CHAPTER FOUR: PRODUCTION AND COSTS

Introduction

Our attention now turns from the behaviour of consumers to the behaviour of producers. In market
economies, a wide variety of businesses produce an even wider variety of goods and services. Each
of those businesses requires economic resources in order to produce its products. In obtaining and
using resources, a firm makes monetary payments to resource owners (for example, workers) and
incurs opportunity costs when using resources it already owns (for example, entrepreneurial talent).
Those payments and opportunity costs together make up the firm’s costs of production.

The purpose of this chapter is to examine the production costs of a firm. The first section develops
the economic concepts of production necessary for understanding the cost structure of a firm. The
second section presents the models of short-run costs. The final section develops the long-run
average total cost curve and discusses its implications for the strategic management of a business.

Objectives of the chapter

Having successfully completed this chapter, students should be able to:

1. Understand the term associated with the short run production function- total product,
average product, and marginal product- and explain and illustrate how they are related to
each other.
2. Explain the concepts of increasing, diminishing, and negative marginal returns and
explain the law of diminishing marginal returns.
3. Understand the terms associated with costs in the short run-total variable cost, total fixed
cost, total cost, average variable cost, average fixed cost, average total cost, and marginal
cost-and explain and illustrate how they are related to each other.
4. Explain and illustrate how the product and cost curves are related to each other and to
determine in what ranges on these curves marginal returns are increasing, diminishing, or
negative.
5. Apply the marginal decision rule to explain how a firm choose its mix of factors of
production in the long run.
6. Define the long run average cost curve and explain how it relates to economies and
diseconomies of scale.

Production and Costs

The reason that an entrepreneur assumes the risk of starting a business is to earn profits. The
fundamental assumption in the theory of production is that a rational owner of a business will seek to
maximize the profits (or minimize the losses) from the operation of his business. However, before
anything can be said about profits we must first understand costs and revenues. This chapter will
develop the basic concepts of production costs.

An economist's view of costs includes both explicit and implicit costs. Explicit costs are accounting
costs, and implicit costs are the opportunity costs of an allocation of resources (i.e., business
decisions). Accountants subtract total cost from total revenue and arrive a total accounting profits.
An economist, however, would include in the total costs of the firm the profits that could have been
made in the next best business opportunity (e.g., the opportunity cost). Therefore, there is a

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significant difference in how accountants' and economists' view profits-economic profits versus
accounting profits.

Economic cost= Explicit costs+ Implicit costs

Economic profit= Total revenue-Economic cost

For the purposes of economic analysis, a normal profit includes the cost of the lost opportunity of the
next best alternative allocation of the firm’s resources (cost of doing business). In a purely
competitive world, a business should be able to cover their costs of production and the opportunity
cost of the next best alternative (and nothing more in the long-run). In an accounting sense there is
no benchmark to determine whether the resource allocation was wise. Instead various financial ratios
are used to determine how the firm has done with respect to similarly situated companies.

Example: Suppose you are earning Frw 22,000 a year as sales representative for a T-shirt
manufacturer. At some point you decide to open a retail store of your own to sell T-shirts. You
invest Frw 20,000 of savings that have been earning you Frw 1000 per year. And you decide that
your new firm will occupy a small store that you own and have been renting out for Frw 5,000 per
year. You hire one clerk to help you in the store, paying her Frw 18,000 annually.

A year after you open the store, you total up your accounts and find the following:

Total sales revenue........................................Frw 120,000

Cost of T-shirts..............................................Frw 40,000
Clerk’s salary.................................................Frw 18,000
Utilities..........................................................Frw 5,000
Total (explicit) costs......................................Frw 63,000
Accounting profit.........................................Frw 57,000

Looks good. But unfortunately your accounting profit of Frw 57,000 ignores your implicit costs and
thus overstates the economic success of your venture. By providing your own financial capital,
building, and labor, you incur implicit costs (foregone incomes) of Frw 1,000 of interest, Frw 5000
of rent, and Frw 22,000 of wages. If your entrepreneurial talent is worth, say, Frw 5,000 annually in
other business endeavors of similar scope, you have also ignored that implicit cost. So:

