1 Relation Between Long Run Cost Short Short Run Cost 1

14.01 Principles of Microeconomics, Fall 2007

Chia-Hui Chen

October 17, 2007

Lecture 14
The Cost of Production and Profit

Maximization

Outline
1. Chap 7: Relation Between Long Run Cost and Short Run Cost
2. Chap 7: Economies of Scale
3. Chap 7: Economies of Scope, Learning

1 Relation Between Long Run Cost Short Short

Run Cost
Since firms can change capital in the long run, the long run cost is always no
more than the short run cost:
CL R(q) � CSR,K (q).
Figure 1 shows three short-run total cost given different capital level. In the long
run, firms will choose the capital level which minimizes the total cost. Thus,
the long-run total cost is equal to the minimum of all possible short-run total
cost, and so long run total cost is the envelope of all short run total costs.
Likewise, long-run average cost is the envelope of all short run average cost.
From Figure 1, we know for a given product q, long run marginal cost is equal
to the corresponding short run marginal cost. Long run total cost and marginal
cost also have the following relation: (see Figure 2)
• If
LM C < LAC,

LAC is decreasing;

• if
LM C = LAC,

LAC is minimized;

• if
LM C > LAC,

LAC is increasing.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
1 Relation Between Long Run Cost Short Short Run Cost 2

10

7 TCSR3

5
C

TCSR2
4

3 TCLR

TCSR1

0
0 1 2 3 4 5 6 7 8 9 10
q

Figure 1: Deriving Long Run Total Cost from Short Run Total Cost.

15

SMC3

10 SMC2 LMC

SMC1
C

SAC1 SAC2

SAC3

LAC

0
0 5 10 15
q

Figure 2: Deriving Long Run Average Cost and Marginal Cost from Short Run
Average Cost and Marginal Cost.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
2 Economies of Scale 3

2 Economies of Scale
• Constant economies of scale:

C(aq) = aC(q), a > 1,

and in this case, AC is constant;

• Economies of scale:

C(aq) < aC(q), a > 1,

and in this case, AC is decreasing;

• Diseconomies of scale:

C(aq) > aC(q), a > 1,

and in this case, AC is increasing.

10

6
AC
C

3 economies of scale diseconomies of scale

2

0
0 1 2 3 4 5 6 7 8 9 10
q

Figure 3: Production Dependence of Average Cost, Different Economies of

Scale.

3 Economies of Scope, Learning

Economies of Scope. When producing more than one type of product that
are closely linked, the cost is lower than when producing them separately.

Product Transformation Curve. Shows various combinations of outputs that

can be produced with a given set of inputs.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
3 Economies of Scope, Learning 4

Example (Product Transformation Curve with Economies of Scope). To produce

1 car and 1 truck, if we produce them separately, we need 2 units of K and 2
units of L; but if we produce them together, we only need 1.5 units of K and 1.5
units of L (see Figure 4). In this case, it is cheaper to produce them together;
thus the firm has economies of scope.

1.8

1.6

1.4

1.2
Trucks

1 K=1.5 L=1.5
(1,1)

0.8
K=1 L=1
0.6 (0.7,0,7)

0.4

0.2

0
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
Cars

Figure 4: Product Transformation Curve with Economies of Scope.

In the case of economies of scope, the product transformation curve is neg­

atively sloped and concave.
The degree of economies of scope is defined as follows:
C(q1 ) + C(q2 ) − C(q1 , q2 )
SC = .
C(q1 , q2 )
• If
SC > 0,

it is economies of scope;

• if
SC < 0,

it is diseconomies of scope.

The learning curve for a firm is shown in Figure 5, with the firm’s cumulative
output as the vertical coordinate, and amount of inputs needed to produce a
unit of output as the horizontal coordinate.
Learning causes a difference in cost between the new firm and the old firm
(see Figure 6).

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
3 Economies of Scope, Learning 5

10

8
Hours of Labor Per Unit of Output

0
0 1 2 3 4 5 6 7 8 9 10
Cumulative Number of Outputs Produced

Figure 5: Learning Curve of a Firm.

10

8 AC

5
C

3 AC*

0
0 1 2 3 4 5 6 7 8 9 10
q

Figure 6: Shift of Cost Curve from Learning.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
3 Economies of Scope, Learning 6

Figure 7: Structure of Production Theory.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].