Average Total Cost: Short Run and Long Run

All right. Now, let's bring back the idea of the short run and the long run and talk about average total costs. So, remember when we talked about the short run the short run, where was where our fixed costs must remain fixed costs. Right? We're gonna have fixed costs in the short run, maybe some lease that we signed and we can't get out of it. Right? There's always gonna be some fixed costs that we can't get out of in the short run. Right. So the idea here is in the short run, we're gonna be stuck with these decisions. We in the past, right, We've made a decision to sign this lease or to build this size factory or anything like that. Right? We made these decisions and now we're stuck with them in the short run. It's not enough time for us to re evaluate these decisions. And here we have a standard I'm gonna use for short run, I'm gonna use S. R. For short run and L R. When we get to a long run for long run. So here, on the graph, I've just put a standard short run average total cost curve. Right? So this is something similar to what we've seen when we are studying average total cost and seeing the graph, I just kind of put one arbitrarily here, right, this represents that curve, right? It's falls hits a minimum and that starts rising, right? Our average total cost in the short run. So this is kind of what we're used to. Right, I was just kind of giving us a baseline. And now I want to talk about the long run, right, this is where the juicy stuff is. So let's go down here to our long run graph and you see a bunch of crazy stuff going on here and I want to dive right in. So let's think about it in the long run, which I'm gonna call L. R. Right? L. R. For long run, all our costs are variable costs, right? All our costs including those fixed costs from before they're now variable. So you can imagine in a long enough time, if we had signed a lease for a factory that that lease would expire, right? And then we could reevaluate, should we keep this factory, should we get a different factory right? We can make that decision at that time? Or even if we built the factory ourselves, right, there's gonna be a long enough time where we'll be able to just ditch the factory and build a new one or something like that. Right? So the long run, it has to do with that long time period where all our costs become variable. And just like I've been saying, we can re evaluate these big decisions like the size of our plant size of the factory. Right? So here we go on the graph, you see a bunch of different curves here. Right? So the idea is that in the long run the companies reevaluating these decisions and what it gets to do is pick a short run curve, right? It gets to pick where it wants to be in the short run. So, we're up above We were stuck with a factory size. Now, we can pick a new factory size to be stuck with. Right, We can build a bigger factory and then be stuck with that in the short term again. But when we think about the long term, we can pick from any of these different situations. So, you can imagine that this short run these are all short run average total cost curves. Right? So, you can imagine that in the long run, what we get to do is pick which one of these short run average total cost curves we wanna use. Right? So, how big of a factory do we want to build? Right. All of these curves are short run average total cost curves. So, what happens is we're gonna get to pick one? Right. So, what the long run average total cost curve looks like I'm gonna draw it here in green, and I'm gonna do my best. All right, So, it's gonna do something like this. We're gonna follow these already messing up. Alright, let's try one more time. It's gonna kind of follow these all along here, right? And it's gonna look something like that. Right? So, it's going to follow all the different possible short run curves that we can pick from? All right, And I'm gonna go ahead and separate this graph into three sections here. So we've got this section right here, draw that again. This section here we're gonna have this section right about here and then that final section. Okay? So let's talk about what's happening in these sections. Notice that our X axis here, it's still quantity, right? Just like we're used to and dollars. Right? Some dollar amount price costs, Right? That's gonna be our Y axis. All right. So what's happening in this first section in this first section on the left, notice that as the quantity increases. So the quantity increases what happens to our average total cost? Our long run average total cost. I'm gonna put the average total cost decreases. Right? So as we're increasing the quantity, you can see that this average cost is decreasing decreasing. Right? These numbers getting smaller and smaller as we move along in this section. Right? So there's a section where quantity increases average total cost decreases in this next section. I didn't draw it so good. But it should be pretty flat. Right? That's what we see here. It's kind of a flat section. So what's happening is that as the quantity keeps increasing? Right from this point here this point this point this point the cost stays the same, right? We're seeing that the average total cost I'm gonna put an equal sign it's staying the same throughout that region. And then finally in this right? Most region we see that we're gonna keep increasing quantity. But now those costs start going up again, right? The costs start increasing during this region. So we see that average total cost eventually starts increasing, right? So this is the typical long run average total cost curve. Or we're going to see that at first we're gonna start decreasing our total costs as we increase quantity, will kind of stabilize and then it'll start increasing again. Right? So let's talk about what these different sections are. The first section describes what we call economies of scale. You might have heard this term before, but let's go ahead and define it. Now, economies of scale are where the long run average total cost decreases, Right? So the cost is decreasing as the quantity goes up, right? We're producing more and more, but that average cost goes down, right? So how can that happen? How can we be producing more units? But have less total cost? Well that comes down to things. We're seeing, right, like ideas of specialization when we were talking about that Pizza company, right, They would add more workers and produce more output and for a small