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

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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
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© 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
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© 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
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© 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 1 2 3 4 5 Labour/day Capital/day
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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
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© 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 LK ) is equal to –
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