Chapter 6

Production and
Cost Analysis
in the Long
Run
ESMA 794
Economics for Managers
Spring 2024
Ahmad Mayyas
Khalifa University
Department of Management Science & Engineering
© 2014 Pearson Education, Inc.
 chapter 5
Production and Cost Analysis in the Short Run

Objectives
• To learn how to examine production and cost
issues in the long run, where all inputs in a
production process are variable
• To be able to use short run cost curves to build
a long run cost curve
• To able to study the effect of changing inputs
and possibly substituting them for each other
on the long-run production function.

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 chapter 6
Production and Cost Analysis in the Long Run

Model of a Long-Run Cost Function

EQUATION 6.1 Model of a

Long-Run Production Function

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Production and Cost Analysis in the Long Run

Input Substitution
• Labor-intensive method of production: A production
process that uses large amounts of labor relative to the
other inputs to produce the firm’s output.
• Capital-intensive method of production: A production
process that uses large amounts of capital equipment
relative to the other inputs to produce the firm’s
output.
• Input substitution: The degree to which a firm can
substitute one input for another in a production
process.
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Production and Cost Analysis in the Long Run

Input Substitution
• The degree of input substitution, or the feasibility of
substituting one input for another in the production
process.

• A manager’s choice of inputs will be influenced by

– The technology of the production process
– The prices of the inputs of production
– The set of incentives facing the given producer
• Firms will substitute cheaper inputs of production for more expensive
ones if they face major incentives to minimize their costs of production.

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Production and Cost Analysis in the Long Run

Derivation of the Long-Run Average Cost Curve

Long-run average cost (LRAC)

• The minimum average or unit cost of producing
any level of output when all inputs are variable.

Short-run average total cost (SATC)

• The cost per unit of output for a firm of a given
size or scale of operation.

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 chapter 6
Production and Cost Analysis in the Long Run

Model of a Long-Run Cost Function

Figure 6.1 shows several short-run average total cost (SATC) curves drawn for
different scales of operation. These curves represent the average total cost of
production for firms with different-sized manufacturing plants or different
amounts of the fixed input buildings.

The long-run average cost curve,

which shows the minimum
average cost of producing any
level of output when all inputs
are variable, is the envelope
curve of the various short-run
average total cost (SATC) curves

FIGURE 6.1 Derivation of the long-

© 2014 Pearson Education, Inc. run average cost (LRAC) curve
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Production and Cost Analysis in the Long Run

Economies and Diseconomies of Scale

A firm can experience both

economies of scale (decreasing
LRAC) or diseconomies of scale
(increasing LRAC) as it expands
plant size.

The size of the plant

represented by the SATC2 curve
minimizes the overall average
cost of production, assuming
the firm wants to produce
output at or near level Q1.

FIGURE 6.2 The Standard Long-Run Average Cost Curve (LRAC)

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Production and Cost Analysis in the Long Run

Diseconomies of scale
• Diseconomies of scale in economics is
the increase in cost due to expansion
of the business size or production.
• At this stage, strategic planning and
effective cost control measures are
crucial; otherwise, the business
profitability gets affected negatively.
Various factors influence the LRAC, for
example, when a firm outgrows in
size, it is common to experience
maturity or saturation.

© 2014 Pearson Education, Inc. https://www.wallstreetmojo.com/diseconomies-of-scale/

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Production and Cost Analysis in the Long Run

Factors Creating Economies and Diseconomies of Scale

Factors Creating Economies of Scale
• Specialization and division of labor (Technical factor)
• Technological factors (Technical
factors)
• The use of automation devices (Technical factor)
• Quantity discounts
(Financial factor)
• The spreading of advertising costs (Financial factor)
• Other financial factors
(Financial factor)

• Technical factors: Specialization and the division of labor, technological

factors, and the use of automation devices. Combination of inputs and the
technology of the production process.
• Financial factor: Quantity discounts, the spreading of advertising costs, and
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other financial factors. They represent financial issues associated with large-
 chapter 6
Production and Cost Analysis in the Long Run

Other Factors Influencing the Long-Run

Average Cost Curve
• Learning by doing: The drop in unit costs as
total cumulative production increases because
workers become more efficient as they repeat
their assigned tasks.

