Long run Production

function
 The long run
llo w th e firm to va ry a llin p u ts—e . g ., p la n t size , a m o u n t o f ca
 Production with Two Variable
Inputs
• When a firm has more than one
variable input it can produce a
given amount of output with many
different combinations of inputs
– E.g., by substituting K for L

7 -3
 Isoquants
• An isoquant identifies all input
combinations (bundles) that
efficiently produce a given level of
output
– Note the close similarity to
indifference curves
– Can think of isoquants as contour
lines for the “hill” created by the
production function

7 -4
 Family of
Isoquants
K , Units of capital per day

6 a

T h e p ro d u ctio n fu n ctio n
a b o ve yie ld s th e iso q u a n ts
o n th e le ft.

b
3

e c f
2
q = 35

d
1 q = 24

q = 14

0 1 2 3 6 L , Workers per day

5
Figure 7.8: Isoquant
Example

7 -6
 Properties of Isoquants

• Isoquants are thin

• Do not slope upward
• Two isoquants do not cross
• Higher-output isoquants lie farther
from the origin

7 -7
• There are an infinite number of
combinations of labour and capital that
can produce each level of output.
• The slope of an isoquantis equal to:
- MPlabour / MPcapital = - MPL / MPK
= ΔK / ΔL
• The slope of the isoquant is called the
marginal rate of technical substitution
which can be defined as the rate at which
a firm can substitute capital for labour
and hold output constant.

Copyright 2002, Pearson Education Canada 8

Figure 7.10: Properties of
Isoquants

7 -9
Figure 7.10: Properties of
Isoquants

7 -1 0
Substitution Between Inputs
• Rate that one input can be substituted for
another is an important factor for
managers in choosing best mix of inputs
• Shape of isoquant captures information
about input substitution
– Points on an isoquant have same
output but different input mix
– Rate of substitution for labor with
capital is equal to negative the
slope

7 -1 1
 Marginal Rate of Technical
Substitution
• Marginal Rate of Technical
Substitution for labor with capital
(MRTSLK ): the amount of capital needed
to replace labor while keeping output
unchanged, per unit of replaced labor
– Let K be the amount of capital that can
replace L units of labor in a way such
that total output ― Q = F(L,K) ― is
unchanged.
– Then, MRTSLK = - K / L, and
– - K / L is the slope of the isoquant
– Therefore, MRTSLK = - slope of the isoquant

•
 Marginal Rate of Technical
Substitution
• marginal rate of technical
substitution (MRTS) - the number of
extra units of one input needed to
replace one unit of another input that
enables a firm to keep the amount of
output it produces constant
decrease in capital − ∆K
MRTS = =
increase in labor ∆L

Slope of Isoquant !
 How the Marginal Rate of Technical
Substitution Varies Along an Isoquant
K , Units of capital per d ay

a
16

∆ K = –6

b
10
∆ L= 1
–3
1 c
7
–2 1 d
5 e
4 –1
1 q = 10

0 1 2 3 4 5 6 7 8 9 10
L , Workers per d ay
Substitutability of Inputs and Marginal
Extra
Products.
Decrease in
units of the units
labor of capital
•
 (ΔL x MPL) = ( - ΔK x MPK).
Increase in q  decrease in q
per extra unit per extra unit
of labor of capital
•
• Along an isoquant output doesn’t
change (∆ q = 0), or
– ∆L × MPL + ∆K × MPK = 0
solving
− ∆K MPL
= MRTS = − = slope of isoquant
∆L MPK
 Therefore the Slope of an
Isoquant Is Equal to the Ratio
of MPL to MPK

16
 Isocosts
• An isocost is a graph that shows all
the combinations of capital and
labour available for a given cost.

Copyright 2002, Pearson Education Canada 17

 Isocost lines
In e q u a tio n fo rm th e to ta lco st is
C = w L + rK ,
w h e re C = To ta lco st o r b u d g e t
le ve l,
w = th e w a g e ra te ,
L = th e a m o u n t o f la b o r ta ke n ,
r = th e re n ta lp rice o f ca p ita l,
and
K = th e a m o u n t o f ca p ita l
ta ke n .
T h is e q u a tio n ca n b e re - exp re sse d a s
K = ( C / r) - ( w / r) L .
W h e n w e w rite th e iso co st lin e in th e
fo rm
K = ( C / r) - ( w / r) L

