Chapter 9: Production and

Cost in the Long Run

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 Production Isoquants
• In the long run, all inputs are variable &
isoquants are used to study production
decisions
• An isoquant is a curve showing all possible
input combinations capable of producing a
given level of output
• Isoquants are downward sloping; if greater
amounts of labor are used, less capital is
required to produce a given output
9-2
A Typical Isoquant Map
(Figure 9.1)

9-3
Production Function

9-4
Typical Isoquants

9-5
 Marginal Rate of
Technical Substitution
• The MRTS is the slope of an isoquant &
measures the rate at which the two inputs
can be substituted for one another while
maintaining a constant level of output

DK
MRTS = -
DL
The minus sign is added to make MRTS a positive
number since ∆K / ∆L, the slope of the isoquant,
is negative
9-6
 Marginal Rate of
Technical Substitution
• The MRTS can also be expressed as the
ratio of two marginal products:
MPL
MRTS =
MPK
As labor is substituted for capital, MPL declines &
MPK rises causing MRTS to diminish

DK MPL
MRTS = - =
DL MPK
9-7
Marginal Rate of Technical Substitution

DK
MRTS = - Slope of production isoquant
DL
DY = ( MPL  DL)  ( MPK  DK )
0 = ( MPL  DL)  ( MPK  DK )
MPL DK
=- = MRTS
MPk DL
Slope of production isoquant
reflects relative marginal product
of labor and capital 9-8

6–8
 Isocost Curves
• Show various combinations of inputs that
may be purchased for given level of
expenditure (C) at given input prices (w, r)
C w
K= - L
r r
• Slope of an isocost curve is the negative of
the input price ratio (-w/r)
• K-intercept is C/r
• Represents amount of capital that may be
purchased if zero labor is purchased 9-9
 Isocost curve
r = $10
w = $5
C = $100
C = wL  rK
C = 5L  10 K
C w
K= - L
r r
100 5
K= - L
10 10
9-10
.
Isocost Curves (Figures 9.2 & 9.3)

9-11
Optimal Combination of Inputs
• Minimize total cost of producing Q by
choosing the input combination on the
isoquant for which Q is just tangent to an

isocost curveare equal in equilibrium

• Two slopes
• Implies marginal product per dollar spent on last
unit of each input is the same

MPL w MPL MPK

= or =
MPK r w r
9-12
Optimal Input Combination to Minimize
Cost for Given Output (Figure 9.4)

9-13
Optimal Allocation of Inputs
Suppose
MPL = 2, w = $1
MPK = 3, r = $2
•Is the firm using the right combination
of inputs?
•If not, how should the firm reallocate
its expenditure?
•Use the last dollar rule
9-14
Optimal Allocation of Inputs
MPL 2
= =2
w $1
MPK 3
= = 1. 5
r $2
Last dollar spent on labor increases output by more
than the last dollar spent on capital
Increase use of labor relative to capital
Decrease use of capital relative to labor

9-15
Output Maximization for Given Cost
(Figure 9.5)

9-16
 Optimization & Cost
• Expansion path gives the efficient (least-
cost) input combinations for every level of
output
• Derived for a specific set of input prices
• Along expansion path, input-price ratio is
constant & equal to the marginal rate of
technical substitution

9-17
Expansion Path (Figure 9.6)

9-18
 Long-Run Costs
• Long-run total cost (LTC) for a given level
of output is given by:
LTC = wL* + rK*
Where w & r are prices of labor & capital, respectively,
& (L*, K*) is the input combination on the expansion
path that minimizes the total cost of producing that
output

9-19
 Long-Run Costs
• Long-run average cost (LAC) measures the cost
per unit of output when production can be
adjusted so that the optimal amount of each
input is employed
• LAC is U-shaped
• Falling LAC indicates economies of scale
• Rising LAC indicates diseconomies of scale

