Production & Costs in Long Run

Question 1

What are the three possibilities of long term production?

Answer 1

1. Constant returns to scale
2. Increasing returns to scale
3. Decreasing returns to scale

Question 2

What does constant returns to scale mean?

Answer 2

Constant returns to scale means that output increases in the same proportion as all inputs. That is, if a firm doubles all inputs, output also doubles.

Question 3

What does increasing returns to scale mean?

Answer 3

Increasing returns to scale means that output increases more than in proportion to the increase in inputs. That is, if a firm doubles all inputs, output more than double.

Question 4

What does decreasing returns to scale mean?

Answer 4

Decreasing returns to scale means that output increases less than in proportion to the increase in all inputs. That is, if a firm doubles all inputs, output less than doubles.

Question 5

Why is the long run referred to as the firm’s “planning horizon”?

Answer 5

• As a firm grows, its production quantity will grow as well
• If a firm wants to further expand its production, it must increase its fixed inputs, otherwise its production will run into diminishing returns
• The LRATC represents the lowest possible average cost for every level of output (thus known as the firm’s “planning horizon”)

Question 6

What are economies of scale?

Answer 6

Economies of scale are decreases in the average costs of production over the long run as a firm increases all its inputs.

Question 7

What are the 6 reasons for economies of scale?

Answer 7

Economies of scale arise because larger firms are better able to take advantage of:

1. Specialization of labor and management, leading to greater efficiency
   
   • Larger firms attract better staff and as output
     increases, current staff gains more expertise
2. Efficiency of larger machines as they can be afforded
3. Bulk buying of inputs at lower average prices
4. More favorable interest rates as larger firms are more credible
5. Elimination of indivisibilities (machines that cannot be used due to limitation in firm size)
6. Spreading of costs for advertising and R&D through increase in output

Question 8

Diseconomies of scale

Answer 8

Diseconomies of scale are increases in the average costs of production over the long run as a firm increases all its input

Question 9

What are the reasons for diseconomies of scale?

Answer 9

If a firm becomes too large, there may be:

1. Management problems due to poor coordination and monitoring of firm activities
2. Communication difficulties resulting in inefficiencies
3. Low worker morale and motivation if they are an unimportant part of a very large firm

Question 10

Relationship between production and costs in the long run

Answer 10

1. When a firm is facing economies of scale, it is experiencing increasing returns to scale
2. When a firm is facing diseconomies of scale, it is experiencing decreasing returns to scale