Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

Explore this textbook

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Chapter 8: Inputs, Production, and Costs in the Long Run​





















Figure 8.1: Construction projects like the one pictured require firms to look into the long run to try and allocate resources as effectively as possible. [1]

Because you did so well as a budding planner, your summer internship assignment has been extended and you have been given more responsibilities. Your boss needs to know what she should do over the next several years. She now has a planning horizon that allows her to vary all inputs. Should she buy more machines and hire fewer workers at each possible level of output? Or perhaps use fewer machines and more workers? What happens to costs if she does substitute one for the other? What will happen to total and average costs if the firm expands production with more of both labor and capital?

8.1 Learning Objectives

After reading this chapter, answering the questions in the text, and doing the exercises, you will be able to:

  • Explain how firms choose among combinations of resources.
  • Use marginal analysis to explain why, when cost is at a minimum at each level of output, the marginal products of a dollar spent on all factors of production are equal.
  • Derive a long-run average cost curve from a series of short-run cost curves.
  • Explain the shape of the long-run average cost curve and the causes of shifts in the curve.
  • Explain why firms are numerous and small in some industries but few and large in other industries.

Agriculture in China uses significant amounts of labor and relatively little capital compared to U.S. farming. Why? Does China not have access to advanced farm machinery?

Automobiles and jets are manufactured in large plants with thousands of workers and millions of dollars of capital equipment. Clothing and furniture are produced in plants with hundreds of workers and thousands of dollars of capital equipment. Why do these processes differ so greatly in size?

In the last chapter, we focused on how changes in variable inputs affect production and costs. All of that discussion was relevant to the short run. In the short run, we usually assume that labor is variable, but capital is fixed. Other inputs, such as land, may be fixed as well.

Now we will turn to the long run. We will ask similar questions regarding output, costs, and profits, but now with all inputs changing. In both the short and long run, firms attempt to produce given amounts of output at the lowest possible cost. In the short run, this means using as little of the variable input as technically possible for any given output level. In the long run, it means selecting a combination of inputs that results in the lowest possible average and total costs at a given level of output. 

Once we have discovered how firms make the choice of inputs, we will explore the effects on costs of producing at a variety of different levels.

Our web page design firm from Chapter 7 has to make two determinations in the long run. The first is how many designers to hire and how many computers to use for each possible level of output. The second is how changes in output will affect costs.

8.2 Efficient Combinations of Labor and Capital 

Figure 8.2: Farming operations require an efficient combination of both capital (the tractor) and labor (the farmer). [2]

A software firm can substitute computers for workers. An automobile manufacturer can buy more robots and hire fewer assembly line workers. It is possible to grow and harvest corn using many workers in the field, but most farms today in the United States use tractors and combines instead.

To understand how each firm makes the decisions about how to produce goods and services, we will again assume that firms want to maximize their profits. There are several steps to maximize profits. Profit maximization can only occur with minimization of costs of inputs, given the level of output. How do we find the cost-minimizing input combination for a given level of output?

Suppose you are asked to advise the manager of a McDonald's franchise for the summer. Your job is to decide on the appropriate number of workers and hamburger-cooking machines that is best for the franchise. We are going to define the best as the combination that results in the lowest cost for each level of output.

The facts are as follows: each worker hired costs the franchise $100 for an eight-hour day. Each worker produces 1000 hamburgers. The last hamburger-cooking machine was rented at $50 per eight-hour day and also resulted in an expansion of 1000 hamburgers produced per day. We will assume that workers and machines can be perfectly substituted for one another.

Assuming (for the moment) that the marginal products of labor and capital do not change as the manager hires more or less labor or rents more or fewer machines, use this information to assist the manager in deciding how to lower costs, yet maintain the current level of total product.

Let’s think about the cost and productivity of the inputs. The manager can lower costs by reducing the number of workers and expanding the number of machines. Removing one worker will lower production by 1000 and reduce costs by $100. Adding a machine will enable the remaining workers to produce 1000 more hamburgers and will add $50 to costs. Thus, the same total product will be maintained and total cost is reduced by $50. This is a fundamental use of marginal analysis : in this case, the comparison of changes, on the margin, of inputs and the effects of those changes on output and costs.

The McDonald's management question is often asked in a slightly different form and a somewhat more challenging way. If it were possible to vary labor by smaller amounts than full-day shifts and possible to rent smaller, less costly machines, perhaps for shorter time periods, how would you make the decision? What if it were possible to look at extremely small margins? In other words, what if it were possible to use just one dollar more or less of our inputs? Can the same output be produced and costs lowered by changing spending by just one dollar on labor and capital?

Question 8.01

Question 8.01

Based on the above information, should the manager change spending on inputs? If so, why?

Hover here to see the hint for Question 8.01. 
Click here to see the answer to Question 8.01.

