industry will be of the same size? The answer is, “no.” The appropriate size of the plant for less efficient management will be smaller than for more efficient management. Will the larger and more efficiently managed firms drive out the smaller and less efficiently managed firms? Here the answer is, “probably not.” And the reason for this is that the firms that command management of exceptional ability have to pay for these abilities in the form of higher salaries and managerial earnings. We shall have more to say about these managerial earnings. Here it suffices to point out that economic theory explains what experience shows to be true: that firms of very different physical sizes can compete indefinitely against one another in the same market, without the big ones having any marked advantage over their smaller rivals. More of the output will be produced by the bigger and more efficiently managed firms—just as the consumer would wish—but the smaller, less efficiently managed firms will continue to operate. Return to a scale of plant. Inspection of the curves in Fig. 10-2

shows that the minimum ATC first decreases and then increases as the size of the plant is increased. Thus C2 is closer to the X-axis than C1, and C3 is still closer, but beyond C3 the minimum ATC’s begin to rise. If we connect these points, Cl9 C2, C3, C4, C5, we get what is known as a firm’s long-run cost schedule, or its planning curve. It declines, reaches a minimum, and then rises. The first stage is described as the stage of increasing returns to scale of plant. The second stage is described as the stage of decreasing returns to scale of plant. If minimum ATC were constant through a range of plant sizes, the situation would be described as one of constant returns to scale of plant.

EXPLANATION

The explanation for increasing returns to scale of plant is usually found in technological factors, the larger plants being able to use more efficient machines and techniques than the smaller plants. In the modern steel industry, a very small plant would be forced to use very primitive techniques for processing ore and for its other operations, and its unit costs of production would be correspondingly high. The explanation of decreasing returns to scale is usually found in the management factors referred to on p. As the plant grows larger, it eventually reaches a size where increased technical efficiencies are more than offset by losses in the efficiency with which the unit can be managed. It is these management factors that eventually place a ceiling on the growth of the firm.

Constant returns to scale are usually found in a range of plant sizes where technological gains from increased size are just balanced by losses in management efficiency. As the plant size is increased beyond this range, diminishing returns to scale of plant is usually encountered.

Significance of returns to scale. Some of the most important questions in economic policy are related to returns to scale. For example, what if the optimum-sized plant in a given industry is a plant of enormous size? Doesn’t this destroy the possibility of competitive behavior?

The answer to this question is, “not necessarily.” If the market is very large (perhaps, a world-wide market), even the very large firm may be small relative to the market in which it operates. This is one of the reasons that economists consistently press for a widening of markets through a lowering of tariffs and other barriers to world trade. Also, as we shall see, the rivalry among a number of large firms, a rivalry that takes many forms, may provide the consumer with more goods at lower cost than would be true if the product were produced by a great number of small firms. But if the large firm is in a position to exploit the consumer, what then? Can it be broken up without a great sacrifice of technical efficiency? The answer here depends in part on a careful distinction between “plant” and “firm.” The large firm possessed of almost monopoly power may be just a collection of a great number of plants, each of approximately optimum size. It may be that the firm could be broken up into a number of firms, each controlling one operating unit, without any great sacrifice of technical efficiency. However, we would do well to delay a final answer to this question until we have completed our survey of market behavior. Without pressing the topic further at this time, it should be clear that the concept of returns to scale is one of considerable practical significance