Accounting profits.....................................Frw 57,000

Foregone interests......................................Frw 1,000
Foregone rent.............................................Frw 5,000
Foregone wages.........................................Frw 22,000
Foregone entrepreneurial income..............Frw 5,000
Total implicit costs....................................Frw 33,000
Economic profit.......................................Frw 24,000

In our example, economic costs are Frw 96,000 (= Frw 63,000 of explicit costs+ Frw 33,000 of
implicit costs). Economic profit is Frw 24,000, found by subtracting the Frw 96,000 of economic
cost from the Frw 120,000 of revenue.

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As long as accounting profit is Frw 33,000 or more (so economic profit is zero or more), you will be
earning a Frw 5,000 normal profit and will therefore continue to operate your T-shirt store.

Time Periods Revisited

As was discussed in the section of elasticity of supply, time periods for economic analysis are
defined by the types of costs observed. These time periods differ from industry to industry, and will
differ by the technology employed between firms. Again, these time periods are; (1) the market
period, (2) the short-run, and (3) the long-run.

In the market period, all costs are fixed costs (nothing can be varied). In the short-run, there are
both fixed and variable costs observed. Generally, plant, equipment, and technology are fixed, and
things like labor, electricity, and materials can still be varied. In the long-run everything is variable.
That is, the plant, equipment, and even the business into which you put productive assets can all be
changed. In the long-run, even the country in which the business is located can be changed. Because
everything is fixed in the market period, this period is of little interest in economic analysis.
Therefore, economists typically begin their analysis of costs with the short-run and proceed to
examine the operation of the firm and the industry. The long-run is of interest because it is also the
planning horizon for the business. While the short run is a “fixed-plant” period, the long run is a
“variable-plant” period.

Production
Another view of the short-run cost structure is that fixed costs are those that must be paid whether
the firm produces anything or not. Variable costs are called variable because they increase or
decrease with the level of production. Therefore to understand short-run costs, you must first
understand production.

Total product or total output is the total number of units of production obtained from the productive
resources employed. Average product is total product divided by the number of units of the variable
factor employed. Marginal product is the change in total product associated with a change in units of
a variable factor of production.

As a firm increases its output it normally makes more efficient use of its available capital. However,
with a fixed level of available capital as variable factors are added to the production process, there is
a point where the increases in total output begin to diminish. The law of diminishing returns is the
fact that as you add variable factors of production to a fixed factor, at some point, the
increases in total output begin to become smaller. In fact, it is possible, at some point, that further
additions in the units variable factors to a fixed level of capital could actually reduce the total output
of the firm. This is called the uneconomic range of production. In reality, most firms come to realize
that their total additions to total output diminish, long before they begin to experience negative
returns to additions to their workforce or other variable factors.

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The following diagram provides a graphical presentation of total, average, and marginal products for
a hypothetical firm.

Figure 4.1: From Total Product to the Average and Marginal Product of Labor

The first two rows of the table give the values for quantities of labor and total product for "Acme
Clothing’s Total Product Curve". Marginal product, given in the third row, is the change in output
resulting from a one-unit increase in labor. Average product, given in the fourth row, is output per
unit of labor. Panel (a) shows the total product curve. The slope of the total product curve is
marginal product, which is plotted in Panel (b). Values for marginal product are plotted at the
midpoints of the intervals. Average product rises and falls. Where marginal product is above
average product, average product rises. Where marginal product is below average product, average
product falls. The marginal product curve intersects the average product curve at the maximum
point on the average product curve.

As a student you can use your own experience to understand the relationship between marginal and
average values. Your grade point average (GPA) represents the average grade you have earned in all
your course work so far. When you take an additional course, your grade in that course represents
the marginal grade. What happens to your GPA when you get a grade that is higher than your
previous average? It rises. What happens to your GPA when you get a grade that is lower than your
previous average? It falls.