Graphing Question 8.01​

​8.2.1 Diminishing Marginal Returns

Figure 8.3: Automated ordering systems like these allow firms to reduce the amount of labor needed. However, workers may still be required to accept the order and make it in the kitchen.

Should the manager continue to switch from labor to capital? As long as the marginal products and prices of inputs remain constant, the replacement of labor should continue. However, it is not reasonable to think of a total replacement of labor where the restaurant uses only capital. With existing technology, it is difficult to imagine a fast food restaurant or very many other kinds of retail businesses without any workers. In other words, even though the capital can add to the production process and replace some amount of labor, we still need some workers to operate the machines.

For the moment, assume a fixed amount of labor. If more machines are added, the law of diminishing returns tells us that eventually, those additional machines will add diminishing amounts of output to the firm’s production. Think about what the additional contribution of a new cooking machine would be to a given number of workers and how effective adding a single machine might be. Many more hamburgers would be cooked as the workers prepare the lettuce, tomatoes, and buns. A second machine may not add as much because workers are still needed to prepare the lettuce and tomatoes. A third machine could be added. What would happen if all the employees were already too busy to operate the third machine? It would add little to production if anything at all. Intuitively, if we already have more machines than can be effectively operated by the workers, adding even more machines won’t increase our output.

Furthermore, think of the same principle occurring, but even faster if we add machines and reduce the number of workers – not just holding the labor fixed. This would reduce the marginal productivity of machines even faster. Also, consider a situation where we keep workers constant but reduce the number of machines from three to two to one. The marginal product of capital (in Table 8.1) increases from 100 to 500 to 1,000. This is the law of diminishing returns in reverse.

Table 8.1: Total and Marginal Product of Capital

As a firm increases the amount of one factor and reduces the other factor (or holds it constant), the returns from the factor that is being increased will eventually begin to diminish. In our example, a dollar spent on machines produces 20 more hamburgers. The reduction in labor by one dollar reduces production by 10 hamburgers.

The marginal product per dollar spent on labor (left side of the inequality below) will be less than the marginal product per dollar spent on capital (right side of inequality).

This can be thought of as a “bang for your buck” comparison. We are getting less “bang for our buck” with labor compared to capital. As a result, it makes sense to use less labor and more capital, as this will reduce our costs of producing the chosen output level. However, changing the amount of inputs will change the marginal productivity of those inputs. As the number of workers is decreased, the marginal product of labor increases. As the amount of machines is increased, the marginal product of capital decreases.

For example, we might see the marginal product of one dollar of labor rise to 12 hamburgers and the marginal product of one dollar of capital decrease to 18 hamburgers.

At this point, there is still the opportunity to use less labor and more machinery and still lower costs. The process will continue until marginal productivities per dollar are equal and no more cost saving is possible. Say, for example, until:

At this point, marginal product of labor divided by its price (left side) is equal to the marginal product of capital divided by its price (right side).

Thus, in the McDonald's example, the manager should replace workers with machines to lower costs. As that happens, the marginal product of the last dollar spent on a worker rises to 15 hamburgers per worker, and the marginal product of the last dollar spent on a machine falls to 15 hamburgers per machine.

Question 8.02

Question 8.02

Can you explain why the marginal product of the worker rises?

Hover here to see the hint for Question 8.02.
Click here to see the answer to Question 8.02.


8.2.2 A Rule for Choosing the Least-Cost Combination of Inputs

As long as the marginal product per dollar spent on one input is greater than that of another, the input with the greater marginal product per dollar spent should be substituted for the other input. Remember how we got the marginal product per dollar spent? It was the marginal product of labor (MPL) divided by the wage rate (w) and the marginal product of capital (MPK) divided by the cost of that capital, which we denote with (r). Thus, if:

We see that we are getting more “bang for our buck” with labor, so more workers should be hired and fewer machines should be used. If the reverse is true and the inequality points the other direction, it means we get more “bang for our buck” with capital. Thus, more machines should be hired to replace workers. Costs will be minimized at any particular level of output if the marginal product per dollar spent on labor divided by its wage is equal to every other marginal product per dollar spent. In other words, where:

Here is the summary of the intuition: There is an inverse relationship between the amount of an input and the marginal productivity of that input, holding other inputs constant. In other words, if we keep adding labor to a fixed amount of capital, the workers eventually run out of ways to use division of labor and be effective. Their marginal product goes down. Remember the concept of diminishing marginal product here. Think about adding 20 workers to a small kitchen. Those last few workers aren’t going to add much productivity. They will just not be able to work effectively on any task. If more labor isn’t increasing productivity, it is not cost effective to use more labor. However, adding more machines (and taking away some workers) will allow the existing labor to get more done efficiently.

