Chapter 9, Thomas and Maurice

CHAPTER 9
PRODUCTION AND COST IN THE LONG-RUN

I. INPUT COMBINATION CHOICE: PRODUCTION IN THE LONG-RUN

• As discussed in the previous chapter, all factors of production are variable in the

long-run. Given our two-input production function, this implies that both capital

and labor are variable for the firm. Thus, our long-run production function is:

Q = f (L, K)

Example: The following is an example for a theoretical long-run production

function:1

Q = 15L2 – L3 + 24K2 − 2K3

Substituting various levels of L and K in the above function will result in the output

levels shown in Table 1.

1 Note that not all production functions are restricted to being cubic functions. Depending on the
data used to estimate the function, one may fit other functional forms through a set of data points.
For example, an alternative long-run production function is Q = 10 K 1/2L1/2. This production
function is known as the Cobb-Douglas production function.

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Table 1: Production Table for Q = 15L2 - L3 + 24K2 – 2K3

Capital Output

1 36 74 130 198 272 346 414 470

2 94 132 188 256 330 404 472 528

3 176 214 270 338 412 486 554 610

4 270 308 364 432 506 580 648 704

5 364 402 458 526 600 674 742 798

6 446 484 540 608 682 756 824 880

7 504 542 598 666 740 814 882 938

8 526 564 620 688 762 836 904 960

9 500 538 594 662 736 810 878 934

10 414 452 508 576 650 724 792 848

1 2 3 4 5 6 7 8

Labor

Production Iso-Quants

• Although one can examine the properties of long-run production functions

using three-dimensional graphs (one axis for Q, one for L, and another one for

K), it is more amenable to use two-dimensional functions. To this end,

economists substitute a given level of output for Q (say Q0) in a long-run

production function. They then find various combinations of L and K that would

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result in Q0 units of output. In this way a three-variable function is converted

into a two-variable one (the variables are capital and labor inputs).

• For example, substituting 270 for Q in the above production function (i.e., Q0=

270) , we obtain:

270 = 15L2 - L3 + 24K2 - 2K3

• Plotting all combinations of K and L that yield 270 units of output and then

connecting these points in a two-dimensional graph result in a curve known as

the iso-quant curve (iso means equal and quant means quantity).

• Definition: An iso-quant curve (function) shows various combinations of L and

K that are used efficiently to produce a specific level of output per unit of

time, given the existing technology.

a. Iso-quants Map

One way to picture the entire production function in two dimensions is to look

at its iso-quants map. It is a contour map of a firm’s production function. Figure

2 shows an iso-quant map with only three iso-quants. Theoretically, there are

infinite number of iso-quants.

b. Marginal Rate of Technical Substitution (MRTS)

Definition: The MRTS is the rate at which one input should be substituted for

another, while maintaining the same output level.

slope of the iso-quant

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Given Q = f (L, K), the total differential of this function is:

dQ = MPLdL + MPKdK

Since dQ = 0 along an iso-quant,

MRTS diminishes as L is substituted for K along a given iso-quant curve: as

L↑ and K↓ ⇒ MPL ↓ and MPK ↑ ⇒ MRTS↓ ⇒ Iso-quant is convex.

Iso-Cost Curves

Definition: Different combinations of L and K that can be purchased with a given

amount of budget.

TC = wL + rK

Where w denotes the wage rate and r stands for the cost of capital (the interest

rate).

Re-arranging the above equation, we get:

• Given that the input prices are determined in a competitive market, both w and r

are constant, meaning that the iso-cost curve is linear. A change in the value of TC

will cause a parallel shift in the iso-cost curve.

• For a given input price, iso-costs curves farther away from origin are associated

with higher costs.

• Changes in input prices would change the slope of the iso-cost line.

An increase in the wage rate, for example, rotates the iso-cost curve

clockwise, holding the total cost of production constant. Similarly, a

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decrease in the wage rate rotates the iso-cost curve counter-

clockwise, holding the total cost of production constant. Figure 4

shows the effect of a decrease in the wage rate.

