Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.

9
Block 5 & 6: The Firm I & II PART A
“same” Quantity (of output)
Isoquant
Capital Input
(Good Y)
Increasing
8 Output

C
6

B
4
Q2 = 150
A
2
Q1 = 100
Q0 = 50
Labour input
0 2 4 6 8 (Good X)

• Isoquant curve: represents all the combinations of inputs (capital & labour) that provide
the same level of output for a firm.

• Higher isoquants are associated with higher levels of output.

 MRS
Slope of an Isoquant; MRTS
Capital

(+4) = (+2) (+2)

8 • A → C:  in output = (MPL)(∆L)
• C → B:  in output = (MPK)(∆K)
Q(A) = 10 Q(C) = 14 (–4) = (+1) (–4)
A C
6 • Since output is unchanged from A to B
(on same isoquant!):
– 4K ∆K (MPL)(∆L) + (MPK)(∆K) = 0
4
Q(B) = 10 (MPK)(∆K) = – (MPL)(∆L)
Marginal Product of Labour
B
2 ∆𝑲 𝑴𝑷𝑳
 𝑴𝑹𝑻𝑺 = =−
∆L Q0 = 10 ∆𝑳 𝑴𝑷𝑲
Marginal Product of Capital
Labour
0 1 2 3 4
+ 2L

• Marginal rate of technical substitution (of labour): is the amount by which the quantity of
capital has to be reduced when one extra unit of labour input is used, so that output
remains constant. MRTS = slope of the isoquant
(e.g. Excavator) • Figure (a): limited opportunities
for input substitution. If L  from 25
to 200, can only  K a little from 40 to
35 to keep output unchanged.
• Figure (b): more abundant
opportunities for input substitution. If
L  from 25 to 200, can  K
– 5K substantially from 80 to 35 & yet keep
output unchanged.
+ 175L
• More L-shaped (linear) the
(e.g. Construction isoquant, more difficult (easy) to
workers) substitute inputs.

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
1|Page
 Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A

Practice (Subject Guide Activity 5.9)

To produce a subject guide, one author & one computer are perfect complements in production.
One author and two computers would not be more productive. Two authors are more productive – but
(probably) only if they each have a computer. Draw the relevant isoquants for this case.

Now imagine that there is a machine that does exactly the same thing as a human in regard to the
production of a certain good. Labour and capital will be perfect substitutes in production in this case.
Draw the relevant isoquants for when the inputs are labour and this type of machine.

Perfect Complements in Production Perfect Substitutes in Production

K K

2 Q=2 2
Fixed proportions/Perfect complements perfect substitutes
→ perpendicular isoquants → linear isoquants
1 Q=1 1

Q=1 Q=2
1 1
L L
1 2 1 2
“same” Total cost (of inputs K & L)
Isocost Line
• Isocost line: shows the maximum combinations of inputs that the firm can afford, for a
given total cost (i.e. production budget) & the prevailing input prices.
Total Labour Cost Total Capital Cost Total cost of production
• Isocost equation: wL + rK =C
wage Qty. of capital
Qty. of labour rent
𝐶 𝑤
𝐾= − 𝐿
Vertical intercept 𝑟 𝑟 Slope; Gradient
Capital
• Vertical intercept (Pt. A): max. amount of
𝐶 A capital inputs firm can afford (L = 0).
max. capital = = 5
𝑟 o = 𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕⁄𝑷𝒄𝒂𝒑𝒊𝒕𝒂𝒍 = 𝑪⁄𝒓
4
• Horizontal intercept (Pt. F): max. amount
3
of labour inputs firm can afford (K = 0).
2
C = C0 o = 𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕⁄𝑷𝒍𝒂𝒃𝒐𝒖𝒓 = 𝑪⁄𝒘
𝒘
1 −
𝒓 F • Slope: opportunity cost of an additional
Labour unit of labour; how much capital must be
0 2 4 6 8 10
𝐶 given up for an additional unit of labour
= = max. labour (to keep total cost unchanged).
𝑤 ∆𝑲
o 𝑺𝒍𝒐𝒑𝒆 = = −𝒘⁄𝒓
∆𝑳

o Below the isocost line: affordable combinations of inputs that cost less than total
cost C0. (i.e. not fully utilise production budget C0).

o On the isocost line: affordable combinations of inputs that cost exactly total cost
C0. (i.e. fully utilise production budget C0).

o Above the isocost line: unaffordable combinations of inputs that cost more than
total cost C0 (i.e. exceed production budget C0).