Question 8.03

Question 8.03

In your own words, describe the adjustment process to a least-cost combination of inputs.

Hover here to see the hint for Question 8.03.
Click here to see the answer to Question 8.03.


Question 8.04

Suppose an additional worker can handle an additional 10 orders per hour. That will cost $15 per hour. An additional telephone answering machine will handle an additional 20 calls per hour at a cost of $10 per hour. Which of the following is correct?

A

The firm should increase labor and decrease capital because labor costs more per hour.

B

The firm should increase capital and decrease labor because labor produces less per hour.

C

The firm should increase capital and decrease labor because labor produces less per dollar spent.

D

The firm should increase labor and decrease capital because labor produces less per dollar spent.


Question 8.05

A car assembly line uses workers and robots. The marginal product of a worker is currently one automobile per month. The wage and benefits of that typical worker are currently $4,000 per month. The firm could hire another robot that would cost $20,000 per month with a marginal product of four automobiles per month. If the automobile company wants to continue producing its current level of output, which of the following should it do?

A

Hire more labor and buy fewer robots

B

Hire less labor and buy more robots

C

Hire more labor and more robots

D

Change neither the current levels of labor or robots

Question 8.06

Question 8.06

Why will countries with large amounts of available labor use more labor in producing goods and services than countries with relatively smaller amounts of labor? Use supply and demand to explain prices of labor, and use the least-cost conditions of labor and capital to determine how much labor will likely be hired.

Hover here to see the hint for Question 8.06.
Click here to see the answer to Question 8.06.

Question 8.07

Question 8.07

If the marginal product of a machine is twice the marginal product of an additional worker and the cost of the machine is one-half the cost of that worker, what should a firm do about its current use of capital and labor? Explain why.

Hover here to see the hint for Question 8.07.
Click here to see the answer to Question 8.07.

Question 8.08

Question 8.08

Assume capital is fixed in the short run, but fully adjustable in the long run. In the short and long runs, an increase in wages will affect average costs in what manner? An increase in the cost of capital will affect costs in what manner?

Hover here to see the hint for Question 8.08.
Click here to see the answer to Question 8.08.

Question 8.09

Question 8.09

If the cost of labor increases, how will firms respond in the long run? Why?

Hover here to see the hint for Question 8.09.
Click here to see the answer to Question 8.09.

Question 8.10

Question 8.10

Explain why an equality of marginal product per dollar spent on inputs minimizes costs per unit of output.

Hover here to see the hint for Question 8.10.
Click here to see the answer to Question 8.10.

Question 8.11

Question 8.11

Does the law of diminishing marginal product hold in the long run? Why or why not?

Hover here to see the hint for Question 8.11.
Click here to see the answer to Question 8.11.

Question 8.12

Question 8.12

Can a firm experience diminishing marginal product and economies of scale at the same time?

Hover here to see the hint for Question 8.12.
Click here to see the answer to Question 8.12.

Question 8.13

Suppose that the cost of capital decreases and the firm must now adjust its inputs accordingly. As the firm adjusts, which of the following best describes the effect on inputs? The marginal product of labor will ________\_\_\_\_\_\_\_\_; the marginal product of machines will ________\_\_\_\_\_\_\_\_.

A

Increase; decrease

B

Not change; not change

C

Increase; increase

D

Decrease; decrease

E

Decrease; increase


Question 8.14

Assume the following data. The marginal product of labor is 150 washed cars per day. The daily wage is $60. If the marginal product of machines that would wash cars is 200 per day and the rent for the machines is $80, what will the firm do?

A

Rent more machines, because their marginal products are higher

B

Hire more workers, because they cost less per day

C

Not change the number of machines or workers

D

Expand both the number of machines and workers


Question 8.15

In the previous question, what will happen if the wage increases to $75 per day and the rent of the machines increases to $100 per day?

A

The firm should expect that its average costs will increase.

B

The firm should reduce the rental of machines and expand labor because the cost of machines increased by a larger amount.

C

The firm should hire more machines, as the marginal product of each dollar spent is less on machines.

D

The firm should hire more labor, as labor still costs less than machines.


Question 8.16

Assume firms have adjusted their hiring to be at optimum. A college-educated worker has a marginal product twice that of a worker with only a high-school education. The college-educated worker should expect that her wages will be ...

A

More than twice the amount of the high-school graduate

B

Twice the amount of the high-school graduate

C

Less than twice that of the high-school graduate

D

One cannot tell. The college worker may have better alternatives.


Question 8.17

In the long run, what will diminishing marginal returns be?

