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Chapter 8

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Queen's University
ECON 110
Ian James Cromb

Chapter 8: Producers in the Long Run The Long Run: No Fixed Factors  When all factors can be varied, there are numerous ways to produce output (unlike s. run) o Could use complex machines w. few workers or simple machines/many workers o Firms must choose the type & amount of plant & equip & the size of labour force  In making these choices, the profit-maximizing firm will try to be technically efficient o Technical efficiency: When a given number of inputs are combined in such a way as to maximize the level of output  Total efficiency is not enough for profits to be maximized o The firm must also choose from among the many technically efficient options the one that produces a given level of output at the lowest cost Profit Maximization and Cost Minimization  An firm that seeks to maximize profits in the long run should select the production method that produces its output at the lowest possible cost  Cost Minimization: An implication of profit maximization that firms choose the production method that produces any given level of output at the lowest cost possible Long Run Cost Maximization  If it is possible to sub one factor for another to keep output constant while reducing total cost, the firm is currently not minimizing its costs o In this situation, the firm should sub one factor for another as long as the marginal product of the one factor per dollar spent on it is greater than the other product’s o Ex. If investing $1 in labour produces more output than investing in capital, then the firm can reduce costs by spending less on capital and more on labour The Principle of Substitution  The principle that methods of production will change if relative prices of inputs change, with relatively more of the cheaper input used and relatively less of the expensive input  Methods of production will change if the relative prices of factors change o More of the cheaper factor, less of the expensive factor  This principle plays a key 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 scarcities of factors in the economy as a whole o Use less scarce factors – and more plentiful ones  ends up being cheaper  Ex. With the decrease in the price of computers and tech, banks can put more money into ATM’s and tech related capital and not hire as any tellers and end up saving money  Ex. Substituting the actual equipment – more fuel efficient machinery Long-Run Cost Curves  As noted, when all factors of prod can be varied, there is always one least-cost method  Thus, with given factor prices, there is a min achievable cost for each level of output o If this output is expressed in terms of dollars per output, we obtain the long run avg cost of producing each level of output  The Long-Run Average Cost Curve shows the lowest possible cost of producing each level of output when all inputs can be varied o It is a “boundary” – the points below the curve are unattainable but points on the curve are attainable if sufficient time elapses for the inputs to be changed o To move from one point on the curve to another requires all factors to be adjusted  Since there are no fixed factors, there is no need to distinguish AVC, AFC, and ATC The Shape of the Long-Run Average Cost (LRAC) Curve  Often described as a U-shape  Three regions on the curve: Decreasing costs, Constant Costs, and Increasing Costs Decreasing Costs  An expansion of output permits a reduction in average costs o From 0  some other quantity the firm has falling average long-run costs  When long-run average cost in falling, the firm has economies of scale o E.o.S. is the reduction of long-run average costs resulting from an expansion in the scale of a firm’s operations so that more of all inputs is being used o Since the curve is drawn under the assumption of constant prices, the decline in average cost occurs because outputs are increasing more than inputs  Over this range, the firm is experiencing increasing returns o Can be a result of division of labour – specialization of equipment = more volume Constant Costs  Known as the firm’s minimum efficient scale o The smallest output which the curve reaches its min – all E.o.S. has been realized  The curve is flat over a short region of output o Firm encounters constant costs over the range of output – avg cost doesn’t change  Since factor prices aren’t changing, the firm’s output must be exactly in proportion to the increase in inputs – said to have constant returns Increasing Costs  When curve is rising, long-run expansion in prod is followed by the rise in average cost  If factor prices are constant, firm’s outputs must be increasing less than increase in inputs  When this happens, the firm is said to have decreasing returns – Diseconomies of Scale o May be associated with the difficulties in managing/controlling an huge business o Could also lead to alienation of workers – more difficult to provide
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