Production

and Cost in
the Long Run
CHAPTER 9
1

No matter how a firm operates in

the short run, its manager can
always change things at some
point in the future. Economists
refer to this future period as the
“long run”.
 ISOQUANT

An isoquant is a curve showing

all possible combinations of the
inputs physically capable of
producing a given (fixed) level
of output.
Characteristics of
Isoquant
An isoquant slopes downward from left to
right.
The higher and more to the right an
isoquant is on a graph, the higher the level
of output it represents.
Two isoquants cannot intersect each other.
An isoquant is convex to its origin point.
An isoquant is oval-shaped.
 Marginal Rate of
Technical Substitution
The marginal rate of technical substitution (of labor
for capital) is the rate at which capital can be reduced
for every one-unit increase in labor, and keeping
output constant. It is defined as the absolute value of
slope of the isoquant drawn with labor on the
horizontal axis, and capital on the vertical axis.
Subtitle here Subtitle here
Relations of MRTS to Marginal
Products

For every small movement along an

isoquant, the marginal rate of technical
substitutions equals the ratio of the
marginal products of the two input.
2

Isocost
Curves
Graphical representation that shows
the various combinations of inputs that
may be purchased for a given level of
expenditure at given input prices.
Isocost Curves
Characteristics
Helps the firm to produce given
output at minimum cost.
Helps the firm to adjust between
two inputs when the price of one
input changes.
Isocost Curve Equation

FORMULA :

where:
w = the wage rate of labor
L = the amount of labor employed
K = the amount of capital employed
r = the rental rate of capital
Example:
Suppose a manager must pay $25 for each unit of labor services and $50 for each
unit of capital services employed. The manager wishes to know what
combinations of labor and capital can be purchased for $400 total expenditure
on inputs.

400 = 25L + 50K

c = 400 w = 25
r = 50 k = ?
L=?
Isocost
Slope
 Shifts in
Isocost Curve

If the constant level of total cost

associated with a particular isocost
curve changes, the isocost curve shifts
parallel.
 Shifts in
Isocost Curve
3

FINDING THE OPTIMAL

COMBINATION OF INPUTS
Constrained Minimization problem
When a manager wishes to produce a given level of output
at the lowest possible total cost, the manager chooses the
combination on the desired isoquant that costs the least.

Constrained Maximization problem

When a manager wishes to maximize output for a given
level of total cost, the manager must choose the input
combination on the isocost curve that lies on the highest
isoquant.
FINDING THE OPTIMAL
COMBINATION OF INPUTS

A Production of a given output at

minimum Cost

B The Marginal Product Approach

to Cost Minimization

C Production of Maximum output

with a given level of Cost
Production of a given
output at minimum Cost
Finding the lowest possible cost (Constrained Minimization).

Example: Output=10,000 units

Formula: Cost = wL + rK In what combination of inputs has
w= price of labor
the lowest input cost?
L= unit of Labor
r= price of Capital
Answer: Combination E
K= unit of Capital
To minimize the cost of producing a
given level of output, the manager
employs the input combination for
which MRTS = w/r.

MRTS= W/R
The Marginal Product Approach
to Cost Minimization
 The marginal rate of technical substitution (MRTS) examines the level
where one input can be replaced for another resource with production remaining constant.

In combination E, the marginal product per dollar spent on labor is equal to the marginal product per dollar
spent on capital,and the constraints Is met (Q= 10,000)
Production of Maximum Output
with a Given Level of Cost

Finding the highest possible

output (Constrained Maximization ).
To see why MPL/w must equal MPK/r to maximize output for a given level of
expenditures on inputs, suppose that this optimizing condition does not hold.
Specifically, assume that w 5 $2, r 5 $3, MPL 5 6, and MPK 5 12, so that

The last unit of labor adds 3 units of output per dollar spent; the last unit of capital
adds 4 units of output per dollar. If the firm wants to produce the maximum output
possible with a given level of cost, it could spend $1 less on labor, thereby reducing
labor by half a unit and hence output by 3 units. It could spend this dollar on capital,
thereby increasing output by 4 units. Cost would be unchanged, and total output
would rise by 1 unit. And the firm would continue taking dollars out of labor and
adding them to capital as long as the inequality holds. But as labor is reduced, its
marginal product will increase, and as capital is increased, its marginal product will
decline. Eventually the marginal product per dollar spent on each input will be equal.
4

Optimization
and Cost
Optimization refers to the process of maximizing
or minimizing an objective function, subject to
certain constraints.
Cost analysis involves assessing and
understanding the various costs associated with
producing goods or services.
Expansion Path

The curve or locus of points that

shows the cost-minimizing input
combination for each level of
output with the input/price ratio
held constant.

