Chapter 8 & Appendix
8.1 The Long Run: No Fixed Factors
Firms in the long run must choose the type and amount of plant and
equipment and the size of their labour force (must choose between possible
short-run cost curves).
Technical efficiency: when a given number of inputs are combined in such a
way as to maximize the level of output.
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.
Cost minimization: an implication of profit maximization that firms choose
the production method that produces any given level of output at the lowest
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.
Only when the ratio of marginal products is exactly equal to the ratio of
factor prices 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.
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.
Where factor scarcities differ across nations, so will the cost-minimizing
methods of production.
Long-run average cost (LRAC) curve: the curve showing the lowest possible
cot of producing each level of output when all inputs can be varied.
The LRAC curve is 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
(above), with known technology and given factor prices, and those that are
The LRAC curve is often “saucer-shaped” and has three portions to it:
o Decreasing Costs
Beginning portion where an expansion of output permits a
reduction of average costs. Economies of scale: 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.
The decline in long-run average cost occurs because output is
increasing more than in proportion to inputs as the scale of the
firm’s production expands.
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
Increasing returns may occur as a result of increased
opportunities for specialization of tasks made possible by the
division of labour.
Large specialized equipment is useful only when the
volume of output that the firm can sell justifies using
o Constant Costs
Middle portion where the firm encounters constant costs over
the relevant range of output, meaning the firm’s long-un
average costs do not change as output changes.
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.
Minimum efficient scale (MES): the smallest output at which
LRAC reaches its minimum. All available economies of scale
have been realized at this point.
o Increasing Costs
End portion where a long-run expansion in production is
accompanied by a rise in average 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
Decreasing returns imply that the firm suffers some
diseconomies of scale.
I.e. difficult to control ever-increasing size of