Microeconomics II

Chapter 3
THEORY OF FIRMS
BEHAVIOR

Topics to be Discussed

Part 1: Production

The Technology of Production

Production with Two Variable Inputs

Returns to Scale

2011,FTU,KieuMinh

Introduction

Our study of consumer behavior was

broken down into 3 steps

Describing consumer preferences

Consumers face budget constraints
Consumers choose to maximize utility

Production decisions of a firm are

similar to consumer decisions

Can also be broken down into three

steps

2011,FTU,KieuMinh

Production Decisions of a Firm

1.

Production Technology

Describe how inputs can be transformed

into outputs

Inputs: land, labor, capital & raw materials

Outputs: cars, desks, books, etc.

Firms can produce different amounts of

outputs using different combinations of
inputs

2011,FTU,KieuMinh

Production Decisions of a Firm

2.

Cost Constraints

Firms must consider prices of labor,

capital and other inputs
Firms want to minimize total production
costs partly determined by input prices
As consumers must consider budget
constraints, firms must be concerned
about costs of production

2011,FTU,KieuMinh

Production Decisions of a Firm

3.

Input Choices

Given input prices and production

technology, the firm must choose how
much of each input to use in producing
output
Given prices of different inputs, the firm
may choose different combinations of
inputs to minimize costs

If labor is cheap, may choose to produce

with more labor and less capital

2011,FTU,KieuMinh

Production Decisions of a Firm

If a firm is a cost minimize, we can

also study

How total costs of production varies with

output
How does the firm choose the quantity to
maximize its profits

We can represent the firms

production technology in for form of a
production function

2011,FTU,KieuMinh

The Technology of Production

Production Function:

Indicates the highest output (q) that a

firm can produce for every specified
combination of inputs.
For simplicity, we will consider only labor
(L) and capital (K)
Shows what is technically feasible when
the firm operates efficiently

2011,FTU,KieuMinh

The Technology of Production

The production function for two

inputs:
q = F(K,L)

Output (q) is a function of capital (K)

and Labor (L)
The production function is true for a
given technology

If technology increases, more output can

be produced for a given level of inputs

2011,FTU,KieuMinh

The Technology of Production

Short Run

Long-run

Period of time in which quantities of one

or more production factors cannot be
changed.
These inputs are called fixed inputs.
Amount of time needed to make all
production inputs variable.

Short run and long run are not time

specific

2011,FTU,KieuMinh

10

Production: Two Variable Inputs

Firm can produce output by

combining different amounts of labor
and capital
In the long-run, capital and labor are
both variable.
We can look at the output we can
achieve with different combinations of
capital and labor Table 6.4

2011,FTU,KieuMinh

11

Production: Two Variable Inputs

2011,FTU,KieuMinh

12

Production: Two Variable Inputs

The information can be represented

graphically using isoquants

Curves showing all possible combinations

of inputs that yield the same output

Curves are smooth to allow for use of

fractional inputs

Curve 1 shows all possible combinations

of labor and capital that will produce 55
units of output

2011,FTU,KieuMinh

13

Isoquant Map
E

Capital 5
per year

Ex: 55 units of output

can be produced with
3K & 1L (pt. A)
OR
1K & 3L (pt. D)

4
3

q3 = 90
D

q2 = 75
q1 = 55

1
2011,FTU,KieuMinh

Labor per year

14

Production: Two Variable Inputs

Diminishing Returns to Labor with

Isoquants
Holding capital at 3 and increasing
labor from 0 to 1 to 2 to 3.

Output increases at a decreasing rate (0,

55, 20, 15) illustrating diminishing
marginal returns from labor in the shortrun and long-run.

2011,FTU,KieuMinh

15

Production: Two Variable Inputs

Diminishing Returns to Capital with

Isoquants
Holding labor constant at 3 increasing
capital from 0 to 1 to 2 to 3.

Output increases at a decreasing rate (0,

55, 20, 15) due to diminishing returns
from capital in short-run and long-run.

