Question

(b) If you drew a firms short run and long run cost curves in the same graph, the short run cost curve would always be above the long run cost curve, except at one level of output. Why? What is special about this level of output?

(c) On a carefully labeled diagram, illustrate the cost minimizing bundle A for a firm with cobb-douglas technology. Now consider an increase in the quantity target to some point B. Draw the new bundle of inputs for the new cost minimizing choice of the firm and illustrate the expansion path.

Answer 1

Distinction is often made between the short-run and long-run.

By short-run is meant that period of time within which a firm can vary its output by varying only the amount of variable factors, such as labour and raw material.

In the short-run period, the fixed factors such as capital equipment, management personnel, the factory buildings, etc., cannot be altered.

As in the short run, costs in the long run depend on the firm’s level of output, the costs of factors, and the quantities of factors needed for each level of output. The chief difference between long- and short-run costs is there are no fixed factors in the long run. There are thus no fixed costs. All costs are variable, so we do not distinguish between total variable cost and total cost in the long run: total cost istotal variable cost.

The long-run average cost (LRAC) curve shows the firm’s lowest cost per unit at each level of output, assuming that all factors of production are variable. The LRAC curve assumes that the firm has chosen the optimal factor mix, as described in the previous section, for producing any level of output. The costs it shows are therefore the lowest costs possible for each level of output. It is important to note, however, that this does not mean that the minimum points of each short-run ATC curves lie on the LRAC curve.

The points on an expansion path occur where the firm's isocost curves, each showing fixed total input cost, and its isoquants, each showing a particular level of output, are tangent, each tangency point determines the firm's conditional factor demands. As a producer's level of output increases, the firm moves from one of these tangency points to the next, the curve joining the tangency points is called the expansion path.