PERFECT COMPETITION, TOTAL ANALYSIS: A perfectly competitive firm produces the profit-maximizing quantity of output that generates the greatest difference between total revenue and total cost. This total approach is one of three methods that used to determine the profit-maximizing quantity of output. The other two methods involve the direct analysis of economic profit or a comparison of marginal revenue and marginal cost.
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LONG-RUN PRODUCTION ANALYSIS:
An analysis of the production decision made by a firm in the long run. The central characteristic of long-run production analysis is that all inputs under the control of the firm are variable. The central principle guiding production in the long run is returns to scale, which indicates how production responds to proportional changes in all inputs. A contrasting analysis is short-run production analysis. The analysis of long-run production indicates how a business pursues the production of output given that all inputs under its control is variable. In particular, a firm is able to alter not only the quantity of labor and materials, but also the amount of capital. In the long run, a firm is not constrained by a given factory, building, or plant size.
Long-run production analysis extends and augments short-run production analysis commonly used to explain the law of supply. The critical difference between the long run and the short run is the law of diminishing marginal returns. This law applies to the short run, which has at least one fixed input, but not the long run, which has all inputs variable.
The guiding principle for the long run is returns to scale, which indicates how production changes due to proportional changes in all inputs. Returns to scale can be either increasing, decreasing, or constant.
Two Runs: Short and LongThe first step in the analysis of long-run production is a distinction between the short run and the long run.
The difference between short run and long run depends on the particular production activity. For some producers, the short run lasts a few days. For others, the short run can last for decades.
- Short Run: The short run is a period of time in which at least one input used for production and under the control of the producer is variable and at least one input is fixed.
- Long Run: The long run is a period of time in which at all inputs used for production and under the control of the producer are variable.
All Inputs: VariableIn the long run, all inputs under the control of the producer are variable. A variable input is an input used in production and under the control of the producer that can be changed during the time period of analysis. While the short-run is characterized by at least one fixed input, usually capital (factory, production facility, building, and/or equipment), in the long run all inputs, including the quantity of capital is variable.
From a practical standpoint, this means that a firm not only has the ability to adjust the number of workers, but also the size of the factory. If the existing production plant is being used beyond capacity, then a bigger one can be constructed in the long run. If the existing office building has unused space, then a firm can move to a smaller one in the long run.
Note that the phrase "under the control of the producer" is included in the specifications of short run, long run, and variable input. The reason is that long-run production analysis is most concerned with how producers adjust the inputs under their control in response to changing prices.
Any production activity invariably includes inputs that are beyond the control of the producer, including government laws and regulations, social customs and institutions, weather, and the forces of nature. These other variables are certainly worthy of consideration, but are not fundamental to explaining and understanding the basic principles of market supply
Three Returns to Scale: Increasing, Decreasing, and ConstantIf a firm or producer changes all inputs proportional, the resulting change in production is guided by returns to scale, which come in three varieties. First, production might actually increase proportionally to the increase in inputs. Second, production might increase more than the increase in the inputs. Third, production might increase less than the increase in inputs. These three alternatives are technically termed constant returns to scale, decreasing returns to scale, and increasing returns to scale.
Returns to scale sheds a little long-run production analysis light on the positive law of supply relation between price and quantity. In the short run, the law of diminishing marginal returns indicates that a higher production cost, and thus a higher price, corresponds with greater production, which is the law of supply.
- Constant Returns to Scale: This occurs if a proportional increase in all inputs under the control of a firm results in an equal proportional increase in production. In other words, a 10 percent increase in labor, capital, and other inputs, also results in an equal 10 percent increase in production.
- Increasing Returns to Scale: This occurs if a proportional increase in all inputs under the control of a firm results in a greater than proportional increase in production. In other words, a 10 percent increase in labor, capital, and other inputs, results in a production increase that is greater than 10 percent.
- Decreasing Returns to Scale: This occurs if a proportional increase in all inputs under the control of a firm results in a less than proportional increase in production. In other words, a 10 percent increase in labor, capital, and other inputs, results in a production increase that is less than 10 percent.
However, in the long run, because returns to scale can increase, decrease, or remain constant, production cost can also increase, decrease, or remain constant, which further means price can increase, decrease, or remain constant. As such, there is no reason to expect that the law of supply correspondence between a higher price and a larger quantity holds in the long run.
One StepThis analysis of long-run production is but the first step in a brisk walk toward a better understanding of market supply. Further steps include the cost of long-run production and the market structure in which a firm operates, such as perfect competition or monopoly.
- Production Cost: An understanding of market supply builds on the long-run production analysis and the key role played by returns to scale. Because the productivity of the variable input can increase, decrease, or remain constant in the long run, long-run production cost can also increase, decrease, or remain constant. This provides insight into the applicability of the law of supply in the long run.
- Market Structure: The market supply also depends on the structure of the market, especially the degree of competition and the resulting market control of each firm. Competitive markets, with limited control over the price, tend to produce output by equating price and marginal cost in the long run. However, less competitive markets, with greater market control by the participating firms, need not equate price and marginal cost.
Two Scale Cost AlternativesLong-run production analysis provides the foundation for understanding long-run cost. In particular, increasing and decreasing returns to scale are behind two important long-run cost concepts--economies of scale and diseconomies of scale.
- Economies of Scale: These occur if a firm experiences a decrease in the long-run average cost due to proportional increases in all inputs. Economies of scale result, in part, from increasing returns to scale. If production increases more than inputs increase, then the average cost of production declines.
- Diseconomies of Scale: These occur if a firm experiences an increase in the long-run average cost due to proportional increases in all inputs. Diseconomies of scale result, in part, from decreasing returns to scale. If production increases less than inputs increase, then the average cost of production increases.
LONG-RUN PRODUCTION ANALYSIS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: March 4, 2024].
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