2011,FTU,KieuMinh

16

Diminishing Returns
Capital 5
per year

Increasing labor
holding capital
constant (A, B, C)
OR
Increasing capital
holding labor constant
(E, D, C

4
3

C
D

q3 = 90
E

q2 = 75
q1 = 55

1
2011,FTU,KieuMinh

Labor per year

17

Production: Two Variable Inputs

Substituting Among Inputs

Companies must decide what

combination of inputs to use to produce
a certain quantity of output
There is a trade-off between inputs
allowing them to use more of one input
and less of another for the same level of
output.

2011,FTU,KieuMinh

18

Production: Two Variable Inputs

Substituting Among Inputs

Slope of the isoquant shows how one

input can be substituted for the other
and keep the level of output the same.
Positive slope is the marginal rate of
technical substitution (MRTS)

Amount by which the quantity of one input

can be reduced when one extra unit of
another input is used, so that output
remains constant.

2011,FTU,KieuMinh

19

Production: Two Variable Inputs

The marginal rate of technical

substitution equals:

Change in Capital input

MRTS
Change in Labor input
MRTS K
2011,FTU,KieuMinh

(for a fixed level of q )

20

Production: Two Variable Inputs

As increase labor to replace capital

Labor becomes relatively less productive

Capital becomes relatively more
productive
Need less capital to keep output constant
Isoquant becomes flatter

2011,FTU,KieuMinh

21

Marginal Rate of
Technical Substitution
Capital
per year

Slope measures MRTS

MRTS decreases as move down
the indifference curve

1
1

2/3

1/3

1
2011,FTU,KieuMinh

Q3 =90

Q2 =75
Q1 =55
5

Labor per month

22

MRTS and Marginal Products

If we are
holding
output
constant

dQ 0
f ( K , L)
f ( K , L)
df ( K , L)
dK
dL 0
K
L
MPK dK MPL dL 0
dK MPL

dL MPK
MRTS KL

2011,FTU,KieuMinh

MPL

MPK
23

MRTS and Isoquants

We assume there is diminishing MRTS

Increasing labor in one unit increments from 1

to 5 results in a decreasing MRTS from 1 to 1/2.
Productivity of any one input is limited

Diminishing MRTS occurs because of

diminishing returns and implies isoquants
are convex.
There is a relationship between MRTS and
marginal products of inputs

2011,FTU,KieuMinh

24

Isoquants: Special Cases

1.

Two extreme cases show the possible

range of input substitution in
production
Perfect substitutes

MRTS is constant at all points on

isoquant
Same output can be produced with a lot
of capital or a lot of labor or a balanced
mix

2011,FTU,KieuMinh

25

Perfect Substitutes
Capital
per
month

Same output can be

reached with mostly
capital or mostly labor
(A or C) or with equal
amount of both (B)

C
Q1

2011,FTU,KieuMinh

Q2

Q3

Labor
per month

26

Isoquants: Special Cases

2.

Extreme cases (cont.)

Perfect Complements

Fixed proportions production function

There is no substitution available
between inputs
The output can be made with only a
specific proportion of capital and labor
Cannot increase output unless increase
both capital and labor in that specific
proportion

2011,FTU,KieuMinh

27

Fixed-Proportions
Production Function
Capital
per
month

Same output
can only be
produced with
one set of
inputs.

Q3

C
Q2

B
K1

Q1
Labor
per month

2011,FTU,KieuMinh

L1

28

Returns to Scale

In addition to discussing the tradeoff

between inputs to keep production
the same
How does a firm decide, in the long
run, the best way to increase output

Can change the scale of production by

increasing all inputs in proportion
If double inputs, output will most likely
increase but by how much?

