2 The long runThe long run is the time frame longer or just as long as it takes the firm to alter the physical plant or production facility.Thus the long run is that time period in which all inputs are variable.
3 cost and outputKOn this slide I want to concentrate on one level of output, as summarized by the isoquant. Input combination E1, K1 could be used and have cost summarized by 4th highest isocost shown. E2, K2 would be cheaper, and E*, K*K1K2K*EE1 E E*is the lowest cost to produce the given level of output. Herethe cheapest cost of the output occurs at a tangency point.
4 cost and outputOn the last screen we saw the tangency of an isoquant and isocost line showsthe cheapest way to produce a certain level of output.The exception to reaching the tangency would be the short run when the amount of some input can not be changed to reach the tangency. In the long run all inputs can be changed in amount and thus the tangency point could be reached.
5 short runKHere the cheapest way to produce the output level as depicted in the isoquant would be to hire E*, K*. But maybe the firm has committed to having K1 units of capital. Thus the cost of this output is indicated by the fourth highest isocost line.K1K2K*EE1 E E*We could follow K1 out and see costs of other levels of output(by putting in more isoquants).
6 Tangency means equal slopes So in the long run when the firm has minimized cost we see a tangency of the slopes of the isoquant and an isocost line.The slope of the isocost line is the negative of the ratio of input prices -(w/r),And the slope of the isoquant is the negative of the ratio of marginal products -(MPE/ MPK). So the tangency means-(MPE/ MPK) = -(w/r) and the negative signs cancel out.
7 Economic meaning of this tangency The equality on the previous page can be rewritten asMPE/w = MPK/r. This says the ratio of the marginal product of each input to the inputs price has to be equal across all inputs for the firm to minimize the cost of making a level of output. Numerical example:Say MPE= 20, w = 10, MPK= 200, r = Then we have 20/10 = 200/100 = 2/1. This means the last dollar spent on each input must yield the same increment to output. Here 2 units of output is obtained from the last dollar spent on each input.
8 Marginal product per dollar spent The statement on the end of the previous screen is that the marginal product per dollar spent must be equal across all inputs. What if it was not? Remember that if you take more of an input the marginal product diminishes (and thus if you take less the marginal product rises) Say the marginal product of capital is 100 and the price is 10 and the marginal product of labor is 20 and the price is 5. So per dollar spent you get 10 units of output from capital and 4 units from labor. Capital has more “bang for the buck,” so take more capital and less labor to move toward equality of ratios.
9 Another view We saw to have cost minimization we need MPE/w = MPK/r. If we take the inverse of these ratio’s we havew/MPE = r / MPK .Recall that that w is the wage and is the change in cost from hiring an additional laborer and MPE is the marginal product of labor, so the ratio is really the marginal cost of production. Another way to see the tangency condition is to say the marginal cost of output is the same for each input used.
10 profit maximizationFirms want to maximize profit. To maximize profit they have to sell the right amount of output and produce that output at the lowest cost. We have just seen lowest cost means produce at a tangency point. In a competitive environment to maximize profit means to sell the output level where the price is equal to the marginal cost. Both of these statements imply w/MPE = r / MPK = p, and thusw = pMPE and r = pMPK.In other words, to maximize profit produce where the wage is equal to the value of the marginal product of labor and where the price of capital is equal to the value of the marginal product of capital.
11 wage fall and impact on isocost line KIf the wage falls the isocost line rotates counterclockwise. The isocost line becomes flatter. More labor can be purchased given a cost amount.E
12 A wage fall may mean that the profit maximizing level of output will have a higher cost than before. If so a lower wage may not only flatten an isoquant, but shift it out as well.
13 substitution and scale effects of a wage fall. KQRPE
14 substitution and scale effects of a wage fall On the previous screen when the wage falls the budget flattens and shifts out and the firm moves from point P to point R. You can see the demand for labor by the firm rises as the wage falls. We break this movement from P to R into two moves: from P to Q and from Q to R.P to Q is called the scale effect of a lower wage.Q to R is called the substitution effect of a lower wage.
15 scale effectThe movement from P to Q is called the scale effect. The real points the firm moves from are from point P to R and its associated isoquants. The movement from P to Q is hypothetical. It is a movement from the original point to a point on the final isoquant, but only a parallel shift of the isocost.The movement is to highlight what happens as the “scale” of output increases when the wage falls. The firm takes advantage of the lower wage by expanding output.
16 substitution effectThe substitution effect is the movement from Q to R. The firm takes advantage of the wage fall by rearranging its mix of inputs, while holding output constant.Here I show the long run demand for labor. It looks like an ordinary demand curve. But you and I know that when the wage falls the quantity of labor demanded rises and behind the scenes that demand for capital may adjust as well.wageW1w2LaborP R
17 Special cases of isoquants We will explore two types of isoquants.1 - the case of inputs being perfect substitutes, and2 - the case of inputs being perfect complements.Before we look at these two let’s review the normal isoquant we have already seen.
18 IsoquantKIn the neighborhood around A, where there is relatively little E and much K, the firm can give up a relatively large amount of K for one more E, but when you are in area B with little capital you can only give up a little capital for one more E. The MRTS is said to diminish the more E we haveEA B
19 perfect substitutesKPerfect subs is a situation where you can always get one more E by giving up the same amount of K, no matter how much of E you start with.As an example say if give up a machine you always need to replace the machine with two workers if you want to maintain the same level of output.The isoquants are straight lines here.E
20 perfect complementsKcomplements mean we have to use things in combination with each other. Say we have a production process where for every machine we need 4 workers, no more no less. The isoquants are right angles - if you have one machine you need four workers but five workers won’t change output because you only have one machine.14E
21 scale and sub effects again KP to Q - scale effectQ to R - Sub effectreal move - P to RQRPE
22 perfect substitutes K Q Thick lines are isoquants. P to Q scale effect Q to R sub effect.The sub effect is as large as it gets here.PRE
23 perfect complements K P to Q - scale effect Q to R - Sub effect real move - P to RThe sub effect is zero here.Q = RPE