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Chapter 8

ECON 101 Chapter 8: Chapter 8.docx

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ECON 101
Robert Gateman

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Chapter 8
The Long Run: No Fixed Factors
- In the long run, when all factors can be carried, there are numerous ways to
produce any given output
- Firms in the long run must choose the type and amount of plant and
equipment and the size of their labor force
- The profit-maximizing firm will try to be technically efficient = using no
more of all inputs than necessary = the firm does not want to waste any of its
valuable inputs
- Technical efficiency is not enough for profits to be maximized, however. In
order to maximize its profit, the firm must choose from among the many
technically efficient options the one that produces a given level of output at
the lowest cost
- Such choices about how much capital and labor to use are long-run choices
because all factors of production are assumed to be variable
Profit Maximization and Cost Minimization
- Cost minimization = any firm that seeks to maximize its profits in the long
run should select the production method that produces its output at the lowest
possible cost
Long-Run Cost Minimization
- If it is possible to substitute one factor for another to keep output constant
while reducing total cost, the firm is currently not minimizing its costs
- The firm should substitute one factor for another factor 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
- The firm is not minimizing its costs whenever theses two magnitudes are
- MPk / Pk = MPL / pL
- Whenever the ratio of the marginal product of each factor to its price is not
equal for all factors, there are possibilities for factor substitutions that will
reduce costs (for a given level of output)
- As the firm substitute between labor and capital, the marginal products of
both factors will change
- The law of diminishing marginal returns = with other inputs held constant, an
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increase in the amount of one factor used will decrease that factor’s marginal
- MPk / MPL = Pk / PL
- The ratio of the marginal products on the left side compares the 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 cannot make any substitutions
between labor and capital to reduce costs (if output is held constant)
- 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 = profit-maximizing (cost-minimizing) firms will
react to changes in factor prices 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 factor will be used
- The principle of substitution plays a central role in resource allocation
- Individual firms are motivated to use less of factors that become scarcer to
the economy and more of factors that become more plentiful
- Where factor scarcities differ across nations, so will the cost-minimizing
methods of production
Long-Run Cost Curve
- Long-run decisions = firm is free to alter the amounts of all factors of
- Long-run average cost (LRAC) curve = minimum cost of producing each
level of output
- The LRAC curve is determined by the firm’s current technology and by the
prices of the factors of production
- Points below it are unattainable / Points on the curve are attainable if
sufficient time elapses for all inputs to be adjusted
- To move from one point on the LRAC curve to another requires an
adjustment in all factor inputs
- The LRAC curve is the boundary between cost levels that are attainable, with
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