2011,FTU,KieuMinh

29

Returns to Scale

Rate at which output increases as

inputs are increased proportionately

Increasing returns to scale

Constant returns to scale
Decreasing returns to scale

2011,FTU,KieuMinh

30

Returns to Scale

Increasing returns to scale: output

more than doubles when all inputs
are doubled

Larger output associated with lower cost

(cars)
One firm is more efficient than many
(utilities)
The isoquants get closer together

2011,FTU,KieuMinh

31

Increasing Returns to Scale

Capital
(machine
hours)

The isoquants
move closer
together

4
30
20

2
10
5
2011,FTU,KieuMinh

10

Labor (hours)

32

Returns to Scale

Constant returns to scale: output

doubles when all inputs are doubled

Size does not affect productivity

May have a large number of producers

Isoquants are equidistant apart

2011,FTU,KieuMinh

33

Returns to Scale
Capital
(machine
hours)

A
6
30
4
2
0
2

Constant
Returns:
Isoquants are
equally spaced

10
5
2011,FTU,KieuMinh

10

15

Labor (hours)

34

Returns to Scale

Decreasing returns to scale: output

less than doubles when all inputs are
doubled

Decreasing efficiency with large size

Reduction of entrepreneurial abilities

Isoquants become farther apart

2011,FTU,KieuMinh

35

Returns to Scale: Carpet

Industry

The carpet industry has grown from a small

industry to a large industry with some very
large firms.
There are four relatively large manufactures
along with a number of smaller ones
Growth has come from

Increased consumer demand

More efficient production reducing costs
Innovation and competition have reduced real
prices

2011,FTU,KieuMinh

36

The U.S. Carpet Industry

2011,FTU,KieuMinh

37

Returns to Scale: Carpet

Industry

Some growth can be explained by

returns to scale
Carpet production is highly capital
intensive

Heavy upfront investment in machines for

carpet production

Increases in scale of operating have

occurred by putting in larger and more
efficient machines into larger plants

2011,FTU,KieuMinh

38

Returns to Scale: Carpet

Industry Results
1.

Large Manufacturers

Increased in machinery & labor

Doubling inputs has more than doubled
output
Economies of scale exist for large
producers

2011,FTU,KieuMinh

39

Returns to Scale: Carpet

Industry Results
2.

Small Manufacturers

Small increases in scale have little or no

impact on output
Proportional increases in inputs increase
output proportionally
Constant returns to scale for small
producers

2011,FTU,KieuMinh

40

Returns to Scale: Carpet

Industry

1.

2.

From this we can see that the carpet

industry is one where:
There are constant returns to scale
for relatively small plants
There are increasing returns to scale
for relatively larger plants

These are however limited

Eventually reach decreasing returns

2011,FTU,KieuMinh

41

Chapter 3 (cont)
Part 2: The Cost of Production

42

Topics to be Discussed

Measuring Cost: Which Costs Matter?

Cost in the Long Run

Long-Run Versus Short-Run Cost

Curves

Production with Two Outputs-Economies of Scope

2011,FTU,KieuMinh

43

Measuring Cost:
Which Costs Matter?

Accountants tend to take a retrospective

view of firms costs, where as economists
tend to take a forward-looking view
Accounting Cost

Actual expenses plus depreciation charges for

capital equipment

Economic Cost

Cost to a firm of utilizing economic resources in

production, including opportunity cost

2011,FTU,KieuMinh

44

Measuring Cost:
Which Costs Matter?

Economic costs distinguish between

costs the firm can control and those it
cannot

Concept of opportunity cost plays an

important role

Opportunity cost

Cost associated with opportunities that

are foregone when a firms resources are
not put to their highest-value use.

2011,FTU,KieuMinh

45

Opportunity Cost

An Example

A firm owns its own building and pays no

rent for office space
Does this mean the cost of office space is
zero?
The building could have been rented
instead
Foregone rent is the opportunity cost of
using the building for production and
should be included in economic costs of
doing business

2011,FTU,KieuMinh

46

Opportunity Cost

A person starting their own business

must take into account the
opportunity cost of their time

Could have worked elsewhere making a

competitive salary

Accountants and economists often

treat depreciation differently as well

2011,FTU,KieuMinh

47

Measuring Cost:
Which Costs Matter?

Although opportunity costs are hidden

and should be taken into account,
sunk costs should not
Sunk Cost

Expenditure that has been made and

cannot be recovered
Should not influence a firms future
economic decisions.

