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ECON 208 Lecture Notes - Diminishing Returns, Economic Efficiency, Technological Change

Economics (Arts)
Course Code
ECON 208
Sebastien Forte

of 3
Chapter 8:
In the long run, all inputs are variable
Firms strive for both technical efficiency and economic efficiency
Technical efficiency relates to trade offs between labour and capital
Economic efficiency relates to output
For any level of output, maximizing profits requires firms to choose their inputs
to minimize total costs
Using K and L to represent capital and labour, Pl and Pk as the price for the two
factors, cost is minimized when:
MPk = MPk or MPk = pk
pk pl MPl pl
When all factors of production can be varied, consider the least-cost method of
producing any level of output
The long run average cost curve (LRAC) separates unattainable and attainable
cost levels, given technology and factor prices
The LRAC curve is usually U shaped
LRAC curve and ATC curve look alike but are different
Falling LRAC = increasing returns to scale (economies of scale)
Constant LRAC = constant returns to scale
Rising LRAC = decreasing returns to scale (diseconomies of scale)
In the long run, you cannot be worse off in the long run than the short run
because things are not fixed
When output exceeds Qm (minimum long run average cost), the firm has rising
unit costs. Such an increasing-cost firm is said to encounter decreasing return to
This results from either difficulties in managing and controlling and enterprise as
its size increases.
*decreasing returns to scale (LR) is not the same as diminishing marginal returns
a short run ATC curve cannot fall below the LRAC curve
each short run average total cost curve (SRATC) is tangent to the LRAC curve at
the level of output for which the quantity of the fixed factor is optimal
changes in technology and factor prices cause the long run cost curve to shift
A rise in factor prices shifts the LRAC curve upward. A fall in factor prices of a
technological improvement shifts the LRAC curve downwards
In the very long run:
Technological change refers to all changes in the available techniques of
Economics use the notion of productivity to measure the extent of technological
If interest rates go down, it is less expensive to acquire physical capital, so you
use more capital at the expensive of labour. And if labour costs go down, you
use more labour relative to capital
They are choosing how many workers relative to machine to use- this is finding
the highest level of profits because they want to make as much money as
MPk = MPk or MPk = pk
pk pl MPl pl
if you don’t have marginal products per dollar equalized, you can decrease costs
by transferring money spent on one unit of the higher cost good to the lower
cost good, and you’ll have leftover money with the same amount of units (just
switched a labour for a machine)
This is the principle of substitution- firms substitute due to changing factors
Diminishing marginal products- it is useless to have two computers when you
only have one employee to use them
When all factors of production can be varied, consider the least-cost method of
producing any level of output
Ideally you want to be at the lowest point on the LRAC curve (lowest attainable
When output exceed Qm (long run capacity) the unit costs are rising- so there
are disadvantages to being at this level of production
LRAC shifts due to changes in prices and technology
Technical efficiency- you chose the trade off between labour and capital that is
best for profits
Economic efficiency is choosing the level of output that has the lowest LRAC
Changes in technology are often endogenous responses to changing economic
signals. Three kinds of changes in the long run
1. New techniques (process innovation)
2. New inputs
3. New products (product innovation) opens an entirely new market
Faced with increases in the price of an input, firms may either substitute away
(LR) or innovate away (VLR) from the input
If wages go up, costs go up, and you substitute part of it away. But if you
innovate so that you no longer need labour, then you isolate your company from
price fluctuations in the labour market