ECONOMIC SECOND EDITION in MODULES S Paul Krugman Robin Wells with Margaret Ray and David Anderson MODULE 20 56 Long Run Costs and Economies of Scale Krugman Wells Why a firm s costs may differ between the short run and the long run How a firm can enjoy economies of scale 3 of 12 Short Run versus Long Run Costs In the short run fixed cost is completely outside the control of a firm But all inputs are variable in the long run This means that in the long run fixed cost may also be varied In the long run in other words a firm s fixed cost becomes a variable it can choose The firm will choose its fixed cost in the long run based on the level of output it expects to produce 4 of 12 Choosing the Level of Fixed Cost of Selena s Gourmet Salsas Cost of case 250 At low output levels low fixed cost yields lower average total cost At high output levels high fixed cost yields lower average total cost 200 150 Low fixed cost ATC 1 100 ATC 2 High fixed cost 50 0 1 2 3 4 5 6 7 8 9 10 There is a trade off between higher fixed cost and lower variable cost for any given output level and vice versa But as output goes up average total cost is lower with the higher amount of fixed cost Quantity of salsa cases High fixed cost FC 216 Low fixed cost FC 108 Quantity Average Average High Low Total Total of salsa variable total cost variable cost total cost cost of case of case cost salsa cost 1 2 3 4 5 6 7 8 9 10 12 120 48 108 192 300 432 588 768 972 1 200 156 216 300 408 540 696 876 1 080 1 308 120 00 78 00 72 00 75 00 81 60 90 00 99 43 109 50 120 00 130 80 6 24 54 96 150 216 294 384 486 600 222 240 270 312 366 432 510 600 702 816 222 00 120 00 90 00 78 00 73 20 72 00 72 86 75 00 78 00 81 60 5 of 12 The Long Run Average Total Cost Curve The long run average total cost curve shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output 6 of 12 Short Run and Long Run Average Total Cost Curves Cost of case Constant returns to scale Increasing returns to scale ATC Decreasing returns to scale ATC 3 B X C 3 ATC L R ATC 9 Y A 0 6 4 5 6 7 8 9 Quantity of salsa cases 7 of 12 Returns to Scale There are increasing returns to scale economies of scale when long run average total cost declines as output increases There are decreasing returns to scale diseconomies of scale when long run average total cost increases as output increases There are constant returns to scale when long run average total cost is constant as output increases 8 of 12 Sunk Cost A sunk cost is a cost that has already been incurred and is non recoverable A sunk cost should be ignored in decisions about future actions Sunk costs should be ignored in making decisions about future actions Because they have already been incurred and are non recoverable they have no effect on future costs and benefits There s no use crying over spilled milk 9 of 12 There s No Business Like Snow Business There is a significant difference in total cost that arise from making different choices about fixed cost Washington D C has fewer snowfalls than Chicago and therefore has fewer snowplows Washington D C and Chicago are like two different businesses who have different expectations about output snow removal and make different decisions about the level of fixed cost 10 of 12 Summing Up Costs 11 of 12 1 In the long run a producer can change its fixed input and its level of fixed cost The long run average total cost curve shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost at each level of output 2 As output increases there are increasing returns to scale if long run average total cost declines decreasing returns to scale if it increases and constant returns to scale if it remains constant Scale effects depend on the technology of production 3 A sunk cost is a cost that has already been incurred and is non recoverable A sunk cost should be ignored in a decision about future actions 12 of 12