W e se e
If L = 0 , th e n K = C / r,
If K = 0 , th e n L = C / w , − ∆K
A n d th e slo p e o f th e li∆nLe , = –w / r.
Isocost Lines Showing the Combinations of
Capital and Labour Available for $5, $6, and
$7 (Figure 7A.3)

Copyright 2002, Pearson Education Canada 20

 Producers Equilibrium
• An isoquant shows all technically
efficient combinations of two
inputs. But, when producers are
faced with several technically
efficient combinations the decision
is taken on the basis of economic
efficiency, i.e ., use that
combination which minimises the
cost of production
• Hence, to be technically efficient , a
producer must determine the
combination of inputs that
produces the output at minimum
cost. A profit maximising firm will
try to use a combination of inputs
that will minimise the cost of
producing a given level of output.
• The maximum output level for any
firm is determined by isoquants,
but they would not give the
minimum cost of production; for
this we would need the isocost.
• Combining the isoquants and
isocosts will help us to understand
the producers equilibrium, or the
optimal combination of inputs in
the long run
 The Cost Minimizing
Equilibrium Condition
• Slope of isoquant = - MPL / MPK
• Slope of isocost = - w / r
•
• For cost minimization we set these
equal and rearrange to obtain:

-MPL / MPK = -w/ r

Copyright 2002, Pearson Education Canada 24

 Finding the Least-Cost Combination of
Capital and Labour to Produce 50 Units of
Output

• Profit-maximizing
firms will minimize
costs by producing
their chosen level
of output with the
technology
represented by the
point at which the
isoquant is
tangent to an
isocost line.
• Point A on this
diagram
Copyright 2002, Pearson Education Canada 25
Minimizing Cost of Production
for qx = 50, qx = 100, and qx
= 150 (Figure 7A.6)
• Plotting a series
of cost-
minimizing
combinations
of inputs -
shown here as
A, B and C -
enables us to
derive a cost
curve.

Copyright 2002, Pearson Education Canada 26

 Returns to Scale
• Just as the law of diminishing returns
to a factor in the short run
phenomenon, return to scale is the
long run phenomenon, in which the
scale of production is determined
on the basis of change in both the
inputs in the production process.
• The long run production process is
described by the concept of returns
to scale.
 Law of Return to Scale
• The word scale refers to the long-run
situation where all inputs are
changed in the same proportion.
• What would be the level of output
when all inputs are increased by
exactly the same proportion in the
long run ?
• If all inputs into the production
process are doubled, three things
can happen:
– output can more than double
• increasing returns to scale
(IRTS)
– output can exactly double
• constant returns to scale
(CRTS)
– output can less than double
• decreasing returns to scale
 Constant Return to Scale
• Refers to the situation where output
changes by the same proportion as
inputs
• Eg if all inputs are increased by 10%,
output also rises by 10%, Inputs are
doubled then output is also doubled
 Increasing Return to Scale
• Refers to the case where output
changes by a larger proportion than
inputs
• Eg if all inputs are increased by 10%,
output rises by more than 10%,
Inputs are doubled then output is
more than doubled
• Division of labour & Specialisation
•
Decreasing Returns to Scale
• Refers to the case where output
changes by a smaller proportion
than inputs
• Eg if all inputs are increased by 10%,
output rises by less than 10%,
Inputs are doubled then output is
less than doubled
• Managerial Diseconomies
•
 The Long-Run Production
Function
• One way to measure returns to scale
is to use a coefficient of output
elasticity:
• Percentage change in Q
EQ =
• Percentage change in all inputs
•
•
• If EQ > 1 then IRTS
• If EQ = 1 then CRTS
• If EQ < 1 then DRTS