7.4Production in the Long Run

overwhelm the website, and increasing output further could require a purchase of additional computer space. For other firms, fixed costs may be relatively low. For example, consider firms that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter. For fixed costs, such firms may need little more than a car to transport workers to homes of customers and some rakes and shovels. Still other firms may find that diminishing marginal returns set in quite sharply. If a manufacturing plant tried to run 24 hours a day, seven days a week, little time remains for routine equipment maintenance, and marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment. Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs, and then using these calculations as a basis for average total cost, average variable cost, and marginal cost. However, making a final decision about the profit-maximizing quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue, which in turn requires looking at the market structure in which the firm finds itself. Before we turn to the analysis of market structure in other chapters, we will analyze the firm’s cost structure from a long-run perspective.

7.4 Production in the Long Run

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Understand how long run production differs from short run production.

In the long run, all factors (including capital) are variable, so our production function is . Consider a secretarial firm that does typing for hire using typists for labor and personal computers for capital. To start, the firm has just enough business for one typist and one PC to keep busy for a day. Say that’s five documents. Now suppose the firm receives a rush order from a good customer for 10 documents tomorrow. Ideally, the firm would like to use two typists and two PCs to produce twice their normal output of five documents. However, in the short turn, the firm has fixed capital, i.e. only one PC. The table below shows the situation: # Typists (L) 1 2 3 4 5 6 Letters/hr (TP) 5 7 8 8 8 8 For K = 1PC MP 5 2 1 0 0 0 TABLE 7.11Short Run Production Function for Typing In the short run, the only variable factor is labor so the only way the firm can produce more output is by hiring additional workers. What could the second worker do? What can they contribute to the firm? Perhaps they can answer the phone, which is a major impediment to completing the typing assignment. What about a third worker? Perhaps the third worker could bring coffee to the first two workers. You can see both total product and marginal product for the firm above. Now here’s something to think about: At what point (e.g., after how many workers) does diminishing marginal productivity kick in, and more importantly, why? In this example, marginal productivity starts to decline after the second worker. This is because capital is fixed. The production process for typing works best with one worker and one PC. If you add more than one typist, you get seriously diminishing marginal productivity. Consider the long run. Suppose the firm’s demand increases to 15 documents per day. What might the firm do to operate more efficiently? If demand has tripled, the firm could acquire two more PCs, which would give us a new short run production function as Table 7.12 below shows. # Typists (L) 1 2 3 4 5 5 Letters/hr (TP) 5 6 8 8 8 8 For K = 1PC MP 5 2 1 0 0 0 Letters/hr (TP) 5 10 15 17 18 18 For K = 3PC MP 5 5 5 2 1 0 TABLE 7.12Long Run Production Function for Typing With more capital, the firm can hire three workers before diminishing productivity comes into effect. More generally, because all factors are variable, the long run production function shows the most efficient way of producing any level of output.

7.5 Costs in the Long Run

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Calculate long run total cost
• Identify economies of scale, diseconomies of scale, and constant returns to scale
• Interpret graphs of long-run average cost curves and short-run average cost curves
• Analyze cost and production in the long run and short run

The long run is the period of time when all costs are variable. The long run depends on the specifics of the firm in question—it is not a precise period of time. If you have a one-year lease on your factory, then the long run is any period longer than a year, since after a year you are no longer bound by the lease. No costs are fixed in the long run. A firm can build new factories and purchase new machinery, or it can close existing facilities. In planning for the long run, the firm will compare alternative production technologies (or processes). In this context, technology refers to all alternative methods of combining inputs to produce outputs. It does not refer to a specific new invention like the tablet computer. The firm will search for the production technology that allows it to produce the desired level of output at the lowest cost. After all, lower costs lead to higher profits—at least if total revenues remain unchanged. Moreover, each firm must fear that if it does not seek out the lowest-cost methods of production, then it may lose sales to competitor firms that find a way to produce and sell for less.

Choice of Production Technology

A firm can perform many tasks with a range of combinations of labor and physical capital. For example, a firm can have human beings answering phones and taking messages, or it can invest in an automated voicemail system. A firm can hire file clerks and secretaries to manage a system of paper folders and file cabinets, or it can invest in a computerized recordkeeping system that will require fewer employees. A firm can hire workers to push supplies around a factory on rolling carts, it can invest in motorized vehicles, or it can invest in robots that carry materials without a driver. Firms often face a choice between buying a many small machines, which need a worker to run each one, or buying one larger and more expensive machine, which requires only one or two workers to operate it. In short, physical capital and labor can often substitute for each other. Consider the example of local governments hiring a private firm to clean up public parks. Three different combinations of labor and physical capital for cleaning up a single average-sized park appear in Table 7.13. The first production technology is heavy on workers and light on machines, while the next two technologies substitute machines for workers. Since all three of these production methods produce the same thing—one cleaned-up park—a profit-seeking firm will choose the production technology that is least expensive, given the