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
2|Page
 Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A

Profit Maximising Input Choice $10,000 $6,000 $4,000

$0 (implicit cost)
• Economic profit = total revenue – total economic cost = TR – (explicit cost + opp. cost)
• 𝝅(𝑸) = 𝑻𝑹(𝑸) − 𝑻𝑪(𝑸) = (𝑷𝒙𝑸) − 𝑻𝑪(𝑸) Accounting Profit
max. max. min. $4,000
• Firms aim to maximise profits → maximise revenue (i.e. output) & minimise cost

• A profit-maximising firm will choose the least cost combination of inputs for a given
desired output level or the input combination that results in the highest output level for a
given total cost.
o i.e. firm selects an input combination where the isoquant and isocost are tangent.

At B, |slope| I.Q. > |slope| I.C. Capital At C, |slope| I.Q. < |slope| I.C.
𝑀𝑃𝐿 𝑤 𝑀𝑃𝐿 𝑤
> 𝐶2 Profit maximising choice <
𝑀𝑃𝐾 𝑟 𝑀𝑃𝐾 𝑟
𝑴𝑷𝑳 𝑴𝑷𝑲 𝑟 𝑴𝑷𝑳 𝑴𝑷𝑲
> 𝐶1 E <
𝒘 𝒓 D 𝒘 𝒓
→ additional output from last 𝑟 B → additional output from last
dollar spent on labour > dollar spent on labour <
additional output from last K A additional output from last
dollar spent on capital dollar spent on capital
→ to  output, L & K Q2 = 10
K → to  output, L & K
Q1 = 5 C = C2
C = C1 F − 𝑤
𝑟 𝐶 Labour
L 𝐶1 2
L
𝑤 𝑤
• Input combination A gives the highest output given the isocost C1.
𝑷𝒓𝒐𝒇𝒊𝒕 𝑴𝒂𝒙𝒊𝒎𝒊𝒔𝒂𝒕𝒊𝒐𝒏 𝑪𝒐𝒏𝒅𝒊𝒕𝒊𝒐𝒏: 𝒔𝒍𝒐𝒑𝒆 𝒐𝒇 𝒊𝒔𝒐𝒒𝒖𝒂𝒏𝒕 𝒄𝒖𝒓𝒗𝒆 = 𝒔𝒍𝒐𝒑𝒆 𝒐𝒇 𝒊𝒔𝒐𝒄𝒐𝒔𝒕 𝒍𝒊𝒏𝒆
𝑴𝑷𝑳 𝒘
− = −
𝑴𝑷𝑲 𝒓
𝑴𝑷𝑳 𝒘
=
𝑴𝑷𝑲 𝒓
𝑴𝑷𝑳 𝑴𝑷𝑲
=
𝒘 𝒓
• MPL/w = MPK/r implies that the marginal product (i.e. output) from the last dollar spent on
labour must be equal to the marginal product of the last dollar spent on capital.
o If MPL/w > MPK/r: firm gets more output from the last dollar spent on labour than
the last dollar spent on capital →  L &  K to  output.
o If MPL/w < MPK/r: firm gets more output from the last dollar spent on capital than
the last dollar spent on labour →  L &  K to  output.
o Firm should continue to adjust their spending on inputs until MPL/w = MPK/r.

• Note that combination D of inputs gives the same output Q2 but it is not the least cost
combination of inputs to achieve output Q2. In fact, the cost of this combination will be C 2,
where C2 > C1. Hence combination D is not the profit maximising way to produce output Q2.

Practice (Subject Guide Sample MCQ)

Choose the statement which is false:
When long-run costs for a firm are at a minimum
a. The ratio MPL/MPK = wage / rental. [this means the tangency condition: slope of isoquant = slope of isocost is fulfilled]
✓ b. MPL = MPK.
c. The extra output we get from the last dollar spent on an input must be the same for all inputs. [i.e. 𝒘
𝑴𝑷𝑳
=
𝑴𝑷𝑲
𝒓
]
d. The firm’s production is economically efficient. [Economically efficient means firm produce at lowest possible cost]
By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
3|Page
Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A