The Optimal Input Combination

Recall that a production function is technically efficient because each input

combination results in the maximum quantity of output. Since an iso-quant

represents a production function at a given output level, one can conclude that

each point on an iso-quant is technically efficient (i.e., the corresponding input

combination yields the highest (best) possible output). But of all these technically

efficient points, there is only one point that is economically efficient (the

corresponding input combination yields the lowest possible cost). This condition

is satisfied at point C in Figure 5.

At point C, the slope of the iso-cost is the same as the slope of the iso-quant. That

is, . Rearranging the terms, we get an economically efficient input combination:

. Optimality condition

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That is, marginal product per dollar spent should be equal for all inputs.

Note that economically efficient input combination is equivalent to an input

combination that is optimal

Example 1: Suppose at given input combination of L and K, the marginal product

of labor and capital are as follows: MPL = 20 units, and MPK = 40 units.

Given that w = $10 and r = $5, is the firm using the optimal combination of labor

and capital?

Solution:

 2>8 Not optimal

The marginal product per dollar spent on capital is larger than the marginal

product per dollar spent labor. Thus, less L and more K should be used.

As L↓ and K↑, due to the law of diminishing returns until the two sides are

identical.

Example 2: A popular production function in economics is Cobb-Douglas

production function. Its general form can be written as:

Q =AKαLβ

Consider the following Cobb-Douglas production function:

Q = 41.9263K1/2L1/2

Where Q is output in units and K and L are in machine-hours and labor-hours,

respectively. Suppose that the firm wishes to produce 7,500 units of output.

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Given that the prices of labor and capital are $200 and $250, respectively,

determine the optimal combination of labor and capital that would minimize the

total cost. What is the total cost at the optimal input combination?

Solution:
First, we need to find the iso-quant equation for Q = 7,500 and then get the

MRTS:

7,500 = 41.9263 K1/2 L1/2

Move the constant and the L1/2 to the left.

(7,500/41.9263)× L-1/2 = K1/2

178.88533 L-1/2 = K1/2

Or K1/2 = 178.88533 L-1/2

Raising both sides to the power 2 yields the following equation for the iso-quant:

K = 31,999.96 L-1 Iso-quant equation

MRTS = Slope of the iso-quant

The slope of the iso-cost is = -0.8. At the optimal input combination:

-31,999.96L-2 = -0.8

Multiply both sides by -1 and move L-2 to the right-hand side:

31,999.96 = 0.8L2

Divide both sides by 0.8:

39,999.95 = L2

L = 200 labor-hours per unit of time.

Inserting 200 into the iso-cost equation results in the critical value of K:

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K = 31,999.96 L-1

K = 31,999.96 (200)-1

K = 160 machine-hours per unit of time.

Therefore, at L = 200 and K = 160, the total cost of producing 7500 units of

output is minimized. Substituting the critical values of L and K in the cost

equation TC = 250K + 200L will result in the minimum total cost:

TC = 250 (160) + 200 (200) = $80,000

I. The Expansion Path

• It is a curve that shows the least cost combinations of inputs as the scale of

production expands (i.e., as the plant size becomes larger). At each point on

this curve the following cost minimizing condition holds: .

• As is evident in the above graph, along a single expansion path, input prices are

held constant. Any change in input prices would shift the path.

• Furthermore, for given prices of inputs, an expansion path represents a constant

MRTS equal to the input price ratio.2

• The expansion path is used to derive the long-run cost functions.

2 Note that at the

tangencies, MRTS = w/r. Thus, if input prices remain constant, MRTS
remains constant along the expansion path.

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II. Returns to Scale

• The concept of returns to scale describes the output response to a proportional

change in all inputs simultaneously. There are basically three possible output

responses:

1. Increasing returns to scale (IRS): A proportional increase in all inputs will

increase output by a greater proportion.

