Lecture 06

# Lecture 06 - Introduction to Economics Lecture 6:...

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© Gustavo Indart Slide 1 ECO 100Y Introduction to Economics Lecture 6: Production and Cost in the Long-Run

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© Gustavo Indart Slide 2 Long-Run Conditions ± All factors of production are variable ± Firms can substitute one factor for another ± Firms will choose a technically efficient combination of K and L ± Production function considers technically efficient technologies ± There are several technically efficient combination of K and L to produce any given level of output
© Gustavo Indart Slide 3 Profit Maximization ± Firms try to maximize profits ± It implies cost-minimization ± Method of production must be economically efficient (and not only technically efficient)

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© Gustavo Indart Slide 4 Economically Efficient Combinations of K and L ± When the last dollar spent on K and L increases total output by the same amount MP K MP L ± = P K P L MP L P L ± = MP K P K
© Gustavo Indart Slide 5 Factor Substitution ± Suppose that at certain combination of K and L the following relationship holds: MP K MP L > P K P L ± What should be done to achieve economic efficiency? Since, beyond the point of diminishing marginal productivity, the marginal product of a factor of production decreases as more of that factor is being used in production, increasing the quantity of K will reduce MP K and decreasing the quantity of L will increase MP L . Therefore, the firm should substitute capital for labour.

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© Gustavo Indart Slide 6 Isoquants ± Different combinations of K and L can produce a given output in a technically efficient way ± For instance, let’s say that Y = 5 can be produced with either (K, L) = (2, 4) or (K, L) = (3, 3) ± An isoquant is the locus of all the technically efficient combinations of K and L that can produced a given level of output
© Gustavo Indart Slide 7 An Isoquant (Y = 5) 5 3.5 4 4 3 5 2 7 1 10 L K 0 2 4 6 8 10 12 12345 Labour/day Ca pi ta l/da y

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© Gustavo Indart Slide 8 Conditions for an Isoquant ± Isoquants satisfy three important conditions: ¾ They are downward- sloping ¾ They are convex to the origin ¾ They cannot intersect K Y 1 L
© Gustavo Indart Slide 9 An Isoquant Map The farther away an isoquant curve is from the origin, the greater the level of output it represents. Y 2 A B C Y 3 If we keep L constant at L 1 while increasing the quantity of K from K 1 to K 2 , then output must increase from Y 1 to Y 2 . If we keep K constant at K 1 while increasing the quantity of L from L 1 to L 2 , then output must increase from Y 1 to Y 2 . K K 2 K 1 Y 1 Y 0 L L 1 L 2

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© Gustavo Indart Slide 10 Marginal Rate of Technical Substitution ± As we move from one point on an isoquant to another, we are substituting one factor of production for another while keeping output constant ± The Marginal Rate of Technical Substitution (MRTS) measures the rate at which one factor of production is substituted for another with output being held constant ± The MRTS of L for K (MRTS
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## This note was uploaded on 01/16/2011 for the course ECO ECO100 taught by Professor Inheart during the Fall '09 term at University of Toronto.

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Lecture 06 - Introduction to Economics Lecture 6:...

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