# 4.6: Long-run Average Total Costs

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So far, we have been examining costs in the short run. The short run is a period during which one or more factors of production are fixed. Fixed factors of production means there will be fixed costs.

The long run is a period in which all factors of production can be altered. Since all factors can vary this means there are no fixed costs in the long run.

Let’s say you are planning on starting a new manufacturing business. During your planning process you will have to decide on the number of employees to hire, machines to buy, and the size of factory to build. Since all factors of production (labor, capital, land) can be altered, you are putting together a long-run plan.

When considering factory construction, a very important thing to get right is size. Production capacity has a dramatic impact on $$\mathrm{ATC}$$.

Figure 4

Let’s say you decide to build a small factory. The small factory’s $$\mathrm{ATC}$$ curve is labeled $$\mathrm{ATC}_{\text {small }}$$ in figure 4. If your production level is 3000, then your average total cost is $8. But what if demand is higher? What if there are orders for 5500 units? If the rate of production increases to 5500 then the average cost per unit increases to$10. This increase in average cost is because production is approaching the small factory’s capacity limit causing worker productivity to fall (remember productivity and marginal costs are inversely related).

What if you had a medium size factory? Figure 5 shows the difference in $$\mathrm{ATC}$$ between the small and medium size factories producing 5500 units.

Figure 5

The medium factory has the capacity to better accommodate a higher rate of output than the small factory. The increase in economies of scale allows for higher output at a lower average total cost.

Why Webvan Drove Off a Cliff

Joanna Glasner 07.10.01

In the sober days of 2001, it's hard to imagine a time when a company with an untested plan for an online grocery shopping service could inspire private investors to instantly part with hundreds of millions of dollars.

It's even more difficult to believe that the same company could convince the public to cough up similar sums of their own cash to build automated warehouses for the super-tech task of sorting groceries.

And perhaps it's even more perplexing that the recipient of all this largesse somehow managed to piddle it all away.

But Webvan Group -- the company that promised to revolutionize the business of grocery shopping -- somehow managed to accomplish all these things in little more than 18 months.

On Monday, the Foster City, California, company said that it closed all operations and filed for Chapter 11 bankruptcy protection. In the announcement, which came just a year and a half after Webvan's remarkably successful IPO, the company said it has no plans to re-open.

The cause? Rapidly disappearing cash reserves.

In a Monday statement, Robert Swan, Webvan's current CEO, said that the volume of orders from Webvan (WBVN) customers dropped considerably in the last three months. He said the company chose to quickly shut down "rather than continuing to operate with high losses and decreasing cash."

In the first quarter of the year, Webvan had reported a net loss of $217 million and an accumulated deficit of$830 million. And things only seemed to be getting worse.

On another obvious note, Webvan was also too optimistic about people's willingness to ditch traditional grocery stores in favor of something new and different. This type of extreme optimism was pervasive in late 1999, when Webvan went public.

"One of the fundamental mistakes that everybody made is the assumption that because there are some problems with the offline experience that everyone would flock to online," Terry said.

In fact, Webvan's problems never really had much to do with its customers. It was the lack of customers that was the trouble.

But while the company built up its empire of tech warehouses and fleets of delivery trucks, shoppers weren't signing up quite so quickly. A recent Jupiter survey found that only 2 percent of Web users had bought groceries online in the last year.

"When Webvan began making incredibly aggressive investments, that's exactly what investors were telling it to do," Cassar said. "Then Wall Street one day changed its mind, and Webvan suddenly found itself with an extraordinary amount of infrastructure and without the ability to get to profitability."

Which of the following points on Web Van’s long-run average total cost curve best fits the information in this news article?

1. A
2. B
3. C
4. D

Explanation: Web Van’s problem centered on the fact that demand for their service was not high enough to justify their “extraordinary amount of infrastructure.” In essence, Web Van built a large distribution and delivery system, but the actual demand was not high enough to achieve a low average total cost. Point C best represents this situation because it shows low deliveries (4 million) relative to the $$\mathrm{ATC}$$ for a large production and distribution system ($$\mathrm{ATC}$$ large).

This page titled 4.6: Long-run Average Total Costs is shared under a not declared license and was authored, remixed, and/or curated by Martin Medeiros.