A

Relevant if all inputs are changed

B

Relevant if one input is changed while the other input is held constant or reduced

C

Not be relevant, because all inputs can be changed

D

Apply if all resources are increased in portion to one another

8.3 Output and Costs in the Long Run

Figure 8.4: Telecommunications companies have vast operations that require large amounts of capital and labor to operate. [4]

Why does a typical automobile factory produce 300,000 cars per year? Why does a typical service station put gasoline in 100,000 cars per year? A typical dentist’s office has a single dentist and two or three dental hygienists. Yet the labs that provide analysis, make caps, and design new teeth employ twenty to thirty individuals and service many dentists’ offices. Manufacturers of automobiles and jets have huge factories. Railroads and telecommunications providers are large companies. Law, medical, and dental offices and gas stations are small firms with only a few employees. Why?

Industries that are dominated by large firms often find that the average cost of goods or services is less with substantial production. Small firm industries find that average cost does not fall as the size of the firm expands and in some cases, find that average cost increases.

In a long-run business plan, a business decides how much capital to purchase – how large of a store or factory to build and how many machines to purchase – and how much labor to employ. The discussion so far in this chapter has focused on answering the question of how much labor and how much capital a business firm should employ at each level of output. Now we turn to the effects on average cost of changing the level of output by hiring more labor and purchasing more capital. We will assume that both labor and capital can be changed and that at each level of output, the firm will use the cost-minimizing combination of inputs.

If our hamburger restaurant is going to increase production in the long run, it will hire more employees, purchase more machinery, or, most likely in the long run, do both. If more resources are used, total cost will increase. A simplified total cost function representing the effect of changes in production on total cost is shown in Figure 8.5. A more difficult challenge is to identify the effects of increased production on average and marginal costs.

Figure 8.5: Long-run total cost and quantity of output.

8.3.1 Graphing Long-run Average Costs

Suppose our web page business had only three choices regarding its size. It could choose to be a small firm with little office space and three computers, a medium-sized firm with more space and ten computers, or a large firm with substantial space and many computers. The short-run average cost curves for each size of firm are shown in Figure 8.6. (Remember that in the short run only one or a few factors are varied, but at least one remains fixed. In the long run, all inputs can be varied.)

Figure 8.6: Short-run average cost curves for three possible firms.​

Average cost curves AC1, AC2, and AC3 are the short-run cost functions. For each individual cost curve, office space and computers are fixed; only labor can be changed. But in the long run, our company can choose what size it wants to be. In other words, it can choose which of the short-run curves it faces. A firm that wants to produce 200 web pages could choose the smallest size, as represented by the first average cost curve (AC1) or the middle-sized firm, as represented by the second average cost curve with ten computers (AC2). You specify which size store, office or plant the profit-maximizing firm will choose to build.

Question 8.18

If the goal is to produce 200 web pages each day for the foreseeable future, which size of office should the firm build, AC1_1, AC2_2, or AC3_3?

Question 8.19

Question 8.19

Why did you make your choice?

Hover here to see the hint for Question 8.19.
Click here to see the answer to Question 8.19.

Figure 8.7: A long-run average cost curve for three possible firms.

The shape of the long-run cost curve in Figure 8.7 is somewhat artificial. For most industries, many more than three sizes are possible. For most firms, a large number of possible firm sizes could be built. If six sizes were possible, the choices might look like those in Figure 8.8.

Figure 8.8: Short-run average cost for six firms.

Question 8.20

Question 8.20

See Figure 8.8. Which size should the firm choose if it believes that it will be producing 125 units of output per week? Which size should it be producing if wants to produce 200 units per week?

Hover here to see the hint for Question 8.20.
Click here to see the answer to Question 8.20.

Graphing Question 8.02

8.3.2 Shapes of Long-run Average Cost Curves

In the short run, average cost initially declines as output increases, partially because total fixed cost is spread over larger quantities of output. As output continues to increase, average cost eventually increases because of diminishing marginal returns. We cannot automatically come to the same conclusions about long-run costs. There are no fixed costs in the long run, and because we are increasing all inputs, the law of diminishing marginal returns does not apply as we expand output. The example in Figure 8.9 shows a series of short-run cost functions associated with different firm sizes that result in long-run average costs remaining constant, no matter the firm size. That is not always going to be true. Another possibility is that long-run average costs will decrease as firm size and output expand. A third is that long-run average cost will increase as output expands.

Figure 8.9: Long-run average cost with economies of scale.​

Figure 8.9 describes a situation known as constant returns to scale. This occurs when long-run average costs do not change (they remain constant) as the firm increases size and expands output. This can make intuitive sense. Imagine a firm as being a factory with equipment and workers producing some amount of output. If we cloned the factory, all equipment, and all workers, we would double our costs of production. But we would also double our output. Since total costs and output both doubled, the average cost of production did not change. Recall that average cost is found by taking the total cost divided by the number of units produced.

While constant returns to scale can make intuitive sense, it may not always be the case that average costs are constant as a firm expands. The larger size firms in Figure 8.10 are able to produce at lower average costs, and thus the long-run average cost function is represented by the downward sloping heavy line in Figure 8.10.

