Businesses in the Long-Run Issues - Essay Example

Topic: Lecturer: Presentation: Introduction Businesses in the long-run usually tend to operate under variable costs as a result of the inconsistency of the factors of production. Long-run involves making future plans for production when expansion of production in the short-run is limited, for example by the inflexibility of the fixed assets such as the size of the industry. The business may successfully make short-run production plans that can only be accomplished within a particular size of the industry. However, in the long-run, production may be increased and the cost of production decreased by expanding the size of the industry. The original industry size can not hold the increased output. However, the size of the expanded industry has to be optimum to ensure that the business is able to avoid diseconomies of scale (Roncaglia 2006 p 582). There are many factors that may affect the effectiveness of a business in the long-run. For example, technological advancement may either improve the operations hence increased output and reduced cost of production, or it may lead to the obsolescence of the existing technology leading to an extra cost for the business. A business may experience falling long-run costs through changing the factors of production. There is an optimum level whereby the prices are expected to be maintained, or gradually begin to rise as the factors of production continue to be varied. However, there are situations when the long-run costs may continue falling even after this point is reached, which indicates the capacity of the industry to satisfy the market with greater variation of the inputs. This essay is a critique of why businesses might experience falling long-run costs as well as the effects of this on the competitive process and the structure of industries. It also critiques the reasons why long-run costs might begin to rise, and how a business can try to avoid the rise, to maintain competitiveness in the market. Falling Long-run Costs Businesses usually experience falling long-run costs after engaging in efforts to expand their production capacity. Such undertakings are usually focused on benefiting from the economies of scale in the sense that when an industry expands and produces in large scale, there is a possibility of lowering the cost of production. This occurs due to the fact that if a particular production system can produce more units when more inputs are applied, it would not be utilized maximally if only a few inputs are applied in the system (Roncaglia 2006 p 582). For example, if a sisal processing plant can produce 300 units of finished product from 700 units of raw materials and operates in an environment whereby the source of raw materials can only supply 400 units, it might benefit in the long-run if it moves to other regions where the raw materials are abundant. This would lead to a fall in the long-run cost since the same plant that was initially used to produce few products for a lower profit will be used to produce a larger quantity of output within the same premises for greater profits. This means that in the long-run, a firm is able to increase its efficiency through increasing the inputs. On the other hand, when inputs are variable, the firm will only maintain the inputs that can reduce the cost of production to improve profitability. Market expansion is significant in leading to a fall in the long-run costs of a business. This is because as new industries are established in a particular region, the prevailing industries are likely to expand to match the emerging industries. Development of industries concentrated in a particular region attracts professionals in the appropriate fields of production; hence it becomes easy for organizations to access skilled labor thereby increasing productivity. The more an industry employs skilled workforce, the more the costs of production decrease. On the other hand, suppliers for raw materials are likely to lower their cost as a result of many suppliers competing for the provision of products in a common market. Excess supply causes a reduction in prices, especially if the industries use similar raw materials, lowering the cost of production (Sexton et al. 1993 p 37). On the other hand, when the industries are concentrated in a particular region, other organizations offering essential services to a company are likely to establish in the region, leading, thereby reducing the cost of searching for these services elsewhere. Essential services such as banking, communication and security are usually necessary for the organization, and they need to be provided. Costs reduce especially when there is a high risk involved. For example, banking services need to be available to ensure that risks associated with accessing banks are minimized. Many organizations incur high costs associated with theft and fraud when transporting money from one area to another. These benefits may not be accomplished if the organization would be operating in isolation. They are advantages that are derived from what Dunning (2001 P 174) refers to as the "neighborhood effect". The figure below illustrates a typical long-run average cost curve. Fig. 1. Long Run Average Cost In the fig. 1. Above, an organization will produce quantity Q1 with high cost of input P1. However, the quantity Q2 that is more can be produced with a lower price P2 in the long-run. When businesses are capable of producing more at a lower price their competitive advantage increases since they can lower the prices of products to increase demand. This is especially applicable for the markets where consumers are highly sensitive to prices. Under such conditions, consumers are likely to demand more of a product when the prices decrease. A business is also capable of taking advantage of economies of scale to offer discounts to attract more customers. On the other hand, businesses producing products in large scale are capable of offering credit facilities to the consumers. They also benefit