Textbook Notes (363,559)
ECON 208 (107)
Chapter 8

Chapter 8 Producers in the Long Run.docx

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School
McGill University
Department
Economics (Arts)
Course
ECON 208
Professor
Mayssun El- Attar Vilalta
Semester
Fall

Description
Chapter 8 Producers in the Long Run 8.1 The Long Run: No Fixed Factors  SR = at least one factor is fixed = must adjust the input of the variable factors to produce output  LR = all factors can be varied = must choose the type and amount of plant and equipment and the size of their labour force  Technical efficiency: when a given number of inputs are combined in such a way as to maximize the level of output  to maximize profits, firm must choose from among the many technically efficient options that produces a given level of output at the lowest cost = combo that minimizes TC  how much capital/labour to use = LR choices = all factors of production are assumed to be variable Profit Maximization and Cost Minimization  Cost minimization: an implication of profit maximization that firms choose the production method that produces any given level of output at the lowest possible cost Long-Run Cost Minimization  Firm should substitute one factor for another as long as the marginal product of the one factor per dollar spent on it is greater than the marginal product of the other factor per dollar spent on it. If these 2 aren’t equal, firm isn’t minimizing costs.  K = capital, L = labour, p and p = prices per unit of the 2 factors; cost minimization occurs when L K MP =KMP L p p K L  Law of diminishing marginal returns says that, with other inputs held constant, an increase in the amount of one factor used will decrease that factor’s marginal product  Reduce K and increase L, MP rikes, MP falLs  Whenever the ratio of the marginal product of each factor to its price isn’t equal for all factors, there are possibilities for factor substitutions that will reduce costs (for a given level of output)  MP =Kp LeKt side: compares the contribution to output of the last unit of capital and last unit of MP =Lp lLbour; Right side: how the cost of an additional unit of capital compares to the cost of an additional unit of labour  If the left < right, it would pay the firm to switch to a method of production that uses less capital and more labour; but if left>right, then it would pay the firm to switch to a method of production that uses less labour and more capital. Only when left=right is the firm using the cost-minimizing production method.  Profit-maximizing firms adjust the quantities of factors they use to the prices of the factors given by the market The Principle of Substitution  Principle of Substitution: the principle that 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; profit-maximizing/cost-minimizing firms will react to changes in factor process by changing their methods of production  Methods of production will change if the relative prices of factors change. Relatively more of the cheaper factor and relatively less of the more expensive factors will be used. 1  Principle of substitution plays a central role in resource allocation because it relates to the way in which individual firms respond to changes in relative factor prices that are caused by the changing relative scarcities of factors in the economy as a whole. Individual firms are motivated to use less of factors that become scarcer to the economy and more of factors that become plentiful  1 example: customer transactions in banks – before bank hired many tellers to deal with the hundreds of customers, now banking transactions facilitated with computers and dealt with ATMs, automated telephone banking, or internet banking. Dramatic reduction in price of comps and modest increase in wages = encouraged bankers to make this substitution of capital for labour  2 : producing same product differs across countries. Canada, labour is highly skilled and expensive, farmers use machinery; developing countries, labour abundant and capital scarce, less mechanized. Where factor scarcities differ across nations, so will the cost-minimizing methods of production  3 : firms can also be induced to substitute between capital and material inputs (fuel); increase in price of oil = change in type of capital equipment to substitute away from jets that use a lot of fuel toward ones that are more fuel efficient Long-Run Cost Curves  With given factor prices, there is a minimum achievable cost for each level of output; if this cost is expressed in terms of dollars per unit of output, we obtain the LR avg cost of producing each level of output.  Long-run average cost (LRAC) curve: the curve showing the lowest possible cost of producing each level of output when all inputs can be varied; determined by the firm’s current technology and by the prices of the factors of production  The LRAC curve is the boundary between cost levels that are attainable (points on it; only if sufficient time elapses for all inputs to be adjusted), with known technology and given factor prices, and those that are unattainable (points below it). To move from one point on the curve to another requires an adjustment in all factor inputs  In deriving the LRAC curve, unlike the SR cost curve, there are no fixed factors of production and all costs are variable in the LR, so no AVC, AFC, ATC, only LRAC for any given set of input prices. The Shape of the Long-Run Average Cost Curve  LRAC First falls and then rises; saucer/U-shaped Decreasing Costs  From 0 to Q mquantity at minimum price) the firm has falling LRAC: an expansion of output permits a reduction of average costs.  Economies of scale: reduction of long-run avg costs resulting from an expansion in the scale of a firm’s operations so that more of all inputs is being used  since the LRAC curve is draw assuming constant factor prices, the decline in LRAC occurs because output is increasing more than in proportion to inputs as the scale of the firm’s production expands. 2  Increasing returns (to scale): a situation in which output increases more than in proportion to inputs as the scale of a firm’s production increases. A firm in this situation is a decreasing-cost firm.  Increasing returns may occur due to increased opportunities for specialization of tasks made possible by the division of labour; larger plants used greater specialization since large, specialized equipment is useful only when the volume of output that the firm can sell justifies using that equipment Constant Costs  Minimum efficient scale (MES): the smallest output at which LRAC reaches its minimum. All available economies of scale have been realized at this point; LRAC fall until output reaches m.  the LRAC curve is then flat over some range of output = firm encounters constant costs over the relevant range of output so the LRAV font change as its output changes; since factor prices are assumed to be fixed, the firm’s output must be increasing exactly in proportion to the increase in inputs  Constant returns (to scale): a situation in which output increases in proportion to inputs as the scale of production is increased. A firm in this situation is a constant-cost firm. Increasing Costs  When the LRAC curve is rising, a LR expansion in production is accompanied by a rise in avg costs  Decreasing returns (to scale): a situation in which output increases less than in proportion to inputs as the scale of a firm’s production increases. A firm in this situation is an incr
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