Figure 8.10: Long-run average cost with economies of scale​.


8.3.2.1 Economies of scale

If long-run average costs fall as production increases, economists describe the industry as experiencing economies of scale. As the scale of the firm grows, there are economies; that is, it is able to produce using fewer resources per product. In this case, average cost falls. Manufacturing plants often exhibit economies of scale. That is why we see automobiles manufactured in very large factories. Airplanes are made in huge factories. Steel mills and shipyards are all large. Electricity is provided by a single firm and several plants in most cities. Universities are often very large, with introductory-level courses seating hundreds of students. This allows a single instructor to generate a lot more education output. We see economies of scale all around us. But why do economics of scale exist?

The causes of economies of scale fall into three categories: specialization of all inputs, dimensional factors, and larger volume equipment. In larger firms with more labor and capital, there are more opportunities for specialization. Larger firms can have individuals who specialize in marketing, accounting, finance, and sales. In smaller firms, single individuals may have to do all of those functions and will not likely do all as well as those who specialize. Can you imagine how one person could know enough about design, steel molding, assembly, computers, fabrics, and paint to make an automobile? Even if it were possible, the manufacturing of an automobile by one person or even a small group would take a very long time and would be very expensive (a high average cost). A factory producing many cars can use an assembly line allowing specialized workers and robots to be used. But it also means that if average costs are to fall, more cars must be produced.

Dimensional factors can play a role too. Water companies use pipes to deliver water. A water pipe with twice the diameter may cost only twice as much to make, yet it can deliver four times as much water. If cost is doubled, but production is quadrupled, average cost will fall. Other firms can benefit from this larger-volume equipment concept as well. Think of a large factory making cereal. Large hoppers and storage tanks full of ingredients may have twice the acquisition cost but may hold three or four times as much volume.

The third reason (related to large-volume equipment) is that in some industries, the capital used is not easily divisible among smaller firms. Capital equipment such as assembly lines, printing presses for newspapers and books, breweries, and bottling facilities all are less costly per good produced if they are large.

In sum, you can think of economies of scale as existing because larger firms can use either more specialized inputs or larger-scale equipment, both of which reduce average costs.

There is a third possible scenario for the long-run average cost to change as output increases. In Figure 8.11, long-run average costs are rising as output increases. As firms get larger, the possible choices for average cost are higher than the smaller firms.

Figure 8.11: Long-run average cost with diseconomies of scale.​

8.3.2.2 Diseconomies of Scale

Many industries do not face the possibilities of lowering their average cost by using increased specialization or large machines. In fact, average costs may increase as the firm grows larger. In these cases, we experience diseconomies of scale

Figure 8.12: Large universities may experience diseconomies of scale with continued growth as more management and personnel programs are needed.​ [5]

Why do diseconomies of scale exist? The simple answer is because there are very large firms often have costs that smaller firms don’t. For example, if multiple locations are built or if the customer base becomes larger, goods produced by the firm may have to be shipped further, increasing transportation and shipping costs. Also, as a firm gets larger, more management and oversight of labor is needed. This may involve hiring someone with a job title such as “Regional Assistant Director,” a person who perhaps commands a high salary but may not directly increase production by very much. In addition, your firm may have to create a payroll department and a human resources department, something that a small firm will not likely need. Finally, there will just be general issues with coordination, management, communication, and bureaucracy (as well as their associated costs) when a firm grows very large.

Do firms ever experience diseconomies of scale? The answer is yes. You can probably think of very large national or international firms or even huge multi-campus universities. But why would a firm choose to grow so large that its average costs go up? The answer lies in profits. We can’t just look at costs – if the price of the output is high enough with a large enough group of consumers willing to pay, the firm will see it worthwhile to grow and produce huge output levels. All other things equal, the firm will certainly not like the higher average costs associated with diseconomies of scale, but these expenses are often necessary to keep all the parts of the business operating effectively. Significant competition will discourage firms from expanding and facing those higher costs. 

8.3.2.3 Economies and Diseconomies of Scale Together

Almost all firms can experience economies of scale, constant returns to scale, and diseconomies of scale, depending on their size. Figure 8.13 shows that as the firm increases output, long-run average costs at first decline (in area A), then remain approximately constant (in area B), and finally increase (area C). The curve looks very much like a short-run average cost curve, but in this case, we must remember it is a long-run cost curve. The shape is similar, but the reasons are quite different from those explaining the short-run relationships. The long-run average cost curve shows what happens as output expands with increases of all inputs. The firm experiences economies of scale as it begins to expand, taking advantage of input specialization and larger volume equipment. Then, it hits constant returns, where output and costs grow at the same rate. Eventually, the firm will reach diseconomies of scale.