from the discounts offered as a result of purchasing inputs in large scale, thereby decreasing the cost of production. This is a significant way of improving an organization's competitiveness through attracting a large market base (Sexton et al. 1993 p 36). Rising Long-run Cost The long-run costs of a business may rise as a result of failure to analyze the market to ensure that it is capable of absorbing all that the industry offers in the market. For example, it is unnecessary to expand a business to expand the inputs to produce more than the quantity demanded in the market. For any extra cost of input, the cost of production may rise by several units because the consumers are not ready to purchase more. This means that the optimum level of production is reached and hence there is no need to produce more units (Dunning 2001 p 176). On the other hand, in a monopolistic industry, there is no need to focus on the increment of the inputs, reason being that if the small industry that dominates the market can satisfy the market demand, there would be no reason for it to focus on expanding to produce more in a market that is not competitive. It would be advantageous for such organizations to maintain production at the optimum quantity Q2 in fig. 1. Businesses may face rising long-run costs as a result of many social reasons. The social factors affecting consumers may lead to a change in the consumption pattern, which may significantly affect the industries that have expanded to produce for the particular market. A decrease in the customers' income for example may lead to an increase in the average cost of production since the industries will be producing more than the quantity demanded. As a result, the organization may suffer from diseconomies of scale. When medium size industries expand to increase their productivity, there is a likelihood of reaching a certain point whereby they compete for the available supplies of raw materials leading to a rise in prices of inputs. A business operating under such conditions may face a rising long-run cost. However, these are factors associated with the external business environment (Sexton et al. 1993 p 36). Businesses need to ensure that they produce at a particular point whereby production of an extra unit of output does not lead to a loss. In essence, the advantage of producing an extra unit of output has to be above the cost of producing one more unit (Dunning 2001 p 176). This means that producers should be careful not to produce at a negative profit. In regard to the inputs for example, it would not be meaningful if at al one worker can produce as much as 2 workers can. Managers need to ensure that each worker is utilized maximally to avoid incurring the cost of hiring an extra worker. For example, if 5 skilled workers can produce 300 units per week given a salary of $200 each over that period, and the organization has a plant capacity capable of producing 320 units, it would not be economically viable for the organization to hire an extra worker to accomplish the capacity of 320 units. This is because the extra worker will not be utilized maximally since only 20 additional units will be produced. Under such circumstances, the industry will benefit in the long run through expanding the plant to the capacity of 360 units for the workers to produce at the same level, i. e. 60 units each. However, if the benefit obtained from producing 20 more units is greater than $200 the 6th worker will be beneficial to the business in the long-run. Business can focus on variable proportions to determine which inputs can substitute each other. For example, if more capital in the business can lead to an increase in production by one unit, and on the other hand the other hand a reduction of capital leads to a decrease in production by one unit while an additional worker can lead to an increase in production of the extra unit with less capital, the managers need to analyze the cost of engaging one more worker and the addition of capital to produce the same unit. Since the two are substitutes in regard to the extra unit to be produced, it means that which ever is less will be applied since the focus is the output. It can help in the avoidance of rising long-run costs since if both capital and labor are applied to produce the same extra unit; the firm may be losing in the long-run (Ghali 2003 p 68). Conclusion Maintenance of falling long-run costs is significant or the success of a business. A firm is likely to benefit from economies of scale through expansion of the production system in the long-run. An industry may also improve its competitiveness as a result of falling long-run costs, which can allow the producers to offer their products at a lower price than the competitors, thereby expanding the consumer base. It may also be capable of offering credit facilities to consumers due to the low cost of inputs as a result of economies of scale obtained through purchasing raw materials in large scale. However, long-run costs may increase as a result of changes in the consumer preferences, as well as increasing output beyond the quantity demanded. The business should ensure that the long-run costs do not increase. This can be done through careful market analysis as well as focusing on the application of the concept of variable proportions to ensure that only the appropriate inputs are applied. References 1. Dunning J. H. "The eclectic (OLI) Paradigm of international production: Past, present and future", International Journal of the Economics of Business, Vol. 8, and (2001): 173 - 190. 2. Ghali M. "A Production-planning horizon, production smoothing, and convexity of the cost functions". International Journal of Production Economics, Vol. 82, 2003: 67-74 3. Roncaglia, A. The Wealth of Ideas: A History of Economic Thought. New York: Cambridge University Press, EH.NET 13, 2006 4. Sexton R. L., Graves, P. E. & Lee D. R. "The Short- and Long-Run Marginal Cost Curve: a Pedagogical Note". Journal of Economic Education, Vol. 24, 1993: 34-38 Read More