ECO 3104

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ECO 3104

• Lecture 12

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Cost in the Long Run
The Cost Minimizing Input Choice

• Assumptions
• Two Inputs Labor (L) capital (K)
• Price of labor wage rate (w)
• The price of capital
• r depreciation rate interest rate

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Cost in the Long Run
The Cost Minimizing Input Choice

• Total Cost
• C wL rK
• Output
• Qf(L,K)

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Cost in the Long Run
The Cost Minimizing Input Choice

• Want to minimize cost of producing a given level
  of output
• minimize wL rK by the choice of L and K
• subject to QQ0 where Qf(L,K)

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Cost in the Long Run
The Cost Minimizing Input Choice

• It can be shown (with calculus or geometry) that
  cost minimization implies

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Cost in the Long Run

• Left-hand side is the marginal rate of technical
  substitution (MRTS) and right-hand side is the
  input price ratio

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Cost in the Long Run

• Rate at which one can substitute one input for
  another (holding output constant) equals rate at
  which can trade one input for another in the
  market

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Cost in the Long Run

• The minimum cost combination can also be written
  as
• Minimum cost for a given output will occur when
  each dollar of input added to the production
  process will add an equivalent amount of output.

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Long-Run VersusShort-Run Cost Curves

• What happens to average costs when both inputs
  are variable (long run) versus only having one
  input that is variable (short run)?

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Long-Run VersusShort-Run Cost Curves

• Costs generally higher in the short run than in
  the long run
• when both inputs are variable (long run) firm has
  more flexibility than one only one input is
  variable (short run)

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Long-Run VersusShort-Run Cost Curves

• Long-Run Average Cost (LAC)
• Constant Returns to Scale
• If input is doubled, output will double and
  average cost is constant at all levels of output.

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Long-Run VersusShort-Run Cost Curves

• Long-Run Average Cost (LAC)
• Increasing Returns to Scale
• If input is doubled, output will more than double
  and average cost decreases at all levels of
  output.

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Long-Run VersusShort-Run Cost Curves

• Long-Run Average Cost (LAC)
• Decreasing Returns to Scale
• If input is doubled, the increase in output is
  less than twice as large and average cost
  increases with output.

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Long-Run VersusShort-Run Cost Curves

• Long-Run Average Cost (LAC)
• In the long-run
• Firms experience increasing and decreasing
  returns to scale and therefore long-run average
  cost is U shaped.

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Long-Run VersusShort-Run Cost Curves

• Long-Run Average Cost (LAC)
• Long-run marginal cost leads long-run average
  cost
• If LMC lt LAC, LAC will fall
• If LMC gt LAC, LAC will rise
• Therefore, LMC LAC at the minimum of LAC

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Long-Run Averageand Marginal Cost
Cost ( per unit of output
Output
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Long-Run VersusShort-Run Cost Curves

• Economies and Diseconomies of Scale
• Economies of Scale
• Increase in output is greater than the increase
  in inputs.
• Diseconomies of Scale
• Increase in output is less than the increase in
  inputs.

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Long-Run VersusShort-Run Cost Curves

• Measuring Economies of Scale
• Ec percent change in cost from a 1 increase in
  output

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Long-Run VersusShort-Run Cost Curves

• Measuring Economies of Scale

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Long-Run VersusShort-Run Cost Curves

• Therefore, the following is true
• EC lt 1 MC lt AC
• economies of scale
• EC 1 MC AC
• constant economies of scale
• EC gt 1 MC gt AC
• diseconomies of scale

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Long-Run VersusShort-Run Cost Curves

• The Relationship Between Short-Run and Long-Run
  Cost
• We will use short and long-run cost to determine
  the optimal plant size

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Long-Run Cost withConstant Returns to Scale
Cost ( per unit of output)
Output
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Long-Run Cost withConstant Returns to Scale

• Observation
• The optimal plant size will depend on the
  anticipated output (e.g. Q1 choose SAC1,etc).
• The long-run average cost curve is the envelope
  of the firms short-run average cost curves.

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Long-Run Cost withConstant Returns to Scale

• What is the firms long-run cost curve?
• Firms can change scale to change output in the
  long-run.
• The long-run cost curve is the dark blue portion
  of the SAC curve which represents the minimum
  cost for any level of output.

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Long-Run Cost withConstant Returns to Scale

• Observations
• The LAC does not include the minimum points of
  small and large size plants
• cost-minimizing output for a given plant is not
  the same as the cheapest way to produce a given
  output when plant size is variable
• The long-run MC lies below the short-run MC for
  increases in output and below for decreases in
  output.
• increasing output raises cost more in the
  short-run than in the long-run
• decreasing output saves more in the long run than
  in the short run

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Long-Run Cost withConstant Returns to Scale

• With economies or diseconomies of scale, analysis
  is essentially the same
• The LAC is U shaped, but relationship between
  short-run and long-run costs is the same

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Long-Run Cost with Economiesand Diseconomies of
Scale
Cost ( per unit of output
Output
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Production with TwoOutputs--Economies of Scope

• Economies of scope exist when the joint output of
  a single firm is greater than the output that
  could be achieved by two different firms each
  producing a single output.

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Production with TwoOutputs--Economies of Scope

• Examples
• Chicken farm--poultry and eggs
• Automobile company--cars and trucks
• University--Teaching and research

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Production with TwoOutputs--Economies of Scope

• What are the advantages of joint production?
• Consider an automobile company producing cars and
  tractors
• both use capital and labor
• the firms share management resources
• both use the same labor skills and type of
  machinery.

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Production with TwoOutputs--Economies of Scope

• Production
• Firms must choose how much of each to produce
• Observations
• There is no direct relationship between economies
  of scope and economies of scale.
• May experience economies of scope and
  diseconomies of scale
• May have economies of scale and not have
  economies of scope

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Production with TwoOutputs--Economies of Scope

• The degree of economies of scope measures the
  savings in cost and can be written
• C(Q1) is the cost of producing Q1
• C(Q2) is the cost of producing Q2
• C(Q1Q2) is the joint cost of producing both
  products

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Production with TwoOutputs--Economies of Scope

• Interpretation
• If SC gt 0 -- Economies of scope
• If SC lt 0 -- Diseconomies of scope

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End of Lecture 12