Impact of a Change in Input Price

K • The profit-maximising choice of
H inputs is at point A where the isocost
𝐶0 D DE is tangent to the isoquant Q0.
𝑟0
• Point A is the cost-minimizing choice
of inputs to produce output Q0 and
also gives the maximum output
B possible with isocost DE.No because efficient output
KB = Q = LK = 5x7 = 35 > 12
SEOE
K
K Practice (Subject Guide Activity 5.8)
KC C (End)
TEK A (Start) A firm has the production function Q(L, K)
KA = L*K. If L = 5 & K = 7, are they producing
efficiently if Q = 12? What level of
production is productive efficient?35What
C = C0 reasons might there be for not producing
Q = Q0 𝟓𝟎 𝑲 𝑴𝑷𝑳 𝒘 𝟓
efficiently? 𝟓= = = > = =𝟏
TEL 𝟏𝟎 𝑳 𝑴𝑷𝑲 𝒓 𝟓
Q = Q1 Suppose Q = 100, w = £5 & r = £5. The firm
OEL SEL decides to employ 50K & 10L. Is this
C = C0 efficient? No because the tangency condition is not fulfilled.
𝑤1 w
− 𝑤0
𝑟0 − Extra Question: What is the optimal qty. of K & L?
F H 𝑟0 E
L Q = LK = 100 --- (1)
LC LB 𝐶0 LA 𝐶1 𝐶0 We first need to fulfil this condition so output equals 100.
Next we need to fulfil the tangency condition.
𝑤1 𝑤1 𝑤0 𝑀𝑃𝐿 𝑤 𝐾 5 𝐾
= → = → = 1 → K = L --- (2)
𝑀𝑃𝐾 𝑟 𝐿 5 𝐿
• Suppose wage rate  from w0 to w1. Since both conditions needs to be fulfilled, subs Eqn (2) into Eqn (1)
→ isocost line steeper (because max. labour ) L(L) = 100 → L2 = 100 → L = 10 → K = L = 10.
→ new isocost line DF. Hence 10L & 10K is the least cost way to produce 100 units of output.
Total cost = wL + rK = 5(10) + 5(10) = $100.

• At original output on isoquant Q0,  in wage leads to a pure substitution effect from A to B;
the point on the old isoquant tangent to an isocost line with the new steeper slope.
→ firm substitutes the now relatively more expensive labour with capital.

• But wage rate , firm can no longer afford to produce output Q0

→ profit-maximizing output  to lower isoquant Q1, the highest possible output with the
new isocost line DF.
→ move from B to C is the pure output effect of a higher wage rate.

• When wage , L surely  as both substitution & output effects  quantity of labour.
• However, the net impact on K is uncertain as SE  K but OE  K.
• Hence in when price of an input , QD of that input will surely  (as SE & OE both  QD of
that input). However, the QD of the other input (of which the price remains unchanged) can
//unchanged (as SE & OE oppose each other)

Short-Run vs Long-Run
(capital)
• Short-run: a period of time in which the quantity of at least one input of production is fixed.
• Long-run: a period of time sufficiently long such that all inputs can be varied.
(Both K & L)
Fixed factors vs Variable Factors (in the short-run)
• Fixed factors:
o inputs whose quantity cannot be changed in the short-run. E.g. capital
o costs of fixed factors are called fixed costs: costs that are independent of output;
borne even if output is zero. E.g. rent

• Variable factors:
o inputs whose quantity can be changed in the short-run. E.g. labour
o costs of variable factors are called variable costs: costs that are positively related
to output; equal to zero if output is zero. E.g. wages.
By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
4|Page
 Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A

The Production Function

• Short-run production function: shows the relationship between variable & fixed inputs &
output produced.

• Q = f(K0, L), where K0 is a given fixed quantity of capital.

Total product; output o E.g.1: 𝑄 = 𝐾0 𝐿0.5
o E.g.2: 𝑄 = 𝐾0 𝐿
“Average output per worker” 𝑸 𝒇(𝑲𝟎 ,𝑳)
• 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝒓𝒐𝒅𝒖𝒄𝒕 𝒐𝒇 𝑳𝒂𝒃𝒐𝒖𝒓: 𝑨𝑷𝑳 = =
𝑳 𝑳
𝐾0 𝐿0.5 0.5 −1 0.5−1 𝐾0 𝐾0
o E.g.1: 𝐴𝑃𝐿 = = 𝐾0 𝐿 𝐿 = 𝐾0 𝐿 = 𝐾0 𝐿−0.5 = =
𝐿 𝐿0.5 √𝐿
𝐾0 𝐿
o E.g.2: 𝐴𝑃𝐿 = = 𝐾0
𝐿

“Additional output from an additional worker” ∆𝑸 𝒅𝒇(𝑲𝟎 ,𝑳)