The relationship between average product and marginal product is similar. However, unlike your
course grades, which may go up and down willy-nilly, marginal product always rises and then falls,
for reasons we will explore shortly. As soon as marginal product falls below average product, the
average product curve slopes downward. While marginal product is above average product, whether
marginal product is increasing or decreasing, the average product curve slopes upward. As we have
learned, maximizing behavior requires focusing on making decisions at the margin. For this reason,
we turn our attention now toward increasing our understanding of marginal product.

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Increasing, Diminishing, and Negative Marginal Returns

Adding the first worker increases Acme’s output from 0 to 1 jacket per day. The second tailor adds 2
jackets to total output; the third adds 4. The marginal product goes up because when there are more
workers, each one can specialize to a degree. One worker might cut the cloth, another might sew the
seams, and another might sew the buttonholes. Their increasing marginal products are reflected by
the increasing slope of the total product curve over the first 3 units of labor and by the upward slope
of the marginal product curve over the same range. The range over which marginal products are
increasing is called the range of increasing marginal returns. Increasing marginal returns exist in
the context of a total product curve for labor, so we are holding the quantities of other factors
constant. Increasing marginal returns may occur for any variable factor.

The fourth worker adds less to total output than the third; the marginal product of the fourth worker
is 2 jackets. The data in Figure 1 "From Total Product to the Average and Marginal Product of
Labor" show that marginal product continues to decline after the fourth worker as more and more
workers are hired. The additional workers allow even greater opportunities for specialization, but
because they are operating with a fixed amount of capital, each new worker adds less to total output.
The fifth tailor adds only a single jacket to total output. When each additional unit of a variable
factor adds less to total output, the firm is experiencing diminishing marginal returns. Over the
range of diminishing marginal returns, the marginal product of the variable factor is positive but
falling. Once again, we assume that the quantities of all other factors of production are fixed.
Diminishing marginal returns may occur for any variable factor. Panel (b) shows that Acme
experiences diminishing marginal returns between the third and seventh workers, or between 7 and
11 jackets per day.

After the seventh unit of labor, Acme’s fixed plant becomes so crowded that adding another worker
actually reduces output. When additional units of a variable factor reduce total output, given
constant quantities of all other factors, the company experiences negative marginal returns.
Now the total product curve is downward sloping, and the marginal product curve falls below zero.
Figure 4.2 "Increasing Marginal Returns, Diminishing Marginal Returns, and Negative Marginal
Returns" shows the ranges of increasing, diminishing, and negative marginal returns. Clearly, a firm
will never intentionally add so much of a variable factor of production that it enters a range of
negative marginal returns.

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Figure 4.2: Increasing Marginal Returns, Diminishing Marginal Returns, and Negative
Marginal Returns

This graph shows Acme’s total product curve with the ranges of increasing marginal returns,
diminishing marginal returns, and negative marginal returns marked. Acme experiences increasing
marginal returns between 0 and 3 units of labor per day, diminishing marginal returns between 3
and 7 units of labor per day, and negative marginal returns beyond the 7th unit of labor.

The idea that the marginal product of a variable factor declines over some range is important
enough, and general enough, that economists state it as a law. The law of diminishing marginal
returns holds that the marginal product of any variable factor of production will eventually decline,
assuming the quantities of other factors of production are unchanged.

Heads Up!

It is easy to confuse the concept of diminishing marginal returns with the idea of negative
marginal returns. To say a firm is experiencing diminishing marginal returns is not to say its
output is falling. Diminishing marginal returns mean that the marginal product of a variable
factor is declining. Output is still increasing as the variable factor is increased, but it is
increasing by smaller and smaller amounts. As we saw in Figure 1. "From Total Product to the
Average and Marginal Product of Labor" and Figure 2. "Increasing Marginal Returns,
Diminishing Marginal Returns, and Negative Marginal Returns", the range of diminishing
marginal returns was between the third and seventh workers; over this range of workers, output
rose from 7 to 11 jackets. Negative marginal returns started after the seventh worker.