2011,FTU,KieuMinh

48

Sunk Cost

Firm buys a piece of equipment that

cannot be converted to another use
Expenditure on the equipment is a
sunk cost

Has no alternative use so cost cannot be

recovered opportunity cost is zero
Decision to buy the equipment might
have been good or bad, but now does
not matter

2011,FTU,KieuMinh

49

Prospective Sunk Cost

An Example

Firm is considering moving its headquarters

A firm paid $500,000 for an option to buy a
building.
The cost of the building is $5 million or a
total of $5.5 million.
The firm finds another building for $5.25
million.
Which building should the firm buy?

2011,FTU,KieuMinh

50

Prospective Sunk Cost

Example (cont.)
The first building should be purchased.
The $500,000 is a sunk cost and
should not be considered in the
decision to buy
What should be considered is

Spending an additional $5,250,000 or

Spending an additional $5,000,000

2011,FTU,KieuMinh

51

Measuring Cost:
Which Costs Matter?

1.

Some costs vary with output, while

some remain the same no matter
amount of output
Total cost can be divided into:
Fixed Cost

2.

Does not vary with the level of output

Variable Cost

Cost that varies as output varies

2011,FTU,KieuMinh

52

Fixed and Variable Costs

Total output is a function of variable

inputs and fixed inputs.
Therefore, the total cost of production
equals the fixed cost (the cost of the
fixed inputs) plus the variable cost
(the cost of the variable inputs), or

TC FC VC
2011,FTU,KieuMinh

53

Fixed and Variable Costs

Which costs are variable and which are

fixed depends on the time horizon
Short time horizon most costs are fixed
Long time horizon many costs become
variable
In determining how changes in
production will affect costs, must
consider if affects fixed or variable costs

2011,FTU,KieuMinh

54

Fixed Cost Versus Sunk Cost

Fixed cost and sunk cost are often

confused
Fixed Cost

Cost paid by a firm that is in business

regardless of the level of output

Sunk Cost

Cost that have been incurred and cannot

be recovered

2011,FTU,KieuMinh

55

Measuring Cost:
Which Costs Matter?

Personal Computers

Most costs are variable

Largest component: labor

Software

Most costs are sunk

Initial cost of developing the software

2011,FTU,KieuMinh

56

Marginal and Average Cost

In completing a discussion of costs,

must also distinguish between

Average Cost
Marginal Cost

After definition of costs is complete,

one can consider the analysis
between short-run and long-run costs

2011,FTU,KieuMinh

57

Measuring Costs

Marginal Cost (MC):

The cost of expanding output by one

unit.
Fixed cost have no impact on marginal
cost, so it can be written as:

VC TC
MC

q
q
2011,FTU,KieuMinh

58

Measuring Costs

Average Total Cost (ATC)

Cost per unit of output

Also equals average fixed cost (AFC) plus
average variable cost (AVC).

TC
ATC
AFC AVC
q
TC TFC TVC
ATC

q
q
q
2011,FTU,KieuMinh

59

Measuring Costs

All the types of costs relevant to

production have now been discussed
Can now discuss how they differ in
the long and short run
Costs that are fixed in the short run
may not be fixed in the long run
Typically in the long run, most if not
all costs are variable

2011,FTU,KieuMinh

60

Cost in the Long Run

In the long run a firm can change all

of its inputs
In making cost minimizing choices,
must look at the cost of using capital
and labor in production decisions

2011,FTU,KieuMinh

61

Cost in the Long Run

Capital is either rented/leased or

purchased

We will consider capital rented as if it were

purchased

Assume Delta is considering

purchasing an airplane for $150 million

Plane lasts for 30 years

$5 per year economic depreciation for
the plane

2011,FTU,KieuMinh

62

Cost in the Long Run

Delta needs to compare its revenues

and costs on an annual basis
If the firm had not purchased the
plane, it would have earned interest
on the $150 million
Forgone interest is an opportunity
cost that must be considered
Assume the interest rate 10 percent

2011,FTU,KieuMinh

63

User Cost of Capital

The user cost of capital must be

considered

The annual cost of owning and using the

airplane instead of selling or never
buying it
Sum of the economic depreciation and
the interest (the financial return) that
could have been earned had the money
been invested elsewhere