• 𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑷𝒓𝒐𝒅𝒖𝒄𝒕 𝒐𝒇 𝑳𝒂𝒃𝒐𝒖𝒓: 𝑴𝑷𝑳 = = Differentiation Example
∆𝑳 𝒅𝑳
𝑑(𝐾0 𝐿0.5 ) 0.5−1 −0.5 𝐾0 𝐾0 𝑌 = 3𝑋 4
o E.g.1: 𝑀𝑃𝐿 = = 0.5𝐾0 𝐿 = 0.5𝐾0 𝐿 = =
𝑑𝐿 2𝐿0.5 2√𝐿 𝑑𝑌
= 3(4)𝑋 4−1
▪ Here, as labour , MPL  → diminishing returns to labour. 𝑑𝑋
𝑑(𝐾0 𝐿)
= 12𝑋
o E.g.2: 𝑀𝑃𝐿 = = 𝐾0
𝑑𝐿

▪ Here, as labour , MPL stays constant → NO diminishing returns to labour.

Diminishing Marginal Returns (Short-run concept)

• Diminishing marginal returns: in the short run, as more & more units of a variable factor
(e.g. labour) are added to a given amount of a fixed factor (e.g. capital), the additional output
produced by an additional unit of the variable factor (e.g. labour) will eventually fall.

Total Product / Output

Using the TP curve,
B 𝑸
• 𝑨𝑷𝑳 = = 𝑺𝒍𝒐𝒑𝒆𝒓𝒂𝒚 (from point. of origin)
TP; Q 𝑳
MPmax ∆𝑸
APmax • 𝑴𝑷𝑳 = = 𝑺𝒍𝒐𝒑𝒆𝒕𝒂𝒏𝒈𝒆𝒏𝒕 (to TP)
∆𝑳

TP  at g rate TP  at g rate TP  at g rate Practice (Subject Guide Exam MCQ)

(MPL g) Which of the following statements best
(MPL g) A (MPL < 0)
summarises the law of diminishing
marginal returns?
a. In the short run, as more labour is
marginal
hired,
˄ output diminishes.
0 8 Labour inputs ✓
b. In the short run, as more labour is
hired, output increases at a
MPL, APL MPL > APL → APL MPL < APL → APL
diminishing rate.
MPL g MPL g c. In the short run, the amount of
labour a firm will hire diminishes as
(specialisation & max. MPL (limits to specialisation means no need workers if
output increases.
output is large enough….
division of & division of labour) d. As more labour is hired, the length
labour) A MPL = max. APL &
of time that defines the short run
Overutilisation diminishes.SR is when 1 input is fixed. It is
& of the fixed factor not based on the qty. of labour.
Underutilisation
• < L3: MPL > APL → APL 
of the fixed
• At L3: MPL = APL → max. APL
factor Diminishing marginal returns sets in
• > L3: MPL < APL → APL 
B APL
0 L3 8 9 Labour inputs
MPL

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
5|Page
Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A

• The marginal product of labour curve is drawn for given level of capital. Hence it will be
higher (shift up) for a higher level of capital, vice-versa.

• Note: Marginal product is not ‘productivity’, which is average product, which is total output
divided by total labour input.

Short-run Total & Avg. Fixed Costs, Total & Avg. Variable Costs & Total & Avg. Costs
• Short-run total costs (STC)
= short-run total fixed cost (STFC) + short-run total variable cost (STVC)

STC = STFC + STVC

Total Costs
STVC 𝑺𝑻𝑽𝑪
𝑺𝑨𝑽𝑪 = = 𝑺𝒍𝒐𝒑𝒆𝒓𝒂𝒚 𝒕𝒐 𝑺𝑻𝑽𝑪
𝑸
𝑺𝑻𝑪
𝑺𝑨𝑻𝑪 = = 𝑺𝒍𝒐𝒑𝒆𝒓𝒂𝒚 𝒕𝒐 𝑺𝑻𝑪
𝑸
∆𝑺𝑻𝑪
𝑺𝑴𝑪 = = 𝑺𝒍𝒐𝒑𝒆𝒕𝒂𝒏𝒈𝒆𝒏𝒕 𝒕𝒐 𝑺𝑻𝑪
∆𝑸
STFC = 𝑺𝒍𝒐𝒑𝒆

STFC (e.g. rent)

0 Output
Q1 Q2 Q3
SMC
Costs SATC = SAVC + SAFC

SMC = min. SATC

𝑺𝑻𝑽𝑪
SAVC = 𝑸
SAFC
SAFC
SMC = min. SAVC

min. SMC 𝑺𝑻𝑭𝑪

SAFC = 𝑸

0 Output
Q1 Q2 Q3

• Short-run average fixed cost (SAFC)

𝑺𝑻𝑭𝑪
o 𝑺𝑨𝑭𝑪 =
𝑸
o  as output  as the total fixed cost is spread over ever-larger output levels.
o Hence gap between SATC & SAVC gets smaller as output .