10 1
20 2
 Expansion Path and
Structure Cost
The structure of cost refers to the composition and
distribution of costs within a firm. It analyzes how costs are
categorized and allocated across different cost
components such as fixed costs, variable costs, semi-
variable costs, direct costs, indirect costs, etc.
The cost structure provides insights into the proportion
and behavior of different cost types.
Expansion Path and Structure Cost

The lowest cost of producing 500 units of output is

$3,000, which was calculated as the price of capital,
$20, times the vertical intercept of the isocost curve,
150. Alternatively, the cost of producing 500 units
can be calculated by multiplying the price of labor by
the amount of labor used plus the price of capital by
the amount of capital used:
Expansion Path and Structure Cost

Using the same method, we

calculate the lowest cost of
producing 700 and 900 units of
output, respectively, as
5
Derivation of Cost Schedules from a
Production Function
We begin our discussion with a situation in which the price of
labor (w) is $5 per unit and the price of capital (r) is $10 per unit.
Total Long Run Cost = (w x l) + (r x k)
w= $5
r = $10
Total Long Run Cost = ($5 x $10) + (10 x 7)
LTC = $120
Derivation of Cost Schedules from a
Production Function

Long-run marginal cost

Long-run Average Cost
Derivation of Cost Schedules from a
Production Function
Derivation of Cost Schedules from a
Production Function
Derivation of Cost Schedules from a
Production Function
This curve reflects three of the commonly assumed characteristics of
LTC.
First, because there are no fixed costs, LTC is 0 when output is 0.
Second, cost and output are directly related; that is, LTC has a
positive slope. It costs more to produce more, which is to say that
resources are scarce or that one never gets something for nothing.
Third, LTC first increases at a decreasing rate, then increases at an
increasing rate. This implies that marginal cost first decreases, then
increases.
6
FORCES AFFECTING LONG-RUN COSTS

Economies of Scale
As the quantity of output goes up,
the cost per unit goes down

Cost advantages that are achieved

when there is an expansion of the
size of production

Diseconomies of Scale
As the quantity of output goes up,
the cost per unit goes up

Remain a fact of life for very large-

scale enterprises
Reasons for Economies of Scale Reasons for Diseconomies of Scale

Firms have greater opportunities for Lack of efficient monitoring and

SPECIALIZATION AND DIVISION OF control systems
LABOR

Firms employ one or more quasi-fixed Misallocation of corporate resources

inputs

Variety of technological factors

Cost of capital equipment
Utilizing the full capacity of machines
A qualitative change in the optical
production process and type of capital
equipment employed
Special case: Constant Costs LAC curve is flat and equal to its
LMC curve at all output levels

Not common in practice but

Absence of Economies and Diseconomies of Scale frequently assumed by businesses

To simplify costs (and profit)

computations in presentation
Minimum Efficient Scale (MES)

A modest scale of operation

May capture all available Economies

of Scale and Diseconomies may arise
until the output is very large

All firms should plan to operate at

MES in the long run
MES with Various Shapes of LAC
ECONOMIES OF SCOPE IN MULTIPRODUCT FIRMS

Typically, multiproduct firms employ some resources that

contribute to the production of two or more goods or
services

Economies of Scope
Exist when the joint cost of producing two or more goods is less
than the sum of the separate costs of producing the goods.
MULTIPRODUCT TOTAL COST FUNCTION: LTC (X,Y)

Gives the lowest total cost for a multiproduct firm to

produce X units of one good and Y units of another good.

It is useful in defining scope economies and explaining

why multiproduct efficiencies arise.
Example

Precision Brakes and Mufflers, a multiservice firm, can

perform 4 brake jobs (B) and replace 8 mufflers (M) a day
for a total cost of $1,400
Example

A single-service firm can install 8 replacement of mufflers

at a total cost of $1,000.

Another single-service firm specializing in brake repair

can perform 4 brake jobs for a total cost of $600.
Example

A multiproduct firm can perform the services at lower

total cost than two separate firm producing the same level
of outputs
Consequence of Scope Economies
It concerns the incremental or marginal costs of adding
new product or service lines.

Example

If the single-service firm wishes to become a multiservice

company by adding 8 muffler repairs daily, the marginal
or incremental cost to do so is $800.
Reasons for Economies of Scope

1. Goods are Joint Products 2. Common or Shared Inputs

Two or more products made from The cost of common inputs gets
a single input spread over multiple products or
Employing resources to produce services
another good at little or no Marginal costs will be less costly
additional cost
PURCHASING ECONOMIES OF SCALE

Quantity Discounts

Large buyers of inputs receive

lower input prices, causing LAC
to shift downward at the point
of discount.
LEARNING OR EXPERIENCE ECONOMIES

Workers become more productive as they learn

by doing or learn through experience

As a result, LAC shifts downward

"Learn by "Learn through

doing" experience"
KEY TAKEAWAYS

Decision makers should ignore average cost (LAC) and

focus instead on marginal cost (LMC) when trying to
reach the optimal level of any activity.
To achieve economies of scale, a manager must have
accurate information, efficient monitoring, and control
systems.
Managers should not increase production levels solely
for the purpose of chasing any one of the cost
economies (cost advantages).
7
RELATIONS BETWEEN SHORT-RUN AND LONG-RUN
COSTS

The main difference

between long run and
short run costs is that there
are no fixed factors in the
long run; there are both
fixed and variable factors
in the short run.
RELATIONS BETWEEN SHORT-RUN AND LONG-RUN
COSTS
Long-Run Average Cost as the Planning Horizon

Long run is the firm’s planning period and the short run its production
period. Indeed, we call the long run the firm’s planning horizon. The long-
run cost function gives the most efficient (the least-cost) method of
producing any given level of output, because all inputs are variable.
Long-Run Average Cost as the Planning Horizon
Restructuring Short-Run Costs

Because managers have the 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 the
output level for which the fixed input is at its optimal level. Thus the firm’s short-
run costs can generally be reduced by adjusting the fixed inputs to their optimal
long-run levels when the long-run opportunity to adjust fixed inputs arises.
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Presented by:
Bautista, Mary Rocel
Eleazar, Lovely
Magrata, Mary Collen
Pedrezuela, Angela
Traje, Isabel