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To see the logic of the law of diminishing marginal returns, imagine a case in which it does not hold.
Say that you have a small plot of land for a vegetable garden, 10 feet by 10 feet in size. The plot
itself is a fixed factor in the production of vegetables. Suppose you are able to hold constant all other
factors—water, sunshine, temperature, fertilizer, and seed—and vary the amount of labor devoted to
the garden. How much food could the garden produce? Suppose the marginal product of labor kept
increasing or was constant. Then you could grow an unlimited quantity of food on your small plot—
enough to feed the entire world! You could add an unlimited number of workers to your plot and still
increase output at a constant or increasing rate. If you did not get enough output with, say, 500
workers, you could use 5 million; the five-millionth worker would add at least as much to total
output as the first. If diminishing marginal returns to labor did not occur, the total product curve
would slope upward at a constant or increasing rate.

The shape of the total product curve and the shape of the resulting marginal product curve drawn in
Figure 4.1. "From Total Product to the Average and Marginal Product of Labor" are typical of any
firm for the short run. Given its fixed factors of production, increasing the use of a variable factor
will generate increasing marginal returns at first; the total product curve for the variable factor
becomes steeper and the marginal product rises. The opportunity to gain from increased
specialization in the use of the variable factor accounts for this range of increasing marginal returns.
Eventually, though, diminishing returns will set in. The total product curve will become flatter, and
the marginal product curve will fall.

Costs in the Short Run

A firm’s costs of production depend on the quantities and prices of its factors of production. Because
we expect a firm’s output to vary with the firm’s use of labor in a specific way, we can also expect
the firm’s costs to vary with its output in a specific way.

The beginning point in developing the cost structure of a firm is to examine total costs in the short
run. Total costs (TC) are equal to total variable costs (TVC) plus total fixed costs (TFC).

TC = TVC + TFC

Variable costs are those costs that can be varied in the short-run, i.e., the cost of hiring labor, costs of
raw materials and utilities. Fixed costs are those costs that cannot be varied in the short-run, i.e.,
plant (interest). The salaries of top management may be fixed costs; any charges set by contract over
a period of time, such as Acme’s one-year lease on its building and equipment, are likely to be fixed
costs. A term commonly used for fixed costs is overhead. Notice that fixed costs exist only in the
short run. In the long run, the quantities of all factors of production are variable, so that all long-run
costs are variable. Therefore, total costs consist of a fixed component and a variable component.

These relations are presented in a graphical form in the following figure 4.3:

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The fixed cost curve is a horizontal line. These costs are illustrated with a horizontal line because
they do not vary with quantity of output. The variable cost curve has a positive slope because it
varies with output. Notice that the total cost curve has the same shape as the variable cost curve, but
is above the variable cost curve by a distance equal to the amount of the fixed cost. This is because
we added fixed cost (the horizontal line) to variable cost (the positively sloped line). The total cost
(TC) at any output is the vertical sum of the fixed cost and variable cost at that output.

From Total Production to Total Cost

Next we illustrate the relationship between Acme’s total product curve and its total costs. Acme can
vary the quantity of labor it uses each day, so the cost of this labor is a variable cost. We assume
capital is a fixed factor of production in the short run, so its cost is a fixed cost.

Suppose that Acme pays a wage of $100 per worker per day. If labor is the only variable factor,
Acme’s total variable costs per day amount to $100 times the number of workers it employs. We can
use the information given by the total product curve, together with the wage, to compute Acme’s
total variable costs.

We know from "Acme Clothing’s Total Product Curve" that Acme requires 1 worker working 1 day
to produce 1 jacket. The total variable cost of a jacket thus equals $100. Three units of labor produce
7 jackets per day; the total variable cost of 7 jackets equals $300. Figure 4.4 "Computing Variable
Costs" shows Acme’s total variable costs for producing each of the output levels given in Figure 4.2.

Figure 4.4 "Computing Variable Costs" gives us costs for several quantities of jackets, but we need a
bit more detail. We know, for example, that 7 jackets have a total variable cost of $300. What is the
total variable cost of 6 jackets?