• Short-run average total cost (SATC)

𝑺𝑻𝑪 𝑺𝑻𝑭𝑪+𝑺𝑻𝑽𝑪
o cost per unit of output. 𝑺𝑨𝑻𝑪 = = = 𝑺𝑨𝑭𝑪 + 𝑺𝑨𝑽𝑪
𝑸 𝑸
→ SATC lies above SAVC & SAFC

o Even as SAVC is ing, SATC can still be ing if the in  SAFC >  in SAVC SATC = SAVC + SAFC
→ SATC reaches its minimum (at Q3) after SAVC reaches its minimum at (Q2).

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
6|Page
Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A

Inverse Relationship between Marginal Product & Marginal Cost, Average Product & Avg. Cost
MPL, APL

MPmax A

APmax • < L3: MPL > APL → APL 

• At L3: MPL = APL → max. APL
• > L3: MPL < APL → APL 

APL
MPL
0 Labour inputs
L1 L3
Costs
Marginal < Average Marginal > Average
→ Average  → Average 

SMC SATC
Diminishing marginal returns sets in

• < Q3: SMC < SATC → SATC 

• At Q3: SMC = SATC → min. SATC
• > Q3: SMC > SATC → SATC 
SACmin
SMCmin
A
SMC = min. SATC
0 Output
Q1 Q3

• Short-run marginal cost (SMC):

o  in short-run total costs (STC) or short-run variable costs (STVC) as output  by 1.
∆𝑺𝑻𝑪 ∆𝑺𝑻𝑽𝑪
𝑺𝑴𝑪 = =
∆𝑸 ∆𝑸

o is the mirror image of the marginal product curve (so are ATC & AP)
▪ When MPL is increasing,
→ additional worker adds more to output than previous workers
→ cost of making extra output is falling
→ SMC 
▪ Once diminishing returns to labour sets in, MPL 
→ additional worker adds less to output than previous workers
→ takes successively more workers to make each extra unit of output
→ cost of making extra output is rising
→ SMC 

Practice (Subject Guide Activity 6.1)

Illustrate the following:
STC, STVC, STFC SATC, SAVC, SAFC, SMC
Cost Cost SATC
SMC
STC SAVC

STVC SAFC
SAFC
> STFC
STFC
> SMC = min. SATC

STFC SMC = min. SAVC

STFC
SAFC
Q Q
By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
7|Page
Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A

Practice (Subject Guide Activity 6.3)

Short-run total cost function: STC = F + aQ2.
• Short-run total fixed cost = F (this is the cost that exists even if Q = 0)
• Total Variable cost = aQ2 (this is the cost that exists only if Q  0)
∆𝑇𝐶 𝑑(𝐹+𝑎𝑄2 )
• Marginal cost = = = 2𝑎𝑄
∆𝑄 𝑑𝑄
𝑇𝐹𝐶 𝐹
• Average fixed cost = =
𝑄 𝑄
𝑇𝑉𝐶 𝑎𝑄2
• Average variable cost = = = 𝑎𝑄
𝑄 𝑄
𝑇𝐶 (𝐹+𝑎𝑄2 ) 𝐹 𝐹
• Average total cost = = = + 𝑎𝑄 OR = AFC + AVC = + 𝑎𝑄
𝑄 𝑄 𝑄 𝑄

Practice (Subject Guide Sample Exam MCQ)

Suppose the short-run total cost of producing T-shirts can be represented as STC = 50 + 2Q where Q
is the level of output. The average & marginal costs of the 5th T-shirt are: TFC TVC
𝑆𝑇𝐶 60
a. 50 & 2 If q = 5, 𝐴𝑇𝐶 = = = 12 Alternative way to get MC
𝑄 5

✓ b.
c.
12 & 2
50 & 10
STC = 50 + 2(5)
= 60
𝑀𝐶 =
𝑑(𝑆𝑇𝐶)
𝑑𝑄
=
𝑑(50+2𝑄)
𝑄
=2 When Q = 4, STC = 50 + 2(4) = 58
When Q = 5, STC = 50 + 2(5) = 60
d. 12 & 10. Hence marginal costs of the 5th T-shirt = 60 – 58 = 2
-----------------------------------------------------------------------------------------------------------------------------
(intersect) ----------
If short-run average total cost equals short run marginal cost, then:

✓a.b.Short-run average total cost is at a minimum.