2. Constant returns to scale (CRS): A proportional increase in all inputs will

increase output in the same proportion.

3. Decreasing returns to scale (DRS): A proportional increase in all inputs

will increase output by a smaller percentage.

• It must be noted that a production system (function) may exhibit all three

different types of returns to scale. Starting from zero output level, as the scale

of operation increases (i.e., as the firm builds larger and larger plants), more

efficient and highly sophisticated machinery and equipment may be purchased

by the firm to replace the less efficient all-purpose equipment. A larger size

plant may also replace the existing plant. Furthermore, the opportunity of

division and specialization of labor may become possible. The overall effect of

all of these changes is that the firm may achieve increasing returns to scale. This

situation, unfortunately, cannot last indefinitely. Beyond a certain level of

output, as the scale of production increases, coordination of different activities

becomes more difficult and hence an increasingly heavy burden is placed on the

management, e.g., it becomes more difficult to obtain the information required

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to make important decisions and even more difficult to be certain that the

management's decisions are carried out. As a result, a diminishing return to

management occurs and may more than offset the benefits of specialization and

more efficient machinery and equipment (this was the case for General Motors

during the 1920s.) Thus, an over-expansion may result in decreasing returns to

scale. It must be noted, however, that the introduction of new scientific methods

of decision making and the development of high-speed data communication and

processing equipment have facilitated the process of decision making. As a

result, the firm may enjoy increasing returns to scale over a wider range of

output, and thus the decreasing returns to scale may happen at a very high level

of output.

• In general, if the production function is Q = f (K, L), and all inputs increase by a

constant proportion, say c, then the output will increase by some proportion, say z.

That is,

z Q = f (cK, cL) c and t are greater than 1.

If, for example, all inputs increase by 50%, the value of c is 1.5. If , in response,

output increases by 20%, the value of z is 1.2.

The returns to scale are determined as follows:

1. If z > c, it means production exhibits increasing returns to scale, IRS.

2. If z = c, it means production exhibits constant returns to scale, CRS.

3. If z < c, it means production exhibits decreasing (diminishing) returns to scale,

DRS.

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• In cases where the constant c can be factored out of the function, the exponent

of c will determine the degree of returns to scale. That is, if the production

function is Q = f (K, L), then multiplying each input by factor c will result in:

f (cK, cL) = c m f (K, L)

This production function is called homogeneous of degree m. The exponent m

is interpreted as follows:

1. If m > 1, it means production exhibits increasing returns to scale.

2. If m = 1, it means production exhibits constant returns to scale.

3. If m < 1, it means production exhibits decreasing returns to scale.

Example: Consider the production function of the following form:

Q = 3K2 + L2 + LK

Find the degree of returns to scale.

Solution:

Let Q1 be the initial output at some levels of L and K.

Let increase each input by proportion c:

Q2 = 3(cK)2 + (cL)2 + (cL)(cK)

Q2 = 3 c2×K2 + c2× L2 + c2×LK

Factor c2 out:

Q2 = c2 [3K2 + L2 + LK]

Substitute Q1 for the bracket,

Q2 = c2 Q1

Since the exponent of c is greater than 1, this production function exhibits IRS.

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If, for example, c = 2, then 22 = 4, meaning that when L and K increase by

100%, the new level of output increases by 300%.

Alternatively, we can start with some initial levels for L and K, say L=4 &

K=6. Find the quantity of output. Next double the quantity of inputs and find

the level of output. And finally calculate the percentage change in output to

determine the degree of returns to scale.

Initially, assume that K = 6 and L = 4. Therefore, the output is:

Q1 = 3 (6)2 + (4)2 + (6)(4) = 148 units per unit of time.

If all inputs are doubled (i.e., c = 2), then the output produced with the new

input combination (K = 12, and L = 8) is:

Q2 = 3 (12)2 + (8)2 + (12)(8) = 592 units per unit of time.