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Figure 4.4: Computing Variable Costs

The points shown give the variable costs of producing the quantities of jackets given in the total
product curve in Figure 1. and Figure 2. Suppose Acme’s workers earn $100 per day. If Acme
produces 0 jackets, it will use no labor—its variable cost thus equals $0 (Point A′). Producing 7
jackets requires 3 units of labor; Acme’s variable cost equals $300 (Point D′).

We can estimate total variable costs for other quantities of jackets by inspecting the total product
curve in Figure 4.2. Reading over from a quantity of 6 jackets to the total product curve and then
down suggests that the Acme needs about 2.8 units of labor to produce 6 jackets per day. Acme
needs 2 full-time and 1 part-time tailors to produce 6 jackets. Figure 4.5 "The Total Variable Cost
Curve" gives the precise total variable costs for quantities of jackets ranging from 0 to 11 per day.
The numbers in boldface type are taken from Figure 4.4 "Computing Variable Costs"; the other
numbers are estimates we have assigned to produce a total variable cost curve that is consistent with
our total product curve. You should, however, be certain that you understand how the numbers in
boldface type were found.

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Figure 4.5: The Total Variable Cost Curve

Total variable costs for output levels shown in Acme’s total product curve were shown in Figure 4.
"Computing Variable Costs". To complete the total variable cost curve, we need to know the
variable cost for each level of output from 0 to 11 jackets per day. The variable costs and quantities
of labor given in Figure 4.4 "Computing Variable Costs" are shown in boldface in the table here
and with black dots in the graph. The remaining values were estimated from the total product curve
in Figure 4.1 and Figure 4.2. For example, producing 6 jackets requires 2.8 workers, for a variable
cost of $280.

Suppose Acme’s present plant, including the building and equipment, is the equivalent of 20 units of
capital. Acme has signed a long-term lease for these 20 units of capital at a cost of $200 per day. In
the short run, Acme cannot increase or decrease its quantity of capital—it must pay the $200 per day
no matter what it does. Even if the firm cuts production to zero, it must still pay $200 per day in the
short run.

Acme’s total cost is its total fixed cost of $200 plus its total variable cost. We add $200 to the total
variable cost curve in Figure 4.5 "The Total Variable Cost Curve" to get the total cost curve shown
in Figure 4.6 "From Variable Cost to Total Cost".

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Figure 4.6: From Variable Cost to Total Cost

We add total fixed cost to the total variable cost to obtain total cost. In this case, Acme’s total fixed
cost equals $200 per day.

Notice something important about the shapes of the total cost and total variable cost curves in Figure
4.6. "From Variable Cost to Total Cost". The total cost curve, for example, starts at $200 when
Acme produces 0 jackets—that is its total fixed cost. The curve rises, but at a decreasing rate, up to
the seventh jacket. Beyond the seventh jacket, the curve becomes steeper and steeper. The slope of
the total variable cost curve behaves in precisely the same way.

Recall that Acme experienced increasing marginal returns to labor for the first three units of labor—
or the first seven jackets. Up to the third worker, each additional worker added more and more to
Acme’s output. Over the range of increasing marginal returns, each additional jacket requires less
and less additional labor. The first jacket required one tailor; the second required the addition of only
a part-time tailor; the third required only that Acme boost that part-time tailor’s hours to a full day.
Up to the seventh jacket, each additional jacket requires less and less additional labor, and
thus costs rise at a decreasing rate; the total cost and total variable cost curves become flatter
over the range of increasing marginal returns.

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Acme experiences diminishing marginal returns beyond the third unit of labor—or the seventh
jacket. Notice that the total cost and total variable cost curves become steeper and steeper beyond
this level of output. In the range of diminishing marginal returns, each additional unit of a
factor adds less and less to total output. That means each additional unit of output requires
larger and larger increases in the variable factor, and larger and larger increases in costs.

From the total, variable and fixed cost curves we can obtain other relations. These are the marginal
cost, and the total, variable, and fixed costs relation to various levels of output (averages).