Figure 8.13: Long-run average cost with economies of scale and diseconomies of scale.​

Question 8.21

Question 8.21

Evaluate the accuracy of this statement: "If the cost of one factor of production increases, in the long run, businesses will use less of that input. Thus, average costs will not increase."

Hover here to see the hint for Question 8.21.
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Question 8.22

Question 8.22

Assume the average Mexican factory worker has lower wages than the average U.S. factory worker and the workers have equal marginal products. Also, suppose that both factories have access to the same technology. If for the first time, a firm is free to hire labor in either country, what is likely to happen? What is likely to happen to wage levels in the two countries?

Hover here to see the hint for Question 8.22.
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Question 8.23

Question 8.23

Soft drink bottlers exist in almost every medium-sized city. Most major beer bottlers have much larger plants located only in major cities. What would the long-run average cost curves for both industries look like? Can we use them to show why we see this difference in industry structure?

Hover here to see the hint for Question 8.23.
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Question 8.24

Question 8.24

Farming in China is quite different from farming in the U.S. The farms are small in China. Planting, plowing, and harvesting are done by hand with few machines to help. Farms are significantly larger in the U.S., with automated planting and harvesting machines and huge tractors to do the plowing. Agriculture does not even look the same in the two countries. Why is China so inefficient? Surely the Chinese know that more advanced technology is available.

Hover here to see the hint for Question 8.24.
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Question 8.25

Suppose a firm doubles its inputs in the long run, and as a result, output doubles. Which of the following is true?

A

This firm is experiencing economies of scale.

B

This firm is experiencing constant returns to scale.

C

This firm is not using the lowest cost combination of capital and labor.

D

This firm is growing too fast and reducing profits.


Question 8.26

Economies of scale happen when increases in output result in _________.

A

Increasing average costs

B

Constant average costs

C

Lower average costs

D

Lower total costs


Question 8.27

What is the main source of diseconomies of scale?

A

Physical capital breaking more often with large output levels

B

Specialization of capital and labor

C

Limited ability to manage and coordinate larger amounts of inputs

D

Workers getting fatigued

8.3.3 Shapes of Long-run Marginal Cost Curves

From what you now know about average and marginal relationships (remember that the average follows the margin), you should be able to tell where long-run marginal costs are in relation to average costs. 

Graphing Question 8.03

Graphing Question 8.04

8.3.4 Shifts in Cost Curves

Figure 8.14:





















Advances in technology can allow firms to use robotic

equipment instead of labor to produce goods and services. [6]​

Changes in productivity resulting from improvements in technology (most often lowering costs) and increases or decreases in prices of inputs will change long-run costs just as they change short-run costs. As prices of inputs rise, total costs rise, and thus average costs rise at each level of output. If productivity increases, total output per unit of input increases and average cost falls. See Figure 8.15 for a graphical representation and summary of this concept.

Figure 8.15: Shifts in the cost curves.​




Question 8.28

In the long run, firms can vary _________.

A

All inputs

B

Only capital; changes in labor occur in the short run

C

Only labor; changes in capital occur in the short run

D

Neither capital or labor. In the long run, the market determines use of inputs


Question 8.29

A long-run average cost curve that rises through all levels of possible outputs represents which effect?

A

The law of diminishing marginal returns

B

Economies of scale

C

Diseconomies of scale

D

None of the above


Question 8.30

In the long run, marginal cost will be ____________\_\_\_\_\_\_\_\_\_\_\_\_ average cost if the firm is experiencing economies of scale.

A

Below

B

Above

C

Equal to

D

None of the above. Marginal cost is a short-run concept.


Question 8.31

An increase in the prices of an input will cause long-run average costs to __________\_\_\_\_\_\_\_\_\_\_.

A

Increase

B

Decrease

C

Not change. The input is fixed.

D

Either increase or decrease, depending upon whether variable inputs are substituted.

8.4 Summary

  • In the short and long runs, profit-maximizing businesses will choose the combination of inputs that minimizes the total cost at each level of output.
  • In the long run, that combination will be where the marginal product of each input divided by the price of that input is equal to the marginal product of every other input divided by its price.
  • In the long run, the minimum cost at each level of output is reached by using the size firm where short-run average costs are the lowest at that level of output.
  • Economies and diseconomies of scale determine whether long-run average costs decrease or increase as output increases.
  • Economies of scale are due to indivisible capital and advantages of specialization of labor. Diseconomies are primarily due to the difficulties of managing large operations and coordinating many different divisions.

8.5 Key Concepts

Short run 
Long run
Marginal analysis
Marginal product per dollar spent on inputs
Minimum average cost in the long run
Long-run average cost 
Long-run marginal cost
Economies and diseconomies of scale

8.6 Glossary

Average cost: Total cost divided by total output.