Since c = 2, and z = Q2/Q1 = 592/148 = 4, the production function exhibits

increasing returns to scale (z > c). Output increased by 300%.

II. LONG-RUN COST

• In the long-run, there are no fixed inputs: all factors of production are variable.

• The long-run can be viewed as a period during which the firm plans ahead to build

the most appropriate scale of plant to produce the desired level of output at the

lowest possible cost. For this reason, the long-run is referred to as the planning

horizon. Once the firm has built a particular scale of plant, it operates in the short-

run (indeed, all production and other economic activities take place in the short-

run). Therefore, a firm operates in the short-run and plans in the long-run.

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• To determine the optimal plant size, the firm' must know the minimum cost of

producing each level of output (as shown below). We start our analysis of the long-

run cost by constructing the long-run total cost curve.

A. Long-Run Total Cost (LTC): Derivation from Production Function

• A long-run total cost can be directly derived from the expansion path. Let's

assume, for analytical purposes, that the firm's purchases of inputs have no

impact on their prices meaning that input prices are held constant. Furthermore,

let's also assume that the firm's production function includes only two variables:

labor (L) and capital (K), whose prices are $10 and $12 per unit of time,

respectively. Columns (1) through (3) in Table 2 illustrate the schedule of the

expansion path for selected levels of output. A smooth and continuous graphical

representation of the expansion path is shown in the upper part of the following

figure.

• For each level of output, we can get the corresponding level of total cost by

multiplying the price per unit of labor by the quantity of labor plus the price per

unit of capital multiplied by the quantity of capital (that is LTC = wL + rK).

Columns (1) and (4) in Table 2 represent the long-run total cost (LTC) schedule.

The derivation of LTC from the expansion path is also shown in the figure

below.

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Table 2: Derivation of Long-Run Total Cost from the Expansion Path

Expansion Path
Output (Q) O Combination of Long-Run Total Cost (LTC) Long-Run Long-Run Average Total
pti Capital (K) Marginal Cost (LAC)
m Cost
al (LMC)
La
bo
r
(L
)
(1) (2 (3) (4) (5) (6)
)
0.0 0. 0.00 0.00 - -
00
100 3. 2.00 54.00 0.54 0.540
00
110 3. 2.16 58.32 0.432 0.530
24
125 3. 2.41 65.02 0.447 0.520
61
150 4. 2.84 76.78 0.470 0.512
27
190 5. 3.60 97.20 0.510 0.511
40

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225 6. 4.32 116.64 0.555 0.518

48
260 7. 5.42 142.14 0.728 0.547
71
290 9. 6.39 167.68 0.851 0.578
10
310 10 7.35 192.80 1.256 0.622
.4
6
320 11 8.08 212.06 1.926 0.663
.5
1

Note: all variables are in thousand units and LTC = $10L + $12K. That is, w = $10 and r = $12 per unit of time.

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Since the LTC is derived from the expansion path, it represents a least cost

schedule. Note that the LTC starts from origin because in the long-run there are no

fixed inputs.

• As is evident from the foregoing analysis, the shape of the LTC curve depends

exclusively on the underlying production function, assuming input prices are

constant. A change in the production schedule (function) would certainly change

the shape of the LTC curve.

• Both Figure 7 and Table 2 illustrate two basic characteristics of the LTC curve.

First, there is a direct relationship between production and cost: the more a firm

produces, the higher the total cost would be. Second, the total cost curve first

increases at a decreasing rate as we move away from the origin up to the

inflection point. Beyond the inflection point, the LTC increases at an increasing

rate as production rises.

• Note that at any point on the long-run total cost curve, the firm is producing the

given output level at the lowest possible cost, i.e., . Note also that each point on

the long-run total cost curve represents a given plant size.

B. Long-Run Average Total Cost (LAC)

• The long-run average total cost is the minimum per unit cost of producing each

level of output when the firm is free to choose any plant that it desires. The

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long-run average total cost is obtained by dividing total cost by the units of

output produced. That is,

• In Table 2, the LAC is obtained by dividing the figures in column (4) by the

corresponding numbers in column (1). The results are shown in column (6).