Average total cost (ATC) is total cost (TC) divided by quantity of output (Q), average variable cost
(AVC) is total variable cost (TVC) divided by quantity of output (Q), and average fixed cost (AFC)
is total fixed cost (TFC) divided by quantity of output (Q). Marginal cost (MC) is the change
(denoted by the Greek symbol delta), in total cost (TC) divided by the change in the quantity of
output (Q).

These relations are presented in equation form below:

ATC = TC/Q
AVC = TVC/Q
AFC = TFC/Q

MC = Change in TC / Change in Q

It equals the slope of the total cost curve. Figure 4.7 "Total Cost and Marginal Cost" shows the same
total cost curve that was presented in Figure 4.6 "From Variable Cost to Total Cost". This time the
slopes of the total cost curve are shown; these slopes equal the marginal cost of each additional unit
of output. For example, increasing output from 6 to 7 units (ΔQ=1) increases total cost from $480 to
$500 (ΔTC=$20). The seventh unit thus has a marginal cost of $20 (ΔTC/ΔQ=$20/1=$20). Marginal
cost falls over the range of increasing marginal returns and rises over the range of diminishing
marginal returns.

Heads Up!

Notice that the various cost curves are drawn with the quantity of output on the horizontal axis.
The various product curves are drawn with quantity of a factor of production on the horizontal
axis. The reason is that the two sets of curves measure different relationships. Product curves
show the relationship between output and the quantity of a factor; they therefore have the factor
quantity on the horizontal axis. Cost curves show how costs vary with output and thus have
output on the horizontal axis.

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Figure 4.7: Total Cost and Marginal Cost

Marginal cost in Panel (b) is the slope of the total cost curve in Panel (a).

Figure 4.8 "Marginal Cost, Average Fixed Cost, Average Variable Cost, and Average Total Cost in
the Short Run" shows the computation of Acme’s short-run average total cost, average variable cost,
and average fixed cost and graphs of these values. Notice that the curves for short-run average total
cost and average variable cost fall, then rise. We say that these cost curves are U-shaped. Average
fixed cost keeps falling as output increases. This is because the fixed costs are spread out more and
more as output expands; by definition, they do not vary as labor is added. Since average total cost
(ATC) is the sum of average variable cost (AVC) and average fixed cost (AFC), i.e.,
AVC+AFC=ATC.

The distance between the ATC and AVC curves keeps getting smaller and smaller as the firm spreads
its overhead costs over more and more output.

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Figure 4.8: Marginal Cost, Average Fixed Cost, Average Variable Cost, and Average Total
Cost in the Short Run

Total cost figures for Acme Clothing are taken from Figure 4.7 "Total Cost and Marginal Cost". The
other values are derived from these. Average total cost (ATC) equals total cost divided by quantity
produced; it also equals the sum of the average fixed cost (AFC) and average variable cost (AVC)
(exceptions in table are due to rounding to the nearest dollar); average variable cost is total
variable cost divided by quantity produced. The marginal cost (MC) curve (from Figure 4.7 "Total
Cost and Marginal Cost") intersects the ATC and AVC curves at the lowest points on both curves.
The AFC curve falls as quantity increases.

Figure 4.8 "Marginal Cost, Average Fixed Cost, Average Variable Cost, and Average Total Cost in
the Short Run" includes the marginal cost data and the marginal cost curve from Figure 4.7 "Total
Cost and Marginal Cost". The marginal cost curve intersects the average total cost and average
variable cost curves at their lowest points. When marginal cost is below average total cost or
average variable cost, the average total and average variable cost curves slope downward.
When marginal cost is greater than short-run average total cost or average variable cost, these
average cost curves slope upward. The logic behind the relationship between marginal cost and
average total and variable costs is the same as it is for the relationship between marginal product and
average product. No such relationship exists between the MC curve and the average fixed cost curve,
because the two are not related; marginal cost includes only those costs that change with output, and
fixed costs by definition are those that are independent of output.