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Production and Cost Analysis in the Long Run

The Minimum Efficient Scale of Operation

Minimum efficient scale (MES)
• That scale of operation at which the long-run average cost curve stops declining or at
which economies of scale are exhausted.
• At this scale, there are no further advantages to larger-scale production in terms of
lowering production costs. The important point is the location of this minimum
efficient scale relative to the total size of the market.
monopoly
Perfect competition
oligopoly

no optimal scale
of operation

FIGURE 6.3 Minimum Efficient Scale (MES) with Different LRAC Curves
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Production and Cost Analysis in the Long Run

The Minimum Efficient Scale of Operation

• Firm A represents a firm that could operate in a competitive market with a
large number of producers.
– It has a relatively small MES compared to the size of the market. Any scale
economies are exhausted quickly. The cost curve also has a relatively steep
gradient, indicating that producing output at a level much greater or less
than MESA will result in a rapid increase in costs
• Firm B has the same MSE of operation as Firm A.
– Unlike Firm A, its LRAC curve is relatively flat over a large range of output.
This means that there is no optimal scale of operation for Firm B.
• Firm C has a cost structure that is more consistent with an oligopoly market
structure
– The minimum efficient scale is one-third of the market, so it is likely that
only a few firms will emerge in the market.
• Firm D represents a natural monopoly, where one large-scale firm will
dominate the market.
– The minimum efficient scale of production comprises the entire market.
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Production and Cost Analysis in the Long Run

Methods for Determining the MES

• Surveys of expert opinion (engineering estimates)
• Statistical cost estimation
• The survivor approach

Economies of scale for many

firms occur over a modest
range of output, and then the
LRAC curve becomes
essentially flat, with neither
further economies nor
diseconomies in the relevant
range of the market.
FIGURE 6.4 Empirical Long-Run
© 2014 Pearson Education, Inc. Average Cost (LRAC) Curve
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Production and Cost Analysis in the Long Run

Problem EoC 6.1

1. A company operates plants in both the United States
(where capital is relatively cheap and labor is
relatively expensive) and Mexico (where labor is
relatively cheap and capital is relatively expensive).
a. Why is it unlikely that the cost-minimizing factor
choice will be identical between the two plants? Explain.
b. Under what circumstances will the input choice be
relatively similar?

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 chapter 6
Production and Cost Analysis in the Long Run

Solution
• a. The cost-minimizing choice depends on the ratio of the marginal
productivity of the input relative to the cost of the input in each
country. Because input costs are very different in the two countries,
it is probable, all other things held constant, that in the United
States the firm will choose an input mix consisting of a lot of capital
and relatively little labor and that in Mexico it will use relatively
more labor and less capital.

• b. If the factors of production cannot be substituted, the input mix

will have to be identical. Additionally, if input productivities vary
between countries, the input choice may be similar (for example, if
U.S. labor is expensive, but highly productive, the firm will use a lot
of labor in the United States as well).

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Production and Cost Analysis in the Long Run

Problem EoC 6.4

• 4. Each of the following statements describes a
market structure. What would you expect the
long-run average cost curve to look like for a
representative firm in each industry? Graph the
curve, and indicate the minimum efficient scale
(MES).
a. There are a few large firms in the industry.
b. There are many firms in the industry, each
small relative to the size of the market.
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 chapter 6
Production and Cost Analysis in the Long Run

Solution
• a. The minimum efficient scale should be at a high
level of output. (oligopoly)
• b. The minimum efficient scale should be at a low
level of output. (perfect competition)
monopoly

Perfect competition
oligopoly

no optimal scale
of operation

FIGURE 6.3 Minimum Efficient Scale (MES) with Different LRAC Curves
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 chapter 6
Production and Cost Analysis in the Long Run

Problem- Application Questions 3

The following graph shows economies of scale in the beer brewing industry.

a. What does this graph tell us about the nature of economies of scale in the
beer brewing industry?
b. What are the particular problems associated with the firm represented by
the SATC curve shown in the graph? Does it represent a firm that would be
able to survive over time?

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 chapter 6
Production and Cost Analysis in the Long Run

Solution
a. Economies of scale are substantial up to a plant capacity of 1.25 to
2.0 million barrels of beer per year. Costs continue to decline more
modestly up to a capacity of approximately 8 million barrels per
year. The long-run average cost curve is essentially flat beyond 8
million barrels per year, so there are no further economies of scale.

b. The firm with the SRAC curve in the diagram represents the type of
firm that did not survive over time. It was too small to take
advantage of all the economies of scale of production. The long-run
average cost curve is the envelope curve of the short-run curves of
firms with the most efficient production. Since the SRAC curve in the
figure is not tangent to the LRAC curve, this firm did not have the
most efficient production techniques even for its size.

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Production and Cost Analysis in the Long Run

Appendix 6A Isoquant Analysis

EQUATION 6.A1 Production

Technology and Input Substitution

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 chapter 6
Production and Cost Analysis in the Long Run

Appendix 6A Isoquant Analysis

FIGURE 6.A1 A Production Isoquant

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Production and Cost Analysis in the Long Run

Appendix 6A Isoquant Analysis

Perfect Substitutes
The inputs in this production
function are perfect substitutes for
one another.

FIGURE 6.A2 Perfect Substitutes

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Production and Cost Analysis in the Long Run

Appendix 6A Isoquant Analysis

Perfect Complements (Fixed Proportions)
The inputs in this production function can
be used only in fixed proportions.

