9781118041581

The Cost of Production 243

Production exhibits increasing returns to scaleor, equivalently, economies

of scale if average cost falls as the firm’s scale of operation increases. For

instance, a 20 percent increase in all inputs generates a greater than 20 percent

increase in output, causing average cost per unit to fall. When increasing returns

prevail, average cost falls as output increases.Finally, decreasing returns to scale

prevail if increasing all inputs by a given percentage amount results in a less

than proportional increase in output. It follows that the presence of decreasing

returns to scale implies rising average costs as the firm’s output and scale increase.

SHORT-RUN VERSUS LONG-RUN COST Consider a firm that produces output

using two inputs, labor and capital. Management’s immediate task is to plan for

future production. It has not leased plant and equipment yet, nor has it hired

labor. Thus, it is free to choose any amounts of these inputs it wishes. Manage-

ment knows that production exhibits constant returns to scale. Consequently,

the firm’s long-run average cost (LAC) is constant as shown by the horizontal

line in Figure 6.3. Furthermore, we can show that the firm should plan to use the

same optimal ratioof labor to capital in production, regardless of the level of

FIGURE 6.3

Short-Run versus

Long-Run Cost

Under constant returns

to scale, the firm’s

LAC is constant.

However, SACs depend

on the size of the firm’s

plant and are

U-shaped.

$5

0

Output (Thousands of Units)

Long-Run Average Cost

4

72 108 144 216

SAC 1

(9,000 ft^2 plant)

SAC 2

(18,000 ft^2 plant)

SAC 3

(27,000 ft^2 plant)

SMC 1 SMC 2 SMC 3

LAC = LMC

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