Examination of the figures in column (6) reveals an important characteristic of

the long-run average total cost. It is a U-shaped curve: it first decreases as

production expands, reaches a minimum at Q = 190 thousand, and then rises

with output.

• Each point on the LTC curve represents the level of output produced at a given

plant size. As the level of production increases, the plant size increases too.

Thus, each point on the LTC curve is both technically and economically

efficient. Since the LRAC is derived from the LTC curve, each point on the

LRAC is both technically and economically efficient.

• In addition, to each point on the LTC curve a short-run TC curve is tangent.

The same holds for the long-run ATC curve. That is, to each point on the long-

run ATC are a short-run ATC is tangent.

• Graphical representation of the LAC is given in Figure 8.

• Both the short-run and the long-run average total cost curves are U-shaped, but

for two different reasons. The short-run average total cost curves are U-shaped

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because some inputs remain fixed in the short-run. Thus, when increasing

amounts of the variable inputs are combined with the fixed inputs, diminishing

average returns to the variable inputs set in beyond a certain level of input

combination. Therefore, the decline in the average fixed cost is eventually more

than offset by the rise in the average variable cost. As a result, the ATC curve

rises after it reaches its minimum. This explanation can not, however, be applied

to the LAC. In the long-run there are no fixed inputs: all inputs are variable. So

what would explain the shape of the long-run average total cost curve? The

economies and diseconomies of scale are the factors responsible for the shape

of the LAC curve. The decreasing portion of the LAC is attributed to the

economies of scale and its rising portion is explained by the diseconomies of

scale. Economies (diseconomies) of scale occur when cost increases

proportionately less (more) than the increase in output.

Economies of Scale: occur when an increase in the scale of operation (the

plant size) leads to a decrease in the cost per unit.

Diseconomies of Scale occur when an increase in the scale of operation

(the plant size) leads to an increase in the cost per unit.

Constant economies of scale occur when an increase in the scale of

operation (the plant size) does not change the cost per unit. Over this

range, the long-run AC curve is flat.

 Reason for Economies of Scale

1. Specialization and division of labor

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As a firm’s scale of operation expands and the size of production increases,

the opportunities for specialization also increase.

As a result, the input productivity increases and the cost per unit decreases.

2. Improved Productive Equipment

As the firm expands its scale of production, it becomes more feasible to buy

better quality and more sophisticated machinery and equipment. This causes

labor productivity to increase further and leads to a greater reduction in the

average total cost.

3. Volume discounts on prices of raw materials and other inputs.

When a firm buys inputs in large quantities, the suppliers are likely to give

volume discounts to the firm, causing the long-run average cost to decline.

 Why a firm might experience diseconomies of scale?

Diseconomies of scale are the result of over-expansion and are a reflection of the

limitations to the efficient functioning of management.

When the scale of production is large, it becomes more difficult for management

to coordinate different activities.

Minimum efficient scale

The plant corresponding to the output level at which the AC is at its minimum is

called the minimum efficient scale.

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The min. efficient scale is the plant that gives the lowest cost per unit. It is the

optimal scale of plant.

Note:

 Economies of scale means production takes place under increasing returns to

scale, defined as a proportional increase in all inputs that causes the output to

increase by a larger proportion.

 Diseconomies of scale means production takes place under decreasing returns to

scale. That is, a proportional increase in all inputs causes the output to increase by

a smaller proportion.

 Constant economies of scale means production takes place under constant returns

to scale. That is, a proportional increase in all inputs leads to the same

proportional increase in output.

C. Long-Run Marginal Cost (LMC)

• The long-run marginal cost is defined as the change in total cost resulting from

one unit change in the firm's output when the firm is free to build any plant that

it wishes. That is,

• Column (5) in Table 2 lists the LMC of producing selected levels of output.