2011,FTU,KieuMinh

64

Cost in the Long Run

User Cost of Capital = Economic

Depreciation + (Interest Rate)*(Value
of Capital)
= $5 mil + (.10)($150 million)

Year 1 = $5 million + (.10)($150 million)

= $20 million
Year 10 = $5 million +(.10)($100
million) = $15 million

2011,FTU,KieuMinh

65

Cost in the Long Run

User cost can also be described as;

Rate per dollar of capital, r

r = Depreciation Rate + Interest Rate

In our example, depreciation rate was

3.33% and interest was 10% so

r = 3.33% + 10% = 13.33%

2011,FTU,KieuMinh

66

Cost Minimizing Input Choice

How do we put all this together to select inputs

to produce a given output at minimum cost?
Assumptions

Two Inputs: Labor (L) & capital (K)

Price of labor: wage rate (w)
The price of capital

r = depreciation rate + interest rate

Or rental rate if not purchasing
These are equal in a competitive capital
market

2011,FTU,KieuMinh

67

Cost in the Long Run

The Isocost Line

A line showing all combinations of L & K

that can be purchased for the same cost
Total cost of production is sum of firms
labor cost, wL and its capital cost rK

C = wL + rK

For each different level of cost, the

equation shows another isocost line

2011,FTU,KieuMinh

68

Cost in the Long Run

Rewriting C as an equation for a

straight line:

K = C/r - (w/r)L
Slope of the isocost: K L w r

-w/r is the ratio of the wage rate to rental

cost of capital.
This shows the rate at which capital can be
substituted for labor with no change in
cost.

2011,FTU,KieuMinh

69

Choosing Inputs

We will address how to minimize cost

for a given level of output by
combining isocosts with isoquants
We choose the output we wish to
produce and then determine how to
do that at minimum cost

Isoquant is the quantity we wish to

produce
Isocost is the combination of K and L
that gives a set cost

2011,FTU,KieuMinh

70

Producing a Given Output at

Minimum Cost
Capital
per
year

Q1 is an isoquant for output Q1.

There are three isocost lines, of
which 2 are possible choices in
which to produce Q1

K2

Isocost C2 shows quantity

Q1 can be produced with
combination K2L2 or K3L3.
However, both of these
are higher cost combinations
than K1L1.

K1

Q1

K3
C0
L2
2011,FTU,KieuMinh

L1

C1
L3

C2
Labor per year

71

Input Substitution When an

Input Price Change

If the price of labor changes, then the

slope of the isocost line change, w/r
It now takes a new quantity of labor
and capital to produce the output
If price of labor increases relative to
price of capital, and capital is
substituted for labor

2011,FTU,KieuMinh

72

Input Substitution When an

Input Price Change
Capital
per
year

K2

If the price of labor

rises, the isocost curve
becomes steeper due to
the change in the slope -(w/L).

The new combination of K

and L is used to produce Q1.
Combination B is used in
place of combination A.

B
A

K1

Q1
C2
2011,FTU,KieuMinh

L2

L1

C1
Labor per year

73

Cost in the Long Run

How does the isocost line relate to

the firms production process?

MRTS - K

MPL

Slope of isocost line K

MPL

2011,FTU,KieuMinh

MPK

MPK

when firm minimizes cost

74

Cost in the Long Run

The minimum cost combination can

then be written as:

MPL

MPK

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.

2011,FTU,KieuMinh

75

Cost in the Long Run

If w = $10, r = $20, and MPL = MPK,

which input would be used more of?

Labor because it is cheaper

Increasing labor lowers MPL

Decreasing capital raises MPK

Substitute labor for capital until

MPL MPK

w
r

2011,FTU,KieuMinh

76

Cost in the Long Run

Cost minimization with Varying

Output Levels

For each level of output, there is an

isocost curve showing minimum cost for
that output level
A firms expansion path shows the
minimum cost combinations of labor and
capital at each level of output.
Slope equals K/L

2011,FTU,KieuMinh

77

A Firms Expansion Path

Capital
per
year

The expansion path illustrates

the least-cost combinations of
labor and capital that can be
used to produce each level of
output in the long-run.

