Because learning changes everything.

Chapter 9
Production and Cost
in the Long Run

© 2020 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 Learning Objectives
v Graph a typical production isoquant and discuss the
properties of isoquants.
v Construct isocost curves.
v Use optimization theory to find optimal input combination.
v Construct the firm’s expansion path and show how it
relates to the firm’s long-run cost structure.
v Calculate long-run total, average, and marginal costs
from the firm’s expansion path.
v Explain how a variety of forces affect long-run costs:
scale, scope, learning, and purchasing economies.
v Show the relation between long-run and short-run cost
curves using long-run and short-run expansion paths.
© McGraw-Hill Education 2
 Production Isoquants
In the long run, all inputs are variable and isoquants
are used to study production decisions.
• An isoquant is a curve showing all possible input
combinations physically capable of producing a given
fixed level of output.
• Isoquants are downward sloping; if greater amounts
of labor are used, less capital is required to produce
a given output.
• An isoquant map is a graph showing a group of
isoquants.

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 Figure 9.1 A Typical Isoquant Map

Figure 9.1

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 Marginal Rate of Technical
Substitution (1 of 2)
The MRTS is the slope of an isoquant and measures
the rate at which the two inputs can be substituted
for one another along an isoquant while maintaining
a constant level of output.
∆(
!"#$ = −
∆)

The minus sign is added to make MRTS a positive number

since ∆K/∆L, the slope of the isoquant, is negative.

© McGraw-Hill Education
 Marginal Rate of Technical
Substitution (2 of 2)
The MRTS can also be expressed as the ratio of two
marginal products:
!&!
!"#$ =
!&"
As labor is substituted for capital, MPL declines and
MPK rises causing MRTS to diminish.

∆) !&!
!"#$ = − =
∆* !&"

© McGraw-Hill Education
 Isocost Curves
• Show various combinations of inputs that may be
purchased for given level of expenditure (C) at given
input prices (w, r)

!
" $
! = #$ + &' '=#−#$

• Slope of an isocost curve is the negative of the input price

ratio (-w/r)
• K-intercept is C/r and represents amount of capital that
may be purchased if zero labor is purchased.

© McGraw-Hill Education 7
 Figure 9.2 An Isocost Curve
(w = $25 and r = $50)

Figure 9.2 and Figure 9.3

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 Figure 9.3 Shift in an Isocost Curve

Figure 9.2 and Figure 9.3

© McGraw-Hill Education 9
 Optimal Combination of Inputs
• Minimize total cost of producing a given Q by
choosing the input combination on the isoquant for
which Q is just tangent to an isocost curve.

• Two slopes are equal in equilibrium, which

implies that the marginal product per dollar spent
on the last unit of each input is the same.

!*! + !*! !*"

!"#$ = = -. =
!*" , + ,

© McGraw-Hill Education
 Figure 9.4 Optimal Input Combination to
Minimize Cost for a Given Output

Figure 9.4 and Figure 9.5

© McGraw-Hill Education 11
 Figure 9.5 Output Maximization for a
Given Level of Cost

Figure 9.4 and Figure 9.5

© McGraw-Hill Education 12
 Optimization and Cost
Expansion path is the curve or locus of points that
shows the cost-minimizing input combination for
each level of output.
• Derived for a specific set of input prices.
• Along the expansion path, the input-price ratio is
constant and equal to the marginal rate of technical
substitution.

© McGraw-Hill Education
 Figure 9.6 An Expansion Path

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=- ด

Figure 9.6 and Figure 9.7

© McGraw-Hill Education 14
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 Long-Run Total Costs
Long-run total cost (LTC) for a given level of output
is given by:

LTC = wL* + rK*

Where w and r are prices of labor and capital, respectively,
and (L*, K*) is the input combination on the expansion
path that minimizes the total cost of producing that output.

© McGraw-Hill Education
 Figure 9.7 Long-Run Expansion Path

Figure 9.6 and Figure 9.7

© McGraw-Hill Education 16
 Long-Run Average 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

)#0
)/0 =
1

© McGraw-Hill Education
 Long-Run Marginal 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

∆!&#
!"# =
∆'
© McGraw-Hill Education
 Table 9.1 Derivation of a Long-Run Cost
Schedule

Table 9.1 and Figure 9.8

© McGraw-Hill Education 19
 Figure 9.8 Long-Run Total, Average, and
Marginal Cost

Table 9.1 and Figure 9.8

© McGraw-Hill Education 20
 Figure 9.9 Long-Run Average and
Marginal Cost Curves

Figure 9.9 and Figure 9.10

© McGraw-Hill Education 21
 Economies of Scale
• Economies of scale occurs when long-run average cost
(LAC) falls as output increases.
• Larger-scale firms are able to take greater advantage of
opportunities for specialization and division of labor.
• Dividing production into separate tasks allows workers to
specialize and become more productive, which lowers unit
costs.
• 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.