Graphical representation of the LMC is given in Figure 10.

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• Examination of the figures in column (3) reflects an important characteristic of

LMC: it is U-shaped. It first declines as output increases, reaches a minimum at

Q = 110 thousand, and then rises with output.

• You can also think of LMC as measuring the slope of the LTC curve at various

output levels. Therefore,

• As shown in Figure 7, the slope of the LTC curve first decreases as we move

along the curve up to the inflection point. Thus, LMC decreases as the size of

the operation expands. At the inflection point the slope of the LTC curve is zero

and hence the LMC curve is at the minimum. Beyond this point, the slope of the

LTC curve increases as output rises.

D. Multiple-Output Cost Functions

• Many firms produce several different products. HP produces printers and

computers. Dell produces PCs, laptops, printers, and TV montors. Ford

makes trucks and cars. Chase sells different financial products

• Suppose a firm produces two products, Q1 and Q2. Assuming all inputs are used

efficiently, the TC then depends on how much of each output the firm produces:

TC = TC(Q1, Q2)

Where TC (Q1, Q2) is the cost function for producing two outputs jointly.

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• Economies of scope explain why a firm produces two or more goods instead of

specializing in one.

Economies of Scope

• In economies of scope, the total cost of producing Q1 and Q2 together is less

than the total costs of producing Q1 and Q2 separately by two different firms:

TC(Q1, Q2) < TC(Q1, 0) + TC(0, Q2)

Where TC(Q1, 0) is the total cost function of producing Q1 only, and TC(0, Q2)

is the total cost function of producing Q2 only.

As the above relationship shows, it is cheaper to produce the two outputs jointly

instead of separately.

• One of the reasons for the economies of scope is that some factor resources are

common in the production of Q1 and Q2, so we need not purchase them

separately.

• Consider the following quadratic total cost function:

TC(Q1, Q2) = f + aQ1Q2 + Q12 + Q22 .

Note f is the fixed cost. This multi-product cost function exhibits economies of

scope if:

TC(Q1, Q2) < TC(Q1, 0) + TC(Q2, 0)

Moving the terms to the left and multiplying both sides by –1, we get:

TC(Q1, 0) + TC(0, Q2) – TC(Q1, Q2) > 0

Substituting the cost function in the above, we get:

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(f +aQ1(0) + Q12+0) + (f +a(0)Q2+0+Q22) – (f +a Q1Q2+Q12+Q22) > 0

(f +Q12) + (f + Q22) – (f +aQ1Q2+Q12+Q22) > 0

After simplifying:

f – aQ1Q2 > 0 Condition for Economies of Scope

Thus, the economies of scope are realized at all levels of outputs Q1 and Q2 if

f >aQ1Q2.

• Example: Suppose the cost function of firm A, which produces two products, is

given by:

TC = 100 – 0.5Q1Q2 + Q12 + Q22

The firm produces 5 units of good 1 and 4 units of good 2.

a. Do the economies of scope exist at the current output levels?

Solution:

Economies of scope? f – aQ1Q2 > 0

100 – 0.5(5)(4) = 90 >0. Thus, there are economies of scope.

b. At the current production levels of these two outputs, what is the total cost?

Solution:
TC(5,4) = 100 – 10 + 25 + 16 = 131

c. Now suppose firm A sells the production line that produces good 2 to firm B who has

the same cost structure. What is the total cost of producing 5 units of good 1and 4

units of good 2 separately by these two firms?

Solution:
The cost to firm A producing 5 units of good 1 is:

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TC(5,0) = 100 + 25 = 125

The cost to firm B of producing 4 units of good 2 will be:

TC(0,4) = 100 + 16 = 116

Firm A’s costs will fall by only $6 when it stops producing good 2, and the cost

to firm B of producing 4 units of good 2 will be $116. The combined costs to

the two firms of producing the output originally produced by a single firm will

be $110 more than the cost of producing by a single firm.

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