Chapter 6

Production and Cost Analysis in the Long-Run

Long-run production function
Q = f(L, K)
Where,
Q = quantity of output
L = quantity of labor input (variable)
K = quantity of capital input (variable)
Labor and capital inputs are variable in the long-run. The
inputs can be changed and substituted for one another to
produce different output levels.
 Q
K

K1 A

Q2
Q2 Q1
MRTS A B
1 B Q K
K2 1 L

L1 L2 L

Q1 and Q2 are isoquants.

Q2 > Q 1
Isoquant
• Different combinations of capital and labor that produce
the same level of output
Marginal rate of technical
substitution
• Rate at which one unit of labor must be substituted for
capital to produce the same output level along the
isoquant
• MRTSLK = -∆K/∆L
Where,
MRTSLK= marginal rate of technical substitution of
labor and capital
∆K = change in capital
∆L = change in labor
Isocost line
• Different combinations of capital and labor that have
the same production cost
• TC = PLL + PKK
Where,
TC = total cost of production
PL = price per unit of labor
L = quantity of labor input
PK = price per unit of capital
K = quantity of capital
 Isocost line, cont’d
K
TC = PLL + PKK
-PKK = -TC + PLL
TC/PK
K = -TC/-PK + PLL/-PK
-PL/PK K = TC/PK – (PL/PK)L
1

ISC1

TC/PL L
 Isocost line, cont’d
K
1. TC1 = PLL + PKK
TC2/PK 2. TC2 = PLL + PKK (TC2>TC1)
TC1/PK
3. TC1 = PL’L + PKK (TC1=TC1)
-PL/PK

1
-PL’/PK

TC1/PL TC2/PL TC1/PL’ L

 Cost minimization
K
TC3/PK Minimum cost combination
TC2/PK L and K
A
TC1/PK 1. -MPL/MPK = -PL/PK
MPL/PL = MPK/PK
-PL/PK

1
B Note:
1. At A, MPL/PL > MPK/PK.
Use more L than K.
TC1/PL TC2/PL TC3/PL L 2. At B, MPL/PL < MPK/PK,
Use more K than L.
3. TC3 > TC2 > TC1
 Changes in the cost of production
K
A: Firm produces output
TC2/PK level Q1 using L1 and K1 at
total cost TC1.
TC3/PK
B: In the short-run, firm
TC1/PK increases output level to Q2
K2 C by increasing labor to L2.
K1 A B Q2 TC2 > TC1.
Q1 C: In the long-run, firm
increases capital to K2 and
decreases labor to L3. TC2
L1 L3 L2
L > TC3 < TC1.
 Cost

SATC1
AC1 SATC2 LRAC
SATCMES
AC2
ACMES

Q1 Q 2 QMES Q

Economies of scale: LRAC is decreasing

Diseconomies of scale: LRAC is increasing
Minimum efficient scale: Beyond QMES, LRAC is
increasing
Factors creating economies of scale
1. Specialization and division of labor
2. Technological factors
3. Automation devices
4. Quantity discounts
5. Spreading of advertising discounts
6. Financial factors
7. Learning by doing
Cost minimization derivation
1. Firm output level is Q1 and production function is Q=f(K,L).
2. The total change in Q due to L and K is zero along the isoquant level Q1.
(df/dK)∆K + (df/dL)∆L = 0
∆K/∆L =-(df/dL)/(df/dK)
∆K/∆L =-(dQ/dL)/(dQ/dK)
∆K/∆L =-(∆Q/∆L)/(∆Q/∆K)
MRTSLK = -MPL/MPK
Where,
df/dK = partial change in Q due to an infinitesimal change in K, holding L constant
df/dL = partial change in Q due to an infinitesimal change in L, holding K constant
∆K = total change in K
∆L = total change in L
MPL = marginal product of labor
MPK = marginal product of capital
Cost minimization derivation, cont’d
3. The minimum cost to produce output level Q1 is the combination of L and K at which the cost to
produce marginal product of labor is equal to the cost to produce marginal product of capital.
MRTSLK = -MPL/MPK = -PL/PK
MPL/PL = MPK/PK