© McGraw-Hill Education
 Diseconomies of Scale
• Diseconomies of scale occurs when long-run
average cost (LAC) rises as output increases.
• Generally attributed to limitations to efficient
management and organization of the firm.
• The cost of monitoring and controlling large-scale
businesses eventually leads to rising unit costs.

© McGraw-Hill Education
 Figure 9.10 Economies and Diseconomies
of Scale

Figure 9.9 and Figure 9.10

© McGraw-Hill Education 24
 Constant Costs
With constant costs, neither economies nor
diseconomies of scale occur.
• Firm experiences constant costs in the long run.
• LAC curve is flat and equal to LMC at all output
levels.

© McGraw-Hill Education
 Figure 9.11 The Special Case of Constant
Costs: LMC = LAC

Figure 9.11 and Figure 9.12

© McGraw-Hill Education 26
 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.

© McGraw-Hill Education
 Figure 9.12 Minimum Efficient Scale

Figure 9.11 and Figure 9.12

© McGraw-Hill Education 28
 Figure 9.13 MES with Various Shapes
of LAC
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นน

Figure 9.13 and Figure 9.14

© McGraw-Hill Education 29
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 Economies of Scope (1 of 2)
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 of producing the two goods:

LTC(X, Y) < LTC(X,0) + LTC(0,Y)

↓ ผ ิต ดล ม , เค อง ม

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)

© McGraw-Hill Education
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 Economies of Scope (2 of 2)
Reasons for economies of scope:
Joint products
• When production of good X causes one or more
other goods to be produced as by-products at little or
no additional cost.

Common or shared inputs

• Inputs that contribute to the production of two or more
goods or services.

© McGraw-Hill Education
 Purchasing Economies of Scale
Purchasing economies of scale arise when
large buyers of inputs receive lower input
prices through quantity discounts, causing
LAC to shift downward at the point of the
discount.

© McGraw-Hill Education
 Figure 9.14 Purchasing Economies of
Scale

Figure 9.13 and Figure 9.14

© McGraw-Hill Education 33
 Learning or Experience Economies

“Learning by doing” or “Learning through

experience.”

When cumulative output increases, causing

workers to become more productive as they
learn by doing and LAC shifts downward as a
result.

© McGraw-Hill Education
 Figure 9.15 Learning or Experience
Economies

Figure 9.15

© McGraw-Hill Education 35
 Relations Between Short-Run and
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.
© McGraw-Hill Education
 Figure 9.16 Long-Run Average Cost (LAC)
as the Planning Horizon

Figure 9.16

© McGraw-Hill Education 37
 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.
• The short-run expansion path is a horizontal line
showing the cost-minimizing input combinations for
various output levels when capital is fixed in the short
run.

© McGraw-Hill Education
 Figure 9.17 Gains from Restructuring
Short-Run Costs

Figure 9.17

© McGraw-Hill Education 39
 Summary (1 of 3)
• In the long run, all fixed inputs become variable inputs.
• An isoquant is a curve showing all possible input combinations
capable of producing a given level of output.

• The marginal rate of technical substitution, MRTS, is the slope

of an isoquant and measures the rate at which the two inputs
can be substituted for one another while maintaining a constant
level of output.
• Isocost curves show the various combinations of inputs
that may be purchased for a given level of expenditure
at given input prices.
• The isocost curve’s slope is the negative of the input price ratio.

© McGraw-Hill Education
 Summary (2 of 3)
• Minimize total cost of producing a given quantity of
output by choosing the input combination on the
isoquant that is just tangent to an isocost curve.
• The two slopes are equal in equilibrium.

• Maximizing output for a given level of expenditure requires

choosing an input combination satisfying the exact same
conditions as for minimizing costs.
• The expansion path shows the optimal (or efficient)
input combination for every level of output; long-run
cost curves are derived from the expansion path.
• LMC lies below (above) LAC when LAC is falling
(rising); LMC equals LAC at LAC’s minimum value.
© McGraw-Hill Education
 Summary (3 of 3)
• When LAC is decreasing, economies of scale are
present, and when LAC is increasing, diseconomies of
scale are present; Economies of scope arise when
firms produce joint products or when firms employ
common inputs in production.
• Because managers possess the greatest flexibility in
choosing inputs in the long run, long-run costs are
lower than short-run costs for all output levels except
the output level for which the short-run fixed input is at
its optimal level.

© McGraw-Hill Education
Because learning changes everything. ®

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© 2020 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.