1 Relation Between Long Run Cost Short Short Run Cost

14.01 Principles of Microeconomics, Fall 2007

Chia-Hui Chen
October 17, 2007

Lecture 14

The Cost of Production and Prot

Maximization
Outline
1. Chap 7: Relation Between Long Run Cost and Short Run Cost 2. Chap 7: Economies of Scale 3. Chap 7: Economies of Scope, Learning

Relation Between Long Run Cost Short Short Run Cost

Since rms can change capital in the long run, the long run cost is always no more than the short run cost: CL R(q ) CSR,K (q ). Figure 1 shows three short-run total cost given dierent capital level. In the long run, rms will choose the capital level which minimizes the total cost. Thus, the long-run total cost is equal to the minimum of all possible short-run total cost, and so long run total cost is the envelope of all short run total costs. Likewise, long-run average cost is the envelope of all short run average cost. From Figure 1, we know for a given product q , long run marginal cost is equal to the corresponding short run marginal cost. Long run total cost and marginal cost also have the following relation: (see Figure 2) If LM C < LAC,
LAC is decreasing;
if LM C = LAC,
LAC is minimized;
if LM C > LAC,
LAC is increasing.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].

1 Relation Between Long Run Cost Short Short Run Cost

10

8 TCSR3

5 TCSR2 4 TCLR
TCSR1
2

5 q

10

Figure 1: Deriving Long Run Total Cost from Short Run Total Cost.

15 SMC3

10

SMC2

LMC

SMC1 C SAC1 SAC2 SAC3 5 LAC

5 q

10

15

Figure 2: Deriving Long Run Average Cost and Marginal Cost from Short Run Average Cost and Marginal Cost.

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2 Economies of Scale

Economies of Scale
Constant economies of scale: C (aq ) = aC (q ), a > 1,
and in this case, AC is constant;
Economies of scale:
C (aq ) < aC (q ), a > 1,
and in this case, AC is decreasing; Diseconomies of scale: C (aq ) > aC (q ), a > 1,
and in this case, AC is increasing.

10 9 8 7 6

AC

5 4 3 2 1 0 0 1 2 3 4 5 6 7 8 9 10

economies of scale

diseconomies of scale

Figure 3: Production Dependence of Average Cost, Dierent Economies of Scale.

Economies of Scope, Learning

Economies of Scope. When producing more than one type of product that are closely linked, the cost is lower than when producing them separately. Product Transformation Curve. Shows various combinations of outputs that can be produced with a given set of inputs.

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3 Economies of Scope, Learning

Example (Product Transformation Curve with Economies of Scope). To produce 1 car and 1 truck, if we produce them separately, we need 2 units of K and 2 units of L; but if we produce them together, we only need 1.5 units of K and 1.5 units of L (see Figure 4). In this case, it is cheaper to produce them together; thus the rm has economies of scope.

1.8

1.6

1.4

1.2 Trucks

1 (1,1) 0.8 K=1 L=1 0.6 (0.7,0,7)

K=1.5 L=1.5

0.4

0.2

0.2

0.4

0.6

0.8

1 Cars

1.2

1.4

1.6

1.8

Figure 4: Product Transformation Curve with Economies of Scope. In the case of economies of scope, the product transformation curve is neg atively sloped and concave. The degree of economies of scope is dened as follows: SC = If SC > 0,
it is economies of scope;
if SC < 0,
it is diseconomies of scope.
The learning curve for a rm is shown in Figure 5, with the rms cumulative output as the vertical coordinate, and amount of inputs needed to produce a unit of output as the horizontal coordinate. Learning causes a dierence in cost between the new rm and the old rm (see Figure 6).
Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].

C (q1 ) + C (q2 ) C (q1 , q2 ) . C (q1 , q2 )

3 Economies of Scope, Learning

10

Hours of Labor Per Unit of Output

3 4 5 6 7 Cumulative Number of Outputs Produced

10

Figure 5: Learning Curve of a Firm.

10

AC

AC*

5 q

10

Figure 6: Shift of Cost Curve from Learning.

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3 Economies of Scope, Learning

Figure 7: Structure of Production Theory.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].