period of time there they were getting um better, better deals, right? They're able to pay produce more with those first few workers, obviously they hit a wall and then it started getting worse again. Right? But you can see that there's this, there's the value of specialization, right? We can get some value out of this where we have the economies of scale or you could see something where the costs are not increasing as quickly as the output. So you can imagine maybe economies of scale that you could get. Is this pizza company? Instead of buying say, you know, packets of cheese from the grocery store? Now they can order this bulk amount of cheese, like a whole farm's worth of cheese, right? You could imagine that they're gonna get a discount, right? So they're getting this these these costs aren't growing as fast, right? Even though those those variable costs of the cheese for the pizza are going up, You're getting discounts and stuff, right? So you might be able to take advantage of that when you grow your output. So that could be an economy of scale or lastly the use of large volume machinery. Right? At our pizza plant, in our example, they had two ovens that they were using, but imagine that they were going to grow, expand extensively and they buy some oven that can cook, say 50 pizzas at the same time, right? They can take advantage of these large machines that they probably couldn't in a small setting. Right? So you get economies of scale there where you can use these bigger machines to so those economies of scale, that's where we see those costs decreasing as we increase our output. Cool, let's go on to that second section where we're gonna call it the constant returns to scale, right? And that's where we saw that, it leveled off right throughout this section, um the second section there, you see that? It's pretty flat, right? It's flat. And that means that we're increasing the quantity, but the cost, the average total cost is staying the same in this region. Right? So long run average total cost uh stays constant uh stays constant as quantity increases. Right? So the constant returns, we're seeing that it flattens out there. And um it's a pretty simple idea there. But one point I do want to talk about is this minimum efficient scale. Right? So minimum efficient scale, it's just basically the point where the constant returns begin. So you imagine that minimum efficient scale. It's gonna be right here, right at the beginning of this section, right? That's our minimum efficient scale. Okay, so the the it's kind of a technical term, but it just basically means one the point where we've exhausted all of our economies of scale, right? You can imagine that all this time where the average total cost is decreasing, that's good for the business, right? We wanted to decrease the cost as much as we can and then it finally levels out. So at that point we're not gonna really get those benefits of increasing our quantity where the cost keeps decreasing. Right? So that point is the minimum efficient scale. It's the least amount we have to produce to get the most economies of scale. Right? So at that point where the constant scale begins, that's our minimum efficient scale. Cool. So that's the quantity where the economies of scale end. Right. And the constant returns begin, minimum efficient scale. That's what we call it. Let's go ahead and talk about this last section where we're gonna have this economies of scale. So you can you can imagine that this is gonna be the opposite of the economies of scale, right? This is gonna be where average total costs in the long run increase, right? Long run average total cost increases as quantity increases. So you're gonna see there's gonna be a point where we're gonna have grown so much. Our factory is so big that it actually starts to cost us more money. Our average total cost starts going up. Right? And that's this last section. You see, as the quantity goes up, we're going further in quantity, higher quantities. The costs start going up as well. Right? You're seeing average total cost increasing over this section. So what could make that happen? Um It's mostly becomes a coordination problem with management. Right? So you can imagine if we built this pizza factory, right? We built this huge pizza factory, we've got hundreds of ovens, thousands of workers, right, producing these pizzas, you can imagine now we're gonna run into like coordination, prob the people preparing the pizzas, there might be like a cheese manager and each oven has an oven manager and they all have to coordinate and there's all these crazy things going on, right? So at a certain point you could, you start losing that efficiency because you've grown too much and now there's too much trouble coordinating. There's a really good example where Henry Ford when he first produced the car, um, he had produced the model T and he got serious economies of scale by taking advantage of specialization, right? He had an assembly line where each worker had a very specific task and they were to produce tons of cars at a very cheap price. So he saw that and he's like, man, that was so great, we made so much money, let's build a gigantic factory and let's do the same thing, right? And their stories written about this factory, he built a ginormous ginormous, like talking huge factory and their stories where they, they had to hire thousands of janitors just to clean the factory right now. Now there's this huge, huge problem that this this factory is so big on top of that, the workers would go in there and they would see they would enter this factory and it's just so vast and there's just so many people and so much going on, they would feel intimidated. So it actually affect their work ethic as well, just because of this huge factory. So, Henry Ford ended up learning a big lesson there about dis economies of scale when he lost a ton of money, the factory wasn't able to compete with his competitors who were able to keep cost low in their smaller factories, and he soon found out that his costs were rising because how big his factory had gotten. Alright, so those Disick on Ami's of scale come in when you're you're just growing too big and there's just trouble with coordination, too much management, too much going on for you to keep the cost down. All right, so that's our discussion here about average total cost in the short run. In the long run, let's go ahead and let's go to move on to the next video. Now, let's do that.