Average variable cost: Total variable costs divided by total output. Same as average total cost or average cost in the long run, when all costs are variable.

Constant returns to scale: Long-run average total cost remains constant as the quantity of output increases.

Diseconomies of scale: Long-run average total cost increases as the quantity of output increases.

Economies of scale: Long-run average total cost decreases as the quantity of output increases.

Long run: A time period long enough for a business to change all of its inputs (factors of production).

Marginal analysis: Comparing the additional benefits resulting from a decision with the marginal costs.

Marginal cost: The change in total costs that results from increasing total product by one unit.

Marginal product of labor (MPL): The change in total output that results from the firm hiring one more unit of labor.

Marginal product of capital (MPK): The change in total output that results from the firm hiring one more unit of capital.

Short run: A period in which at least one input or factor of production is fixed.

Total costs: All costs of producing a specific amount of output.

Total product:The total amount of output produced.

Total revenue: The amount a firm receives for its product at each level of output.

Variable costs: The costs (prices multiplied by amounts of inputs) of the inputs that can be changed. In the long run, all inputs are variable. These costs vary as output changes.





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Answers to Discussion Questions

Answer to Question 8.01

A dollar more spent on labor will provide ten more hamburgers. That is derived from dividing 1000 hamburgers, the marginal product of labor, by $100, the wage of that worker. The marginal product of another dollar spent on labor is equal to ten hamburgers per dollar spent. In other words, if 1000 hamburgers can be made with spending $100 on labor, 10 hamburgers can be made by spending $1 on labor.

Another dollar spent on machines will expand output by 20 hamburgers; 1000 hamburgers divided by $50 is equal to 20 hamburgers per dollar spent on capital. Thus, if the manager wants to maintain the current level of production, the manager should expand the capital spending by $1 (getting 20 more hamburgers) and will be able to reduce spending on labor by $2 (reducing production by two times the 10 hamburgers). Costs are lowered and quantity produced is maintained. Thus, we’ve increased our profits since the same amount of output was produced (keeping our revenues the same) but our costs of production are lower.

Click here to return to Question 8.01.







Answer to Question 8.02

This is an application of the law of diminishing marginal returns. If marginal product decreases when one input is increased, marginal product will increase as the input is reduced

Click here to return to Question 8.02.














Answer to Question 8.03

If the additional output that a company can get from hiring $1 more of one input is greater than the output that a company loses from reducing a substitute input by $1, the firm should substitute the input with the higher marginal product per dollar spent. As a result of that substitution, the marginal product of the dollar spent on the increased input will decline and the marginal product of the dollar spent on the decreased input will increase. The substitution should continue until the two marginal products are equal. At that point, switching between the two inputs will no longer lower costs.

Click here to return to Question 8.03.











Answer to Question 8.06

If demand for labor is the same in all countries, those with larger supplies of labor will have lower wages. If all countries initially use the same amounts of labor, the lower wages will mean that the marginal product per dollar spent on labor will be greater in those countries with lower wages than in other countries. The countries with the higher marginal product per dollar spent on labor will expand the amount of labor. That process will continue, decreasing the marginal product of labor, until the marginal product per dollar spent on labor is equal to the marginal product per dollar spent on capital.

Click here to return to Question 8.06.











Answer to Question 8.07

The marginal product per dollar spent on machines is greater than the marginal product per dollar spent on labor. Thus, the firm should reduce the labor and expand the amount of capital. A reduction of one worker will allow the firm to rent two machines. Because the marginal product of a machine is twice that of a worker, output (for the same cost) will increase by four times the output lost by reducing workers.

Click here to return to Question 8.07.












Answer to Question 8.08

In the short run, an increase in wages will increase variable costs (and thus average and marginal costs) and an increase in the cost of capital will increase fixed costs (and thus average costs). In the long run, increases in both will increase marginal and average costs.

Click here to return to Question 8.08.













Answer to Question 8.09

If the cost of labor increases, the firm will use more capital and less labor as it can get more output per dollar spent from capital than labor. Average cost of production will increase, as the cost of the labor still used will be higher and the additional capital used will have a lower marginal product and thus higher cost per output unit.

Click here to return to Question 8.09.













Answer to Question 8.10

If the marginal products per additional dollar spent on all inputs are not equal, a firm can reduce inputs that have lower marginal products per dollar spent, and take a portion of those dollars saved and spend them on other inputs that have higher marginal products per dollar spent. The firm will have reduced costs as a result.

Click here to return to Question 8.10.













Answer to Question 8.11

Yes, it still holds. We can still hold an input constant in the long run, but we have the option to change them all. If we hold capital constant, we’ll still see diminishing marginal returns to labor. But remember that in the long run we can add more capital if we need to.

Click here to return to Question 8.11.