150 $3000

Expansion Path
100

$200
0

C
75
B
50
300 Units

A
25

200 Units

50
2011,FTU,KieuMinh

100

150

200

300

Labor per year

78

Expansion Path & Long-run

Costs

Firms expansion path has same

information as long-run total cost
curve
To move from expansion path to LR
cost curve

Find tangency with isoquant and isocost

Determine min cost of producing the
output level selected
Graph output-cost combination

2011,FTU,KieuMinh

79

A Firms Long-Run Total Cost

Curve
Cost/
Year
Long Run Total Cost
F

3000

E
2000

1000

100
2011,FTU,KieuMinh

200

300

Output, Units/yr

80

Long-Run Versus Short-Run

Cost Curves

In the short run some costs are fixed

In the long run firm can change
anything including plant size

Can produce at a lower average cost in

long run than in short run
Capital and labor are both flexible

We can show this by holding capital

fixed in the short run and flexible in
long run

2011,FTU,KieuMinh

81

The Inflexibility of Short-Run

Production
Capital E
per
year

Capital is fixed at K1
To produce q1, min cost at K1,L1
If increase output to Q2, min cost
is K1 and L3 in short run

Long-Run
Expansion Path

A
K2

Short-Run
Expansion Path

K1

In LR, can
change
capital and
min costs
falls to K2
and L2

Q2
Q1
L1

2011,FTU,KieuMinh

L2

L3

Labor per year

82

Long-Run Versus
Short-Run Cost Curves

Long-Run Average Cost (LAC)

1.

Most important determinant of the shape

of the LR AC and MC curves is relationship
between scale of the firms operation and
inputs required to min cost

Constant Returns to Scale

If input is doubled, output will double

AC cost is constant at all levels of output.

2011,FTU,KieuMinh

83

Long-Run Versus Short-Run

Cost Curves
2.

Increasing Returns to Scale

3.

If input is doubled, output will more than

double
AC decreases at all levels of output.

Decreasing Returns to Scale

If input is doubled, output will less than

double
AC increases at all levels of output

2011,FTU,KieuMinh

84

Long-Run Versus Short-Run

Cost Curves

In the long-run:

Firms experience increasing and

decreasing returns to scale and therefore
long-run average cost is U shaped.
Source of U-shape is due to returns to
scale rather than diminishing marginal
returns to a factor of production
Long-run marginal cost curve measures
the change in long-run total costs as
output is increased by 1 unit

2011,FTU,KieuMinh

85

Long-Run Versus Short-Run

Cost Curves

Long-run marginal cost leads

long-run average cost:

If LMC < LAC, LAC will fall

If LMC > LAC, LAC will rise
Therefore, LMC = LAC at the
minimum of LAC

In special case where LAC if

constant, LAC and LMC are equal

2011,FTU,KieuMinh

86

Long-Run Average and Marginal

Cost
Cost
($ per unit
of output

LMC
LAC

Output
2011,FTU,KieuMinh

87

Long Run Costs

As output increases, firms AC of

producing is likely to decline to a point
1.

2.

3.

On a larger scale, workers can better

specialize
Scale can provide flexibility managers can
organize production more effectively
Firm may be able to get inputs at lower cost
if it can get quantity discounts. Lower
prices might lead to different input mix

2011,FTU,KieuMinh

88

Long Run Costs

At some point, AC will begin to

increase
1.

2.

3.

Factory space and machinery may make it

more difficult for workers to do their job
efficiently
Managing a larger firm may become more
complex and inefficient as the number of
tasks increase
Bulk discounts can no longer be utilized.
Limited availability of inputs may cause
price to rise

2011,FTU,KieuMinh

89

Long Run Costs

When input proportions change, the

firms expansion path is no longer a
straight line

Concept of return to scale no longer

applies

Economies of scale reflects input

proportions that change as the firm
change its level of production
Unlike returns to scale, economies of
scale allows inputs proportions vary

2011,FTU,KieuMinh

90

Economies and Diseconomies of

Scale

Economies of Scale

Diseconomies of Scale

Increase in output is greater than the

increase in inputs.
Increase in output is less than the increase
in inputs.

