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Chapter 9
THE COST STRUCTURE OF
FIRMS IN THE LONG RUN

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Learning Outcomes
Profit-maximizing firms use an input mix such that the ratio
of marginal products of inputs equals the ratio of input
prices
If input prices change, methods of production will change
to use fewer of those inputs that have become relatively
expensive and more of those that have become relatively
cheaper
There is a family of short-run ATC curves, each one
tangent to the long-run ATC curve
The long-run cost curve can take on various shapes
depending on the scale effects when all inputs are allowed
to vary at once
Changes in technology are often endogenous responses
to changing economic signals

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Combinations of Inputs: Profit

maximization and cost minimization
In the long run all the factors are variable and hence, we
can select the best cost minimization method.
Profit maximization through cost minimization:

Choice of input mix :

(MPK ) / PK = (MPL) / PL
Whenever, the two sides are not equal, there are
possibilities for input substitutions that will reduce costs.
Different look to cost minimizations :
(MPK ) / (MPL) = (PK ) / (PL)

Principle of cost minimization

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Principle of Substitution
(MPK ) / (MPL) > (PK ) / (PL)
The firm substitute capital for labour, the method of
production will be more capital and less labour.
(MPK ) / (MPL) < (PK ) / (PL)
The firm substitute labour for capital, the method of
production will be more labour and less capital.
According to the law of diminishing return, firm use
more of one factor, the marginal productivity
reduces. So, the firm follow the substitution till
(MPK ) / (MPL) = (PK ) / (PL)

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Isoquants: An Alternative analysis of

the firms long run input decisions
Iso quants shows the set of technologically
efficient possibilities for producing a given
level of output.
It is also called the production indifference
curve.
As we move from one point on the isoquant
to another point, we are substitute one input
with another input holding output constant.

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Marginal rate of substitution(MRS)

MRS measures the rate at which one input
is substituted with another with output held
constant.
Marginal rate of substitution between two
inputs is equal to the ratio of their marginal
products.

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Alternative methods of producing six units of output

Method

K/L

18

12

-6

- 6.0

-3

- 3.0

-3

- 1.5

-2

- 0.67

12

-1

- 0.33

18

-1

- 0.17

An isoquant for output of six units

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Quantity of K

20

16

12

Q=6

f
4

12

Quantity of L

16

20

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Properties of Isoquant
Isoquants are negatively sloped
If one input is increased, other inputs have to be decreased.

They are convex to the origin

Diminishing marginal rate of technical substitution

Two isoquants do not intersects each

other.

An Isoquant Map

Quantity of K

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Q =12

Q=10
Q=4
0

Quantity of L

Q=6

Q= 8

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Producers Equilibrium
Isocost line
The determination of least cost method of
output.
The effect of a change in input prices on
cost and input proportions.

A Long-run Average Cost-curve

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Cost per unit

LRAC
Attainable levels of cost

Unattainable levels of cost

qm
Output per period

A Long-run Average Cost-curve

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LRAC

E0
Attainable levels of cost

Cost per unit

c0

Unattainable levels of cost

q0

qm
Output per period

A Long-run Average Cost-curve

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c2
c0

LRAC

E0
E1

Cost per unit

c1

Attainable levels of cost

Unattainable levels of cost

q0

q1

qm
Output per period

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The Shape of the long run

average cost curve
Decreasing Costs: The presence of
economies of scale. Expansions of output
permit a reduction of costs per unit of
output.
Increasing Costs: The presence of
diseconomies of scale. This is due to
difficulties of managing and controlling,
planning and coordination, management
cost per unit will increase, appropriate
supervision is difficult.

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A Long-run Average Cost-curve

The long-run average cost (LRAC) curve is the boundary
between attainable and unattainable levels of cost.
Since the lowest attainable cost of producing q0 is c0 per
unit, the point E0 is on the LRAC curve.
Suppose a firm producing at E0 desires to increase output
to q1.
In the short run, it will not be able to vary all factors, and
thus unit costs above c1, say c2, must be accepted.
In the long run a plant that is the optimal size for producing
output q1 can be built and costs of c1 can be attained.
At output qm the firm attains its lowest possible per-unit cost
of production for the given technology and factor prices.

Long-run Average Cost and Short-run Average Cost Curves

Cost per unit

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qm
Output per period

Long-run Average Cost and Short-run Average Cost Curves

Cost per unit

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SRATC

LRAC

c0

q0

qm
Output per period

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Long-run Average Cost and Short-run Average Cost Curves

The short-run average total cost (SRATC) curve is tangent to the
long-run average cost (LRAC) curve at the output for which the
quantity of the fixed factors is optimal.
The curves SRATC and LRAC coincide at output q0 where the fixed
plant is optimal for that level of output.
For all other outputs, there is too little or too much plant and
equipment, and SRATC lies above LRAC.
If some output other than q0 is to be sustained, costs can be
reduced to the level of the long-run curve when sufficient time has
elapsed to adjust the size of the firms fixed capital.
The output qm is the lowest point on the firms long-run average
cost curve.
It is called the firms minimum efficient scale (MES), and it is the
output at which long-run costs are minimized.

The Envelope Long-run Average Cost Curve

Cost per unit

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LRAC

Output per period

The Envelope Long-run Average Cost Curve

Cost per unit

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SRATC
LRAC
c0

q0
Output per period

The Envelope Long-run Average Cost Curve

Cost per unit

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SRATC
LRAC
c0

q0
Output per period

The Envelope Long-run Average Cost Curve

Cost per unit

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SRATC

SRATC
LRAC

c0

q0
Output per period

The Envelope Long-run Average Cost Curve

Cost per unit

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SRATC

SRATC
LRAC

c0

q0
Output per period

The Envelope Long-run Average Cost Curve

Cost per unit

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SRATC

SRATC
LRAC

c0

q0

qm
Output per period

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The Envelope Long-run Average Cost Curve

Each short-run curve shows how costs vary if

output varies, with the fixed factor held constant at
the level that is optimal for the output at the point
of tangency with LRAC.
As a result, each SRATC curve touches the LRAC
curve at one point and lies above it at all other
points.
This makes the LRAC curve the envelope of the
SRATC curves.

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CHAPTER 9: THE COST STRUCTURE IN THE LONG RUN

Costs in the Long Run

In the long run, the firm will adjust all factor inputs to
minimise the cost of producing any given level of
output.
This requires that the ratio of a factors marginal
product to its price be the same for all factors.
The principle of substitution states that when relative
factor prices change, firms will substitute relatively
cheaper factors for relatively more expensive ones.
Long-run cost curves are often assumed to be Ushaped
indicating
decreasing
average
costs
[increasing returns to scale] followed by increasing
average costs [decreasing returns to scale].

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CHAPTER 9: THE COST STRUCTURE IN THE LONG RUN

The long-run cost curve may be thought of as the

envelope of the family of short-run cost curves, all of
which shift when factor prices shift.

The Very Long Run

in the very long run, innovations introduce new
methods of production that later the production
function.
These innovations often occur as response to changes
in economic incentives such as variations in the prices
of inputs and outputs.
They cause cost curves to shift downwards.