7.3 The structure of costs in the long run  (Page 2/26)

Production technology 1 uses the most labor and least machinery, while production technology 3 uses the least labor and the most machinery. [link] outlines three examples of how the total cost will change with each production technology as the cost of labor changes. As the cost of labor rises from example A to B to C, the firm will choose to substitute away from labor and use more machinery.

Example A shows the firm’s cost calculation when wages are $40 and machines costs are $80. In this case, technology 1 is the low-cost production technology. In example B, wages rise to $55, while the cost of machines does not change, in which case technology 2 is the low-cost production technology. If wages keep rising up to $90, while the cost of machines remains unchanged, then technology 3 clearly becomes the low-cost form of production, as shown in example C.

This example shows that as an input becomes more expensive (in this case, the labor input), firms will attempt to conserve on using that input and will instead shift to other inputs that are relatively less expensive. This pattern helps to explain why the demand curve for labor (or any input) slopes down; that is, as labor becomes relatively more expensive, profit-seeking firms will seek to substitute the use of other inputs. When a multinational employer like Coca-Cola or McDonald’s sets up a bottling plant or a restaurant in a high-wage economy like the United States, Canada, Japan, or Western Europe, it is likely to use production technologies that conserve on the number of workers and focuses more on machines. However, that same employer is likely to use production technologies with more workers and less machinery when producing in a lower-wage country like Mexico, China, or South Africa.

Economies of scale

Once a firm has determined the least costly production technology, it can consider the optimal scale of production, or quantity of output to produce. Many industries experience economies of scale. Economies of scale refers to the situation where, as the quantity of output goes up, the cost per unit goes down. This is the idea behind “warehouse stores” like Costco or Walmart. In everyday language: a larger factory can produce at a lower average cost than a smaller factory.