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MC and Marginal Product
The marginal cost curve’s shape is a consequence of the law of diminishing returns. Assuming that
labor is the only variable input and that its price (the wage rate) is constant, as long as marginal
product is rising, marginal cost will fall. When marginal product is at its maximum, marginal cost is
at its minimum. And when marginal product is falling, marginal cost is rising. Under the same
assumptions, when AP is rising, AVC is falling, and when AP is falling, AVC is rising.

The following graph relates average and marginal product to average variable and marginal cost:

Where marginal cost equals average variable cost, the marginal product curve intersects the average
product curve. In other words, the cost structure of the firm mirrors the engineering principles giving
rise to the firm’s production, hence its costs.

This presents some interesting disconnects from how business is presently evolving. The high
compensation levels of executives seems to not reflect the actual output of their labors.

We turn next in this chapter to an examination of production and cost in the long run, a planning
period in which the firm can consider changing the quantities of any or all factors.

The Long Run Average Total Cost Curve

In the long-run all costs are variable. In other words, a firm can vary its plant, equipment, technology
and any of the factors that were either fixed or variable in the short-run. Therefore, anything that is
technologically feasible is available to this firm in the long-run. Further, any short-run average total
cost curve (consistent with any size of operation) could be selected for use in the long-run.

The long-run average total cost curve (LRATC) is therefore a mapping of all minimum points of all
possible short-run average total cost curves (allowing technology and all factors of production (i.e.,
costs) to vary). The enveloping of these short-run total cost curves map all potential scales of
operation in the long-run. Therefore, the LRATC is also called the planning horizon for the firm
or planning curve.

As in the short run, costs in the long run depend on the firm’s level of output, the costs of factors,
and the quantities of factors needed for each level of output. The chief difference between long-
and short-run costs is there are no fixed factors in the long run. There are thus no fixed costs.
All costs are variable, so we do not distinguish between total variable cost and total cost in the long
run: total cost is total variable cost.

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The long-run average total cost (LRATC) curve shows the firm’s lowest cost per unit at each level of
output, assuming that all factors of production are variable. The LRATC curve assumes that the firm
has chosen the optimal factor mix, for producing any level of output. The costs it shows are therefore
the lowest costs possible for each level of output. It is important to note, however, that this does
not mean that the minimum points of each short-run ATC curves lie on the LRATC curve. This
critical point is explained in the next paragraph and expanded upon even further in the next section.

Figure 4.9 "Relationship between Short-Run and Long-Run Average Total Costs" shows how a
firm’s LRATC curve is derived. Suppose Lifetime Disc Co. produces compact discs (CDs) using
capital and labor. In the short run, Lifetime Disc might be limited to operating with a given amount
of capital; it would face one of the short-run average total cost curves shown in Figure 4.9
"Relationship between Short-Run and Long-Run Average Total Costs". If it has 30 units of capital,
for example, its average total cost curve is ATC30. In the long run the firm can examine the average
total cost curves associated with varying levels of capital. Four possible short-run average total cost
curves for Lifetime Disc are shown in Figure 4.9. "Relationship between Short-Run and Long-Run
Average Total Costs" for quantities of capital of 20, 30, 40, and 50 units. The relevant curves are
labeled ATC20, ATC30, ATC40, and ATC50 respectively. The LRATCcurve is derived from this set of
short-run curves by finding the lowest average total cost associated with each level of output. Again,
notice that the U-shaped LRATC curve is an envelope curve that surrounds the various short-run
ATC curves. With the exception of ATC40, in this example, the lowest cost per unit for a particular
level of output in the long run is not the minimum point of the relevant short run curve.

Figure 4.9: Relationship between Short-Run and Long-Run Average Total Costs

The LRATC curve is found by taking the lowest average total cost curve at each level of output.
Here, average total cost curves for quantities of capital of 20, 30, 40, and 50 units are shown for the
Lifetime Disc Co. At a production level of 10,000 CDs per week, Lifetime minimizes its cost per CD
by producing with 20 units of capital (point A). At 20,000 CDs per week, an expansion to a plant size
associated with 30 units of capital minimizes cost per unit (point B).