X
Short-run marginal cost is at a minimum.
c. Both a. & b. are correct.
d. Neither a. nor b. are correct.

Long-run Total, Average & Marginal Costs

• In the long run, there are no fixed factors → total cost = 0 when output = 0.
→ all factors are variable; all costs are variable

Costs
Marginal < Average Marginal > Average
→ Average  → Average 
LATC
LMC

• < Q3: LMC < LATC → LATC 

• At Q3: LMC = LATC → min. LATC
• > Q3: LMC > LATC → LATC 
LACmin
LMCmin
A LMC = min. LATC
0 Output
Q3

Practice (Subject Guide Activity 6.5)

Draw the long-run cost curves in the boxes below as marked:

Cost LTC Cost LMC, LATC

LTC
LAC ing LAC ing LMC
 RTS; EOS  RTS; DOS LATC

LMC = min. LATC

Q Q

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
8|Page
 Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A

Returns to Scale (Economics & Diseconomies of Scale) & their link to Long-run Average Cost
Long-run concept

• Returns to scale (RTS): relationship between long-run average cost & output produced
by a firm when all inputs are changed by the same factor (i.e. in the long-run).
 𝑳𝑻𝑪 x 2
o ing RTS (Economies of Scale): LAC  as output  → downward sloping LAC 𝑳𝑨𝑪 =
𝑸 x4
▪ E.g. all inputs double; total cost double → output > double → LAC 
𝑳𝑻𝑪 x 2
o Constant RTS: LAC constant as output  → horizontal LAC 𝑳𝑨𝑪 =
▪ E.g. all inputs double; total cost double → output = double → same LAC 𝑸 x2
 𝑳𝑻𝑪 x 2
o ing RTS (Diseconomies of Scale): LAC  as output  → upward sloping LAC 𝑳𝑨𝑪 =
𝑸 x 1.5
▪ E.g. all inputs double; total cost double → output < double → LAC 

Reasons for Economies of Scale (EOS) Reasons for Diseconomies of Scale (DOS)
1) Indivisibilities in the production process 1) Geography
▪ Certain inputs come in large capacities ▪ E.g. If 1st factory is located at the best site
that a small output would underutilise. that minimises cost of transporting goods,
site of 2nd factory is less advantageous
▪ E.g. If a robot assembly line makes 5 cars a
week → enormous AC. However, at high → LAC 
output levels, the machinery cost can be ▪ E.g. In extracting coal from a mine, firm will
spread over a large output → LAC  extract the easiest coal first. To  output,
▪ There are EOS because these costs can be deeper coal seams have to be accessed
spread over more units of output as → LAC 
output  → LAC 
2) Specialization 2) Managerial diseconomies of scale
▪ A sole trader must undertake all the ▪ Large companies need many layers of
different tasks of the business. management
▪ But as the firm expands & takes on more
→ bureaucratic
workers, each worker can concentrate on → co-ordination problems arise
a single task → more efficient → LAC  → LAC 
3) Managerial
▪ Managerial costs may not  in proportion
with output.
▪ E.g. the manager can organize three
workers as easily as two.
▪ E.g. a firm requires a manager & a
telephone; cannot have half a manager &
half a telephone merely because it wishes to
operate at low output levels.

4) Marketing EOS
- Bulk purchase when firm grows larger
By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
→ more bargaining power 9|Page
→ better discount on inputs → AC 
 Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A
Output

• Output  at increasing rate (dQ/dC ing)

140 → ing RTS; EOS
→ LAC 
x 1.75
• Output  at constant rate (dQ/dC constant)
80 → constant EOS
→ LAC unchanged
x2 (EOS) (DOS)
ing RTS ing RTS
• Output  at decreasing rate (dQ/dC ing)
40
→ ing RTS; DOS
x4
→ LAC 
10

1 x 2 2 2.5 5
x 1.25 x2 (ratios)
• Composite input: combination of labour & capital where the proportions of each are held
constant/fixed. E.g. 1C = 2L + 1K → 2C = 4L + 2K

• Here, output level represented by each

successive isoquant  by an equal amount
= 400
each time.
g RTS
= 350 • Notice that the isoquants get closer (EOS)
(EOS)
= 300 & then further apart (DOS)
= 250 • Notice that the input combinations lie on the
= 200
g RTS same “ray” from the point of origin
= 150
(EOS) → fixed capital to labour ratio.
= 100
= 50

g RTS (EOS) g RTS (EOS)