It implies that there is only one

combination of inputs (L1, K1, at point A)
that can be used to produce output level
Q1 and that the inputs have to be used in
this proportion.
No input substitution is possible
because moving along the isoquant in
either direction (from point A to point B
or from point A to point C) involves the
greater use of one input and no smaller
amount of the other input. FIGURE 6.A3 Perfect Complements (Fixed Proportions)

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Production and Cost Analysis in the Long Run

The Isocost Line

FIGURE 6.A4 The Isocost Line

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Production and Cost Analysis in the Long Run

The Isocost Line

Change (Increase) in the Total Cost

of Production (Input Prices Constant)

A change in the total cost of production

is represented by a parallel shift of the
isocost line. If the total cost of
production increases from TC1 to TC2,
the isocost line shifts out from ISC1 to
ISC2

FIGURE 6.A5 Change (Increase) in the Total

Cost of Production (Input Prices Constant)

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Production and Cost Analysis in the Long Run

The Isocost Line

Change (Decrease) in the Price
of Labor (All Else Constant)

The isocost line swivels out, pivoting

on the K-axis. Because the price of
capital has not changed, the
maximum quantity of K that can be
purchased does not change either.
However, the price of labor has
decreased, so labor has become
cheaper relative to capital.

FIGURE 6.A6 Change (Decrease) in the

© 2014 Pearson Education, Inc. Price of Labor (All Else Constant)
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Production and Cost Analysis in the Long Run

The Isocost Line

Cost Minimization
The cost-minimizing combination of inputs
(L1, K1) is represented by point A, the
tangency between the isoquant and the
isocost line where the marginal rate of
technical substitution equals the ratio of
the input prices.

Any other point on the given isocost line

represents a combination of labor and
capital that is not sufficient to product
output level Q1. Thus, the combination of
labor and capital at points A, L1, and K1
represents the cost-minimizing
combination of inputs that can be used to
produce output level Q1
FIGURE 6.A7 Cost Minimization
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Production and Cost Analysis in the Long Run

The Isocost Line

Technological change typically

increases productivity and decreases
the costs of production

FIGURE 6.A10 Change in Technology

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Production and Cost Analysis in the Long Run

Problem- EoC 6.7

The following graph shows the firm’s

cost-minimizing input choice at current
factor prices.

a. What are the current prices of capital

and labor, based on the graph?
b. Suppose that the price of labor
increases. If the firm wishes to continue
to produce the current level of output,
how will the firm’s optimal input choice
change (relative to its current choice)?
Support your answer with a graph.
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Production and Cost Analysis in the Long Run

Solution
a. PL = $5, PK = $5

TCnew > 500

b. While we cannot determine the firm’s
precise input choice without knowing the
production function, the isocost curve will
pivot on the K-axis at K = 100 and get steeper
as the wage rate rises (green line). Qnew
The firm will not be able to produce the
current level of output with the same total
cost of production. With a higher cost of
production (new isocost line, red line and red
Q curve), the optimal input mix will use
relatively less labor and relatively more
capital.
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Production and Cost Analysis in the Long Run

Problem- Exercise- EoC 6.8

The following graph shows the firm’s cost-minimizing input choice at current
factor prices. The firm is currently employing 100 units of capital and 100
units of labor. The wage rate is $20, and the price per unit of capital is $10.

a. In the short run, the firm cannot change

its level of capital. The price of labor rises to
$25. If the firm wishes to continue to
produce the current level of output, show
the firm’s short-run cost minimizing input
choice.
b. What will happen to the firm’s short-run
cost curves?
c. How will the firm’s cost-minimizing input
choice be different in the long run, when all
factors of production are variable? Support
your answer with a graph.
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Production and Cost Analysis in the Long Run

Solution
a. In the short run, with fixed capital, the firm cannot change its input mix
because capital is fixed. Thus, the firm must employ exactly the same inputs if
it wishes to produce the same quantity of output. However, the total cost of
production will increase (new isocost line).
b. The firm’s short-run cost curves will increase (shift leftward).
c. In the long run, with all factors variable, the firm will switch to an input mix
with less labor and more capital. (Note also that the rise in costs may reduce
the quantity that the firm wishes to produce.) The total cost of production
will increase in order to produce the original level of output, but not by as
much as when the input mix was held constant (part a).

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Production and Cost Analysis in the Long Run

Problem EoC 6.3

3. The following table shows the quantity and the long-
run total cost of a firm.

a. At what level(s) of quantity are there economies of

scale? Explain your answer.
b. Discuss three factors that create economies of scale.

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Production and Cost Analysis in the Long Run

Solution
a. The minimum efficient
scale occurs where the long-
run average cost curve
reaches its minimum point

b. Because there is a wide range of output over which firms

have identical costs, firms need not be the same size to be
efficient. Thus, in an industry like this, there could be firms of
the same scale or of very different scales of production.
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