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Chapter 8.pdf

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McGill University
Economics (Arts)
ECON 208
Mayssun El- Attar Vilalta

Chapter 8 Producers in the long-run Long-run: no fixed factors - all factors can be varied - numerous ways to produce any given output - firms in the long-run must choose the type/amount of plant/equipment/labor force - producers aim to be technically effi cient (inputs are combined to maximize output) - technical efficiency isn't enough for profit maximization - the firm must choose from the many technically efficient options and pick the one that produces a given level of output at the lowest cost - choices about how much capital and labor to use are long-run choices because all factors are assumed to be variable Profit maximization and cost minimization - cost minimization = firms choose the production method that produces a given level of output at the lowest possible cost - long-run cost minimization: - if its possible to substitute one factor for another to keep output constant/reduce total cost the fi rm is not minimizing its costs - the firm should substitute one factor for another factor as long as the marginal product of one factor is greater than the marginal product of another factor - i.e. if more $ spent on labor produces more output than more $ spent on capital would, the fi rm can reduce costs by spending more on labor and reducing expenditure on capital - MP of capital/price of one unit of capital = MP of labor/price of one unit of labor - when they are not equal there are possibilities for factor substitutions that will reduce costs - but will the law of diminishing returns - new cost-minimizing condition: MP of capital/MP of labor = price of one unit of capital/price of one unit of labor - new condition compares contribution to output of the last unit of capital and the last unit of labor - the right side shows how the cost of an additional unit of capital compares to the cost of an additional unit of labor - if the two sides are the same then the firm can't make any substitutions between labor/capital to reduce costs - if the ratio on the right side < left side then the firm should switch to a production method that uses less labor and more capital - only when the ratio of MPs is exactly = to the ratio of factor prices is when the firm is using the cost- minimizing production method Principle of substitution - methods of production will change if relative prices of inputs change, with relatively more of the cheaper input and relatively less of the more expensive input being used - this principle plays a central role in resource allocation - it relates to the way firms respond to changes in relative factor prices that are caused by the changing scarcities of factors in the economy - firms are motivated to use less factors that become scarce and more factors that are plentiful in the economy i.e. banks: price of labor has gone up, price of atm equipment has gone down, now employ more capital than labor Long-run cost curves - LRAC: shows lowest possible cost of producing each level of output when all inputs can be varied - with given factor prices there is a minimum achievable cost for each level of output - if cost is in $ per unit of output, we get the LRAC of producing - LRAC = U shape, part before the mi
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