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The lowest cost per unit is achieved with production of 30,000 CDs per week using 40 units of
capital (point C). If Lifetime chooses to produce 40,000 CDs per week, it will do so most cheaply
with 50 units of capital (point D).

Economies and Diseconomies of Scale

Notice that the long-run average cost curve in Figure 4.9 "Relationship between Short- Run and
Long-Run Average Total Costs" first slopes downward and then slopes upward. The shape of this
curve tells us what is happening to average cost as the firm changes its scale of operations. A firm is
said to experience economies of scale when long-run average cost declines as the firm expands
its output. A firm is said to experience diseconomies of scale when long-run average cost
increases as the firm expands its output. Constant returns to scale occur when long-run
average cost stays the same over an output range.

Why would a firm experience economies of scale?

One source of economies of scale is gains from specialization. As the scale of a firm’s operation
expands, it is able to use its factors in more specialized ways, increasing their productivity. Another
source of economies of scale lies in the economies that can be gained from mass production
methods. As the scale of a firm’s operation expands, the company can begin to utilize large-scale
machines and production systems that can substantially reduce cost per unit.

Why would a firm experience diseconomies of scale?

At first glance, it might seem that the answer lies in the law of diminishing marginal returns, but this
is not the case. The law of diminishing marginal returns, after all, tells us how output changes as a
single factor is increased, with all other factors of production held constant.

In contrast, diseconomies of scale describe a situation of rising average cost even when the firm is
free to vary any or all of its factors as it wishes. Diseconomies of scale are generally thought to be
caused by management problems. As the scale of a firm’s operations expands, it becomes harder and
harder for management to coordinate and guide the activities of individual units of the firm.
Eventually, the diseconomies of management overwhelm any gains the firm might be achieving by
operating with a larger scale of plant, and long-run average costs begin rising. Firms experience
constant returns to scale at output levels where there are neither economies nor diseconomies of
scale. For the range of output over which the firm experiences constant returns to scale, the longrun
average cost curve is horizontal.

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Figure 4.10: Economies and Diseconomies of Scale and Long-Run Average Cost

The downward-sloping region of the firm’s LRATC curve is associated with economies of scale.
There may be a horizontal range associated with constant returns to scale. The upwardsloping
range of the curve implies diseconomies of scale.

Firms are likely to experience all three situations, as shown in Figure 4.10 "Economies and
Diseconomies of Scale and Long-Run Average Cost". At very low levels of output, the firm is likely
to experience economies of scale as it expands the scale of its operations. There may follow a range
of output over which the firm experiences constant returns to scale—empirical studies suggest that
the range over which firms experience constant returns to scale is often very large. And certainly
there must be some range of output over which diseconomies of scale occur; this phenomenon is one
factor that limits the size of firms. A firm operating on the upward-sloping part of its LRTAC curve
is likely to be undercut in the market by smaller firms operating with lower costs per unit of output.

The Size Distribution of Firms

Economies and diseconomies of scale have a powerful effect on the sizes of firms that will operate
in any market. Suppose firms in a particular industry experience diseconomies of scale at relatively
low levels of output. That industry will be characterized by a large number of fairly small firms. The
restaurant market appears to be such an industry. Barbers and beauticians are another example.

If firms in an industry experience economies of scale over a very wide range of output, firms that
expand to take advantage of lower cost will force out smaller firms that have higher costs. Such
industries are likely to have a few large firms instead of many small ones. In the refrigerator

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industry, for example, the size of firm necessary to achieve the lowest possible cost per unit is large
enough to limit the market to only a few firms. In most cities, economies of scale leave room for
only a single newspaper.

One factor that can limit the achievement of economies of scale is the demand facing an individual
firm. The scale of output required to achieve the lowest unit costs possible may require sales that
exceed the demand facing a firm. A grocery store, for example, could minimize unit costs with a
large store and a large volume of sales. But the demand for groceries in a small, isolated community
may not be able to sustain such a volume of sales. The firm is thus limited to a small scale of
operation even though this might involve higher unit costs.

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