The Long Run Production Function & Returns to Scale
• Cobb–Douglas long run production function: 𝑸 = 𝑲𝜶 𝑳𝜷 , where 𝜶 > 𝟎 & 𝜷 > 𝟎.
o Suppose all inputs  by  > 0
→ 𝑄1 = (𝐾)𝛼 (𝐿)𝛽 → 𝑄1 = 𝛼 𝐾 𝛼 𝛽 𝐿𝛽 → 𝑄1 = 𝛼+𝛽 𝐾 𝛼 𝐿𝛽 → 𝑄1 = 𝛼+𝛽 𝑄0
→ output  by a factor of 𝛼+𝛽
▪ α + β > 1, Cobb–Douglas production function displays increasing RTS
i.e. all inputs  by same factor → output  more than proportionally → LAC 

▪ α + β = 1, Cobb–Douglas production function displays constant RTS

i.e. all inputs  by same factor → output  by same factor → LAC unchanged

▪ α + β < 1, Cobb–Douglas production function displays decreasing RTS

i.e. all inputs  by same factor → output  less than proportionally → LAC 

Practice (Subject Guide Sample Exam MCQ)

Let the production function be Q = ALaKb where Q is output, L is labour & K is capital. The function
exhibits increasing returns to scale if:
𝑄0 = 𝐴(𝐿0 )𝑎 (𝐾0 )𝑏 =
a. a + b = 1 (constant RTS) Suppose all inputs are doubled (i.e.  = 2)
✓ b. a + b > 1
c. a + b < 1 (decreasing RTS)
𝑄1 = 𝐴(2𝐿0 )𝑎 (2𝐾0 )𝑏 = 𝐴(2)𝑎 (𝐿0 )𝑎 (2)𝑏 (𝐾0 )𝑏
= 𝐴(2)𝑎 (2)𝑏 (𝐿0 )𝑎 (𝐾0 )𝑏 = (2)𝑎+𝑏 𝐴(𝐿0 )𝑎 (𝐾0 )𝑏
d. cannot be determined with the information given. = (2)𝑎+𝑏 𝑄0
By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
10 | P a g e
 Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A

Practice (2017 Finals Zone A MCQ Q4)

LAC  as Q 
Figures a to d show long run average cost curves (LAC). Which of the figures shows economies of
scale at all levels of output?
EOS DOS
(g RTS) (g RTS) EOS (g RTS)
throughout all Q

Constant RTS
throughout all Q DOS (g RTS)
> > > > > > throughout all Q

a. figure a
✓ b.
c.
figure b
figure c
d. figure d

Relationship between Short-run Cost & Long-run Cost

SR & LR impact of w  with output unchanged
K S • Initially, with wages w0, the least cost
L way of producing output Q0 was C0,
𝐶0 D using LA and KA (i.e. Pt. A) of inputs.
𝑟0 C = C2 C = C 1
(Lower) long-run isocost
Short-run isocost needed • When wages  to w1 & if firm wishes to
to keep output unchanged at Q0
needed to keep output keep output at Q0, the new least-cost
after wage 
unchanged at Q0 after
way to producing Q0 is C2, using LB and
wage 
KB B (LR) KB (i.e. Pt. B) of inputs. (i.e. L & K)

(LR) SEK • However, changing both L & K is

KA A (SR)
only possible in the long-run.

• In the short-run, the amount of K

C = C0 remains at KA. Hence the firm will
Q = Q0
still have to continue employing LA
amount of labour and incur a higher
SEL total cost C1 in the short-run.
C = C0
𝑤1 w
− 𝑤0
𝑟0 L S −
F 𝑟0 E
L
LB 𝐶0 LA 𝐶2 𝐶1 𝐶0
𝑤1 𝑤1 𝑤1 𝑤0
(LR)

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
11 | P a g e
 Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A

Relationship between Short-run Cost & Long-run Cost

K SR & LR analysis of  in output • Suppose a firm is initially producing
𝐶0 output Q0 at a total cost C0 using least-
C = C1 cost combination LA and KA (i.e. Pt. A)
𝑟0 of inputs.
C = C2 Short-run isocost
Long-run isocost • Assume the firm wishes to  output
from Q0 to Q1. In the short-run, K
cannot be changed. Hence the firm
KC would have to use KA and LB amount of
C
(LR) OEK (LR) inputs, incurring a total cost of C1.
KA A B (SR) • However, Point B is not the least-cost
way to produce Q1 since the isocost C1
is not tangent to isoquant Q1 at Pt. B.
C = C0 Q = Q1 • In the long-run, the firm can vary both
output  K & L & hence can produce output Q1
using the least cost-combination KC
Q = Q0 and LC of inputs (i.e. Pt. C), incurring a
OEL lower total cost of C2.
𝑤0
−
𝑟0
L
LA LC 𝐶0 𝐶2 𝐶1
(LR)𝑤0 𝑤0 𝑤0
LB
(SR)

(K=1) (K=2) (K=3) (K=4)

(B)
CA
CE
CB
(C)

ing RTS ing RTS

(EOS) (DOS)

(Q0) (Q1)

• Suppose firm is initially producing output Q1 & wishes to  output to Q2.

