Long-Run Production (Cambridge International A-Level Economics)

Long-run production

• In the long run, firms can vary all factors of production, including labour, capital, land and enterprise

• This allows firms to change the scale of production, for example by expanding factories, investing in new machinery or adopting new technologies

• The long-run production function shows the relationship between inputs and output when all factors of production are variable

  • Firms can adjust the quantity of every input
  • This allows them to choose the most efficient scale of production
  • The long run therefore focuses on how output changes when all inputs increase

Choosing the best factor combination

• Firms aim to produce a given level of output using the most cost-effective combination of inputs The choice of inputs depends on:

  • The price of each factor of production (e.g. wages, rent, cost of machinery)
  • The productivity of each factor (how much output each input produces)

• To compare inputs, firms consider the marginal product generated per unit of cost

$\frac{\mathrm{Marginal} \mathrm{Product}(\mathrm{additional} \mathrm{output} \mathrm{from} \mathrm{adding} \mathrm{one} \mathrm{more} \mathrm{factor})}{\mathrm{Price} \mathrm{of} \mathrm{the} \mathrm{factor}}$

• Efficiency is achieved when the marginal product per unit of cost is equal across inputs

• For example, a technology firm deciding whether to hire more engineers or invest in cloud infrastructure will compare:

  • The additional output generated by each option
  • The cost of each input

• The firm will allocate resources toward the input that generates the highest output relative to its cost

Returns to scale

• Returns to scale describe how output changes when all inputs increase proportionally
• Three outcomes are possible

1. Increasing returns to scale

• Output increases more than proportionally compared to the increase in inputs
• This occurs because firms experience economies of scale
• Production becomes more efficient as the firm expands

2. Constant returns to scale

• Output increases in the same proportion as inputs
• Production efficiency remains unchanged

3. Decreasing returns to scale

• Output increases less than proportionally compared to the increase in inputs
• This occurs due to diseconomies of scale
• Production becomes less efficient as the firm becomes very large

Increasing and decreasing returns to scale

• The diagram below illustrates how the long-run average cost (LRAC) curve reflects different returns to scale

  • At low levels of output, firms experience economies of scale, so average costs fall
  • At moderate levels of output, firms may experience constant returns to scale
  • At very high levels of output, diseconomies of scale cause average costs to rise

As a firm grows, economies of scale help it reach its minimum efficient scale, before diseconomies raise the cost/unit again

Diagram analysis

• In the short-run, the firm operates on its short-run average cost curve

• In the long-run, the firm will increase its capacity (e.g. build a new factory), and then operate for a period of time on a new short-run cost curve

• Each subsequent short-run average cost (SRAC) curve represents growth and an increase in size

• Output increases with each period of growth

• Initially, firms experience increasing returns to scale as a result of the economies of scale

• At a certain level of output, the firm will reach the minimum efficient scale where it experiences constant returns to scale

• If it continues to grow beyond that level of output, the firm will experience decreasing returns to scale as diseconomies of scale occur