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Chapter 8

Economics 101: Chapter 8

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University of British Columbia
ECON 101
Robert Gateman

Chapter 8 8.1 The Long Run: No Fixed Factors  In the long run when all factors are variable, there are several ways to produce any given output o New machinery, change in workforce, new technology etc.  Technically Efficient: using no more inputs than necessary (reduce waste of variable factors) o Must shift variable factors in order to become technically efficient in the long run o Being technically efficient is a key part of being a profit maximizer o Costs of production must also be minimized in order to be a profit maximizer Long-Run Cost Minimization:  Cost Minimization: profit maximizing firms with a long-term goal to produce output at the lowest possible cost o Least costly means of production at whatever level of output the firm chooses  o When the ratio is not equal, there are possibilities for factor substitution that will reduce costs (for a given level of output) o If the last dollar spend on capital is equal to less output than that of the last dollar spend on labour, the firm can reduce costs by using more labour and less capital o Different combinations may not change output, but will reduce/increase costs o The law of diminishing marginal returns helps balance the equation as more labour is used, the marginal product of labour falls, and the marginal product of capital rises  o Left side: compares the contribution to output of the last unit of capital and the last unit of labour o Right side: shows how the cost of an additional unit of capital compares to the additional unit of labour o If the equation equals, the firm cannot make any decision to further reduce costs o Only when the equation equals is the firm using the minimizing production method o Profit maximizing firms adjust the quantities of factors they use to the prices of the factors given by the market The Principle of Substitution:  Profit maximizers will react to changes in factor prices by changing methods of production o Methods of production will change if the relative prices of factors change  Relatively more of the cheaper factor, and less of the more expensive factor  The principle of substitution plays a central role in resource allocation o Relates to the way individual firms respond to changes in factor prices caused by scarcity o Firms are motivated to use less of scarce resources and more of plentiful resources  Factor scarcities and cost minimization methods differ with different products and nations Long-Run Cost Curves:  Long-run average cost curve (LRAC): graphed from each minimum cost point for each level of production o Determined by the firms current technology, and price of factors of production o Points below the curve are unattainable, above are attainable o To move from one point to another, there must be an adjustment to all factor inputs  LRAC curve is the boundary between cost levels that are attainable, with known technology and given factor prices, and those that are unattainable o Describes relationship between factor inputs and outputs  Does not include fixed factors of production (no fixed in long run) Shape of the Long-Run Average Cost Curve:  The curve first falls and then rises (u-shaped, or saucer shaped curve)  Decreasing Costs: from 0 output to Qm (minimum efficient scale) o An expansion of output allows for a reduction of average costs o Economies of scale: long-run average costs fall as output rises o Increasing returns: output increases more than in proportion to inputs as the scale of a firm's production expands o Maximizing efficiency, cost minimizing, productive resources/factors  Constant Costs: at the point of Qm (minimum efficient scale) o Minimum efficient scale: level of output at which the LRAC reaches it minimum o When the LRAC hits Qm, it is flat for a period of time  Over this period, costs do not change given a particular output level o Constant returns: output level is increasing exactly in proportion to the increase of inputs  Increasing Costs: the part of the curve right of Qm o Decreasing returns: output is increasing less than in proportion to the increase in inputs o Diseconomies of scale: decreasing returns  Often occurs when firms are growing too fast to make adequate decisions  Control of labour in large firms may create troubles (middle management etc.) Relationship between Long-Run and Short-Run Costs:  LRAC: shows the lowest cost of producing any output when all factors are variable  SRATC: shows the lowest cost of producing any output when one or more factors are fixed  SRATC cannot fall below LRAC because LRAC rep
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