Lecture 11: Production and Cost in the Long Run

Outline:

1. Definition of the Long Run

2. Choice of the input mix

3. Principle of Substitution

4. Long Run Average Cost Curve

i. Definition

ii. Shape

iii. Returns to scale

5. The Very Long Run

i. The process of technological change in a market economy

ii. Invention - process and product

iii. Innovation

6. Significance of productivity growth

7. "Lean production"

1. Definition:

The LR is the period of time during which the firm can vary all of its factors of production but the level of technology is fixed.

2. Choice of the input mix:

* In the LR the firm has the ability to vary all of its inputs

* This raises the question: what is the optimal (best) mix of the inputs?

* The firm chooses the mix of inputs according to the following condition:

MP_K/ P_K = MP_L/ P_L

where: MP_K = marginal product of capital

MP_L = marginal product of labor

P_K = price of a unit of capital

P_L = price of a unit of labor

This equation states that the firm should choose the mix of capital and labor such that the marginal product per $ spent on each is equalized.

Suppose not: Suppose MP_K/ P_K > MP_L/ P_L

How should the firm change its mix of inputs?

3. Principle of Substitution:

* Methods of production will change when the prices of the inputs change.

* Firms will substitute away from inputs that are relatively expensive and substitute toward inputs that are relatively cheap.

* This principle explains why a country like Indonesia for example, with relatively cheap abundant labor, uses production methods that are relatively more labor intensive, than a country like Japan, which has relatively cheap abundant capital, and uses more capital intensive production methods.

4. Long Run Average Cost (LRAC):

Definition:

The LRAC curve represents the minimum cost of producing each level of output on a per unit of output basis

Explanation: When the firm can vary all of its inputs, it can choose the least cost method of producing every possible level of output.

* The LRAC curve then gives the least cost method of producing every level of output.

* The LRAC curve is determined by the technology and by the input prices - if any of these change, the LRAC changes.

* The LRAC curve is the boundary between cost levels that are attainable and those that are unattainable with the given technology and input prices

Shape of the LRAC curve:

U-Shaped - Initially LRAC decreases (decreasing costs) then it flattens out (constant costs) then it increases (increasing costs)

Decreasing costs: Technologies with the property that an expansion of output leads to a decrease in costs per unit are said to exhibit

INCREASING RETURNS TO SCALE or ECONOMIES OF SCALE.

Question: Would we expect to see large firms, small firms, or any size firm in an industry characterized by economies of scale?

Constant costs: Technologies with the property that an expansion of output leaves cost per unit unchanged are said to exhibit

CONSTANT RETURNS TO SCALE

Question: Would we expect to see large firms, small firms, or any size firm in an industry characterized by constant returns to scale?

Increasing costs: Technologies with the property that an expansion of output leads to an increase in cost per unit are said to exhibit

DECREASING RETURNS TO SCALE or DISECONOMIES OF SCALE

Question: Would we expect to see large firms, small firms, or any size firm in an industry characterized by diseconomies of scale?

5. The very long run:

Technological change involves both invention and innovation - invention is a precondition to innovation.

Invention: Is the creation of something new - a new production process or a new product or new/improved inputs.

Innovation: Is the introduction of an invention into methods of production.

Questions: What motivates technological change in a market economy?

Which technologies actually "see the light of day" in a market economy?

What kind of technological change has characterized the U.S. economy in the post WWII period?

6. The significance of productivity growth:

* Growth in productivity permits increases in output per person which is linked to rising living standards.

* Productivity growth was rapid in the industrialized countries from WWII up to the 1970's.

* Since the 1970's industrialized countries have seen a slowdown in rates of productivity growth - with the decline being greatest in the U.S.

* A permanent slow-down in productivity growth means living standards rise more slowly than before.

Question:

The rate of technological change has been very rapid over the last 25 years so why has the rate of productivity growth in the U.S. remained so low?

7. Lean production:

* Lean production is the most fundamental change in the methods of production that has taken place since the introduction of mass production.

* Lean production is a form of production pioneered by the Japanese.

Evolution of production methods:

Craft methods:

Highly skilled workers making non-standardized products, high quality products, workers get a lot of job satisfaction.

Mass production methods:

Specialization and division of labor, using skilled workers to design products and production methods, unskilled labor to produce standardized parts and assemble them using specialized machinery, generally along an assembly line.

* Sometimes referred to as Fordism - since this production method was perfected by Henry Ford in the early twentieth century.

* The result was a standardized product, produced at low cost with few variants, the work was repetitive, and workers got very little job satisfaction.

Lean production methods:

Combine the flexibility and high quality of craft production with the low cost of mass production. The production is called lean because it uses less of all inputs.

* Workers are organized as teams, and each worker does all of the tasks assigned to the team, using equipment that is less highly specialized than in mass production.

* The emphasis is on initiative and individuality rather than repetition. Workers are encouraged to identify potential improvements, and costs of switching from on variant of a product to another are low.

* Production takes place "just in time" - in the sense that inventory levels are kept at a bare minimum - and this keeps overhead costs low.

* Workers have more identification with the job.

* Japanese auto companies have used lean production and it has been identified as a major source of their competitive advantage in automobiles.

* U.S. auto makers have increasingly adopted lean production methods.