LTC
LAC =
Q
9-20
 Long-Run Costs
• Long-run marginal cost (LMC) measures the
rate of change in long-run total cost as output
changes along expansion path
• LMC is U-shaped
• LMC lies below LAC when LAC is falling
• LMC lies above LAC when LAC is rising
• LMC = LAC at the minimum value of LAC
DLTC
LMC =
DQ
9-21
 Derivation of a Long-Run Cost
Schedule (Table 9.1)
Least-cost
combination of

Output Labor Capital Total cost LAC LMC

LMC
(units) (units) (w = $5, r = $10)

100 10 7 $120 $1.20 $1.20

200 12 8 140 0.70 0.20
300 20 10 200 0.67 0.60
400 30 15 300 0.75 1.00
500 40 22 420 0.84 1.20
600 52 30 560 0.93 1.40
700 60 42 720 1.03 1.60 9-22
Long-Run Total, Average, &
Marginal Cost (Figure 9.8)

9-23
Long-Run Average & Marginal
Cost Curves (Figure 9.9)

9-24
 Economies of Scale
• Larger-scale firms are able to take greater
advantage of opportunities for
specialization & division of labor
• Scale economies also arise when quasi-
fixed costs are spread over more units of
output causing LAC to fall
• Variety of technological factors can also
contribute to falling LAC
9-25
 Returns to Scale
f(cL, cK) = zQ
• If all inputs are increased by a factor of c &
output goes up by a factor of z then, in
general, a producer experiences:
• Increasing returns to scale if z > c; output goes up
proportionately more than the increase in input usage
• Decreasing returns to scale if z < c; output goes up
proportionately less than the increase in input usage
• Constant returns to scale if z = c; output goes up by the
same proportion as the increase in input usage

9-26
Returns to Scale

9-27
Economies & Diseconomies
of Scale (Figure 9.10)

9-28
 Constant Long-Run Costs
• Absence of economies and diseconomies
of scale
• Firm experiences constant costs in the long
run
• LAC curve is flat & equal to LMC at all output
levels

9-29
Constant Long-Run Costs
(Figure 9.11)

9-30
 Minimum Efficient Scale (MES)
• The minimum efficient scale of operation
(MES) is the lowest level of output needed
to reach the minimum value of long-run
average cost

9-31
Minimum Efficient Scale (MES)
(Figure 9.12)

9-32
MES with Various Shapes of LAC
(Figure 9.13)

9-33
 Economies of Scope
• Exist for a multi-product firm when the joint cost of
producing two or more goods is less than the sum of the
separate costs for specialized, single-product firms to
produce the two goods:
LTC(X, Y) < LTC(X,0) + LTC(0,Y)
• Firms already producing good X can add production of
good Y at a lower cost than a single-product firm can
produce Y:
LTC(X, Y) – LTC(X,0) < LTC(0,Y)
• Arise when firms produce joint products or employ
common inputs in production
9-34
Purchasing Economies of Scale
• Purchasing economies of scale arise
when large-scale purchasing of raw
materials enables large buyers to obtain
lower input prices through quantity
discounts

9-35
Purchasing Economies of Scale
(Figure 9.14)

9-36
Learning or Experience Economies
• “Learning by doing” or “Learning through
experience”
• As total cumulative output increases,
learning or experience economies cause
long-run average cost to fall at every
output level

9-37
Learning or Experience Economies
(Figure 9.15)

9-38
 Relations Between Short-Run &
Long-Run Costs
• LMC intersects LAC when the latter is at its
minimum point
• At each output where a particular ATC is tangent
to LAC, the relevant SMC = LMC
• For all ATC curves, point of tangency with LAC is
at an output less (greater) than the output of
minimum ATC if the tangency is at an output less
(greater) than that associated with minimum
LAC
9-39
Long-Run Average Cost as the
Planning Horizon (Figure 9.16)

9-40
 Restructuring Short-Run Costs
• Because managers have greatest flexibility to
choose inputs in the long run, costs are lower
in the long run than in the short run for all
output levels except that for which the fixed
input is at its optimal level
• Short-run costs can be reduced by adjusting fixed
inputs to their optimal long-run levels when the
opportunity arises

9-41
Restructuring Short-Run Costs
(Figure 9.14)

9-42