• In the short-run, given the fixed plant size, it remains on SATC 1 & moves from point A to point
E where AC  from CA to CE.

• In the long-run, the firm is able to  its plant size & move to SATC2 & move from point E to point
B where AC  from CE to CB.

• Hence the LATC curve shows the least-cost way to make a given level of output when all
inputs are variable. → every point in LATC curve is productive efficient. Productive
efficiency occurs when a certain quantity of a good is produced at the lowest possible
input cost. i.e. firm is obtaining the maximum possible output from its inputs.
(E.g. point A & point B)
• The LATC curve is always below the SATC curve, except at point where the two coincide.

• Short-run costs typically exceed its long-run costs because in the short run the firm cannot
make all the inputs adjustments it would like.
By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
12 | P a g e
Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A

Practice (Subject Guide Sample Exam Long Question)

a. What is an isoquant?

b. Why does an isoquant get flatter as you move towards the right?

c. Draw an isoquant and an isocost line which have a point of tangency and indicate the productive
efficient level of output. How will this change if there is an increase in the wage level? Clearly
indicate output and substitution effects.

d. Use the following information to derive the total cost curve for Ice Cream Inc. (indicating three
points on the curve will be sufficient):

Production function: Q(K, L) = K*L

Rental rate of capital = £15 per hour
Wage = £15 per hour

----------------------------------------------------------------------------------------------------------------------------- ----------
The isocost line is the graph of factor inputs such that their total combined cost is equal to a given
constant. Suppose a firm uses two factor inputs, labour (L) & capital (K). Per day, the wage rate for
labour is £15 while renting units of capital costs £60.

a. Depict on a graph the isocost line for a firm spending C* = £3,000 on factor inputs. Put on this
graph a typical isoquant for output level, say Q*, to illustrate the optimal input levels N* & K* at cost
C*.

b. The government introduces a minimum wage for labour at £20. With capital fixed at K* in the short
run, show graphically & describe how much it costs the firm to continue to produce Q*.

c. Taking the minimum wage as given, show graphically & describe how the optimal factor input mix
to produce Q* changes in the long run. How does the eventual production cost compare to that in
the short run & that before the minimum wage?

----------------------------------------------------------------------------------------------------------------------------- ----------
a. Bob Smith manages a branch office of a large financial services firm. He uses computers (capital,
K) & people (labour, L) to produce consulting advice Q, according to the production function: Q = K
× L.

Employing people costs the wage rate w = 1 while renting computers costs the rental rate r. Suppose
computers cost twice what people do (i.e., r = 2w = 2). For now the number of computers in the
̅.
branch is fixed at K = 𝐾

i. How much labour does Mr Smith employ if he needs to produce output Q? Show that total
̅ + Q/𝐾
cost is C(Q) = 2𝐾 ̅

̅, derive average & marginal

ii. Given that the first derivative of the total cost function above is 1/𝐾
cost. How do average & marginal cost vary with output?

iii. Corporate headquarters has just authorised Mr Smith to upgrade the branch office by varying
the quantity of computers. What is the optimal (cost-minimising) mix of capital & labour? Using
the production function given above, the marginal product of labour is equal to K & the marginal
product of capital is equal to L.

b. In the diagram below choose levels of output for the three unlabelled isoquants such that from a to
b there are increasing returns to scale, from b to c constant returns to scale & from c to d decreasing
returns to scale.

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
13 | P a g e
Lecture 5: Chap 6, 7.1, 7.2 & 7-appendix & Chap 7.3 – 7.9
Block 5 & 6: The Firm I & II PART A

Acknowledgements & References

Economics 11e by David Begg, Gianluigi Vernasca, Stanley Fischer, Rudiger Dornbusch
ISBN: 0077154517. Publisher: Mc Graw Hill

Subject Guide 2016 for EC 1002 Introduction to Economics by O. Birchall assisted by D. Verry
University of London International Programmes

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
14 | P a g e