U-shaped LAC shows economies of

scale for relatively low output levels
and diseconomies of scale for higher
levels

2011,FTU,KieuMinh

91

Long Run Costs

Increasing Returns to Scale

Output more than doubles when the

quantities of all inputs are doubled

Economies of Scale

Doubling of output requires less than a

doubling of cost

2011,FTU,KieuMinh

92

Long Run Costs

Economies of scale are measured in

terms of cost-output elasticity, EC

EC is the percentage change in the

cost of production resulting from a 1percent increase in output

C
C
EC

2011,FTU,KieuMinh

Q Q

MC

AC
93

Long Run Costs

EC is equal to 1, MC = AC

EC < 1 when MC < AC

Costs increase proportionately with output

Neither economies nor diseconomies of scale
Economies of scale
Both MC and AC are declining

EC > 1 when MC > AC

Diseconomies of scale
Both MC and AC are rising

2011,FTU,KieuMinh

94

Long-Run Versus Short-Run

Cost Curves

We will use short and long-run cost to

determine the optimal plant size
We can show the short run average
costs for 3 different plant sizes
This decision is important because
once built, the firm may not be able
to change plant size for a while

2011,FTU,KieuMinh

95

Long-Run Cost with

Constant Returns to Scale

The optimal plant size will depend on

the anticipated output

If expect to produce q0, then should build

smallest plant: AC = $8
If produce more, like q1, AC rises
If expect to produce q2, middle plant is
least cost
If expect to produce q3, largest plant is
best

2011,FTU,KieuMinh

96

Long-Run Cost with Economies

and Diseconomies of Scale

2011,FTU,KieuMinh

97

Long-Run Cost with

Constant 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.
Firm will always choose plant that
minimizes the average cost of production

2011,FTU,KieuMinh

98

Long-Run Cost with

Constant Returns to Scale

The long-run average cost curve

envelopes the short-run average cost
curves
The LAC curve exhibits economies of
scale initially but exhibits
diseconomies at higher output levels

2011,FTU,KieuMinh

99

Production with Two Outputs

Economies of Scope

Many firms produce more than one

product and those product are closely
linked
Examples:

Chicken farm--poultry and eggs

Automobile company--cars and trucks
University--Teaching and research

2011,FTU,KieuMinh

100

Production with Two Outputs

Economies of Scope

1.
2.

3.

Advantages
Both use capital and labor.
The firms share management
resources.
Both use the same labor skills and
type of machinery.

2011,FTU,KieuMinh

101

Production with Two Outputs

Economies of Scope

Firms must choose how much of each

to produce.
The alternative quantities can be
illustrated using product
transformation curves

Curves showing the various combinations

of two different outputs (products) that
can be produced with a given set of
inputs

2011,FTU,KieuMinh

102

Product Transformation Curve

Number
of tractors

Each curve shows

combinations of output
with a given combination
of L & K.

O2

O1

O1 illustrates a low level

of output. O2 illustrates
a higher level of output with
two times as much labor
and capital.

Number of cars
2011,FTU,KieuMinh

103

Product Transformation Curve

Product transformation curves are

negatively slope

Constant returns exist in this example

To get more of one output, must give up

some of the other output
Second curve lies twice as far from origin
as the first curve

Curve is concave

Joint production has its advantages

2011,FTU,KieuMinh

104

Production with Two Outputs

Economies of Scope

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

2011,FTU,KieuMinh

105

Production with Two Outputs

Economies of Scope

The degree of economies of scope (SC) can

be measured by percentage of cost saved
producing two or more products jointly:

C(q1 ) C(q 2 ) C(q1,q2 )

SC
C(q1,q 2 )

C(q1) is the cost of producing q1

C(q2) is the cost of producing q2

C(q1,q2) is the joint cost of producing both

products

2011,FTU,KieuMinh

106

Production with Two Outputs

Economies of Scope

With economies of scope, the joint

cost is less than the sum of the
individual costs
Interpretation:

If SC > 0 Economies of scope

If SC < 0 Diseconomies of scope
The greater the value of SC, the greater
the economies of scope

2011,FTU,KieuMinh

107