Answer to Question 8.12

This is tricky, but the answer is yes. Diminishing marginal product means labor becomes less productive at the margin when capital is fixed. However, we could still add capital (in the long run) to get lower average costs with economies of scale, allowing both inputs to specialize more. Don’t get caught up thinking the firm can’t “operate at the same time” in both the short and long run – that’s not what the question is really asking. Think about the given output level and firm size. For any given level of capital, a firm could have diminishing marginal product of labor at some point. However, when capital can be changed, the firm could have economies of scale, constant returns to scale, or diseconomies of scale.

Click here to return to Question 8.12.











Answer to Question 8.19

AC1 is the correct choice. The firm would choose the smallest firm size, as the average cost of producing 200 units of output would be less than if it built a larger capacity. This is seen graphically by noticing that at output Q = 200, AC1 is below AC2. That is, the small firm will have lower average costs than the medium firm at this output level. If the firm wanted instead to produce 300 web pages, it would choose to build the medium-sized firm. A lower average cost is achieved by building the medium plant size at this higher output level. In the long run, our firm will choose the amount of capital (office space and computers) and the amount of labor that minimize average cost. Thus, the long-run average cost curve is the lowest average cost at each level of output. If we are given short-run average cost curves, the long-run average cost curve is the part of each short-run average cost curve that minimizes average cost for that specific level of output.

Click here to return to Question 8.19.










Answer to Question 8.20

At 125 units of output, the firm can choose a firm size with short-run average cost curve one, two, or three. The lowest average cost could be reached if the firm chooses size two. The smallest firm would generate a slightly higher average cost and the third largest would have the highest average cost. At 200 units of output, the firm can choose among the second, third, and fourth sizes. The second size firm appears to be the most expensive, the fourth, slightly less expensive, and the third, the least expensive. In planning for the long run, businesses will choose the size, office or factory that minimizes average cost for its chosen level of output. Thus, the long-run average cost curve, with many possible firm sizes and with each size firm able to produce at about the same minimum average cost, will look like the heavy line in Figure 8.9 (see below).

Click here to return to Question 8.20.










Answer to Question 8.21

As the price of one factor increases, a firm will use less of the factor. So the first part of the statement is true. However, total costs will rise. This is because the cost per unit still used is higher. Why? When we use more of the other input, the marginal product of that other input will be lower but have the same cost per unit as before. Thus, costs will increase due to an increased use of that factor.

Click here to return to Question 8.21.













Answer to Question 8.22

Some firms will hire Mexican labor and reduce U.S. labor. As the demand for Mexican labor increases, wages will increase. As the demand for U.S. labor decreases, wages will decrease.

Click here to return to Question 8.22.














Answer to Question 8.23

Beer bottlers may face significant economies of scale and therefore be able to produce beer more inexpensively in large plants. If soft drink bottlers do not face the same economies of scale, it may not lower costs to have just a single bottler in an area and pay greater transportation costs.

Click here to return to Question 8.23.













Answer to Question 8.24

This was answered earlier in the chapter. China is not inefficient. With less expensive labor, it makes sense to use more labor and less capital.

Click here to return to Question 8.24.













Image Credits

[1] Image courtesy of Unsplash under CC0 1.0.

[2] Image courtesy of Keith Weller, U.S. Department of Agriculture in the Public Domain.

[3] Image courtesy of FunnyKHK under CC BY-SA 3.0.

[4] Image courtesy of Tony Wills under CC BY-SA 3.0.

[5] Image courtesy of Danmichaelo under CC BY-SA 3.0.

[6] Image courtesy of ICAPlants under CC BY-SA 3.0.


Short run: a period in which at least one factor of production is fixed
Long run: A time period long enough for a business to change all of its inputs
Marginal analysis: The process of comparing the change in benefits with the change in costs resulting from an action
Think about the cost and productivity of the inputs
Think about the law of diminishing marginal product. Can it work in reverse?
A firm will try to produce the output at the lowest cost. How can it keep output the same but reduce production costs?
A high supply means a low price, ceteris paribus.
Set up a comparison of productivity per dollar to help compare the inputs.
If an input gets more expensive, will a firm use more or less of that input?
If an input gets more expensive, will a firm use more or less of that input?
Think about why an inequality (rather than equality) CANNOT result in cost minimization!
Think about how diminishing marginal product can be applied with inputs.
Does one cause the other, or are they different concepts?
Where are costs lowest for the chosen level of output?
Find the curve with the lowest cost at the chosen level of output.
Economies of scale: Long-run average total cost decreases as the quantity of output increases
Diseconomies of scale: Long-run average total cost increases as the quantity of output increases
How are all the cost functions related?
If firms are now allowed to use cheaper inputs, what will happen?
Could there be differences in the amount of economies of scale each firm has?
Is China really inefficient?