Today Production and cost in the Short

Run Print out slides #31 & #32 full-

sized for easier work.

How Costs Vary with Output

Recall: Short-Run & Long-Run Short run: When an economic

agent can adjust somewhat (but not completely) to an event.

Long run: When an agent has fully adjusted to an event.

SR & LR for a Firm Short run: Period of time during which

some important input or inputs is fixed or limited in quantity. The firm can stop producing but can’t close down.

Long run: Period of time needed so that all inputs are variable in quantity. Everything can be adjusted. The firm could close down, liquidating resources.

Example: Pizza Parlor Pizza parlor sees increased demand &

decides to sell 20% more pizzas. SR: cannot increase the size of the

building, # of ovens. May hire more workers per shift, use more ingredients, or expand the hours of business.

LR: add ovens, floor space, kitchen space. May take several months to a year.

A Note on SR & LR These are not set periods of time:

their length will depend on the type of firm or industry.

We can think of them as response times.

“Production in the SR” . . . refers to how the firm is able

to vary its level of output while some input (or inputs) is fixed in quantity.

Pizza Parlor In the short run, assume the following is

fixed: restaurant size # of ovens # of tables workspace

Variable inputs in short run labor ingredients (will not focus on these)

Adding more labor to fixed inputs # Workers Total Product

0 01 102 223 324 385 36

What can you notice about the relation between workers and total product?

Definition of Marginal Product Marginal Product of Labor (MPL) =

TP/L.

Add MP to the Table L TP MP

0 0 n/a 1 10 10 2 22 12 3 32 10 4 38 6 5 36 -2

Graphing Marginal Product L MP

0 n/a

1 102 123 104 65 -2

L

MP

1 2 3 4 5

2

468

MP

10

-2

The Pattern of MP In this example, MP increases at first.

Represents increased division of labor. Can separate cooking from serving

functions. MP then decreases.

Represents the effects of crowding. More people trying to use limited space,

equipment. MP negative: extreme crowding.

Law of Diminishing Marginal Returns Holding some important inputs (or

inputs) constant and increasing the use of another input by equal increments will eventually result in a decreasing marginal product.

Notes on the Law of Diminishing Marginal Returns A physical law (doesn’t involve

prices). Allows for increasing MP at initial

levels of output. Applies to SR situations only

(why?)

What the LDMR implies for costs Beyond some point, adding

additional labor leads to a falling Marginal Product.

This implies that beyond that same point, it will cost more and more to produce an extra unit of output.

Let’s make this idea more formal.

Definitions of TC, TFC, TVC Total cost (TC): the economic cost of

producing a given level of output. Total Fixed Cost (TFC): Costs which do

not vary with changes in output, given a particular short run situation. (Overhead)

Total Variable Cost (TVC): Costs which do vary as output changes.

TC = TFC + TVC

Ex: Producing Cheese in the Short Run Fixed factors in the

SR: Size of factory Machinery Manager

Fixed Costs (in $1,000)

Rent on factory-$6 Rent on machinery-$2 Manager salary-$2 TFC = $10

Variable factors in the SR:

Labor Raw materials such as

milk, rennet. Variable Costs

Wages of production workers

Cost of raw materials. TVC depends on Q

Ex: TVC, TFC, TC Why is TFC equal

to 10 for every Q? Where does TC

come from? Note: Q is the

same thing as TP.

Q TVC TFC TC

0 0 10 10

1 3 10 13

2 5 10 15

3 8 10 18

4 12 10 22

5 17 10 27

6 23 10 33

Definitions of ATC, AVC, AFC Average Total Cost: TC/Q, where Q

= quantity of goods produced. Average Variable Cost: TVC/Q Average Fixed Cost: TFC/Q

Table: AVC, ATC Do you

see where the values in the AVC and ATC columns come from?

Q TVC AVC TC ATC

0 0 n/a 10 n/a

1 3 3.0 13 13.0

2 5 2.5 15 7.5

3 8 2.7 18 6.0

4 12 3.0 22 5.5

5 17 3.4 27 5.4

6 23 3.8 33 5.5

Graph of AVC, ATC ATC and AVC

both are U-shaped.

AVC lies everywhere below ATC. Why?

$/Q

Q

AVC

ATC

2 4 6

4

8

12

2

6

10

14

Notes on ATC and AVC How can you see AFC on this

graph? Why do ATC and AVC grow closer

together as Q rises? The minimum of AVC occurs at a

lower level of output than for ATC. Why?

Marginal Cost Marginal Cost (MC): The change in

total cost associated with increasing output by one unit.

MC = TC Q What are marginal fixed costs equal

to? Is MC the same thing as MVC?

Table: MC Do you

see where the values in the MC column come from?

Q TVC MCMC AVC TC ATC

0 0 n/an/a n/a 10 n/a

1 3 33 3.0 13 13.0

2 5 22 2.5 15 7.5

3 8 33 2.7 18 6.0

4 12 44 3.0 22 5.5

5 17 55 3.4 27 5.4

6 23 66 3.8 33 5.5

Graph of MC Graph MC

half-way between the old & new Q for greater accuracy.

$/Q

Q

AVC

ATC

2 4 6

4

8

12

2

6

10

14

MC

Notes on MC MC must eventually rise due to the

Law of Diminishing Marginal Returns. If each successive laborer has a lower

MP, then the MC of producing one more unit is rising.

MC cuts ATC and AVC and their lowest points. Why?

The Relation between Marginal and Average When marginal cost is below average

cost, average cost will be falling. When marginal cost is above average

cost, average cost will be rising. This relationship between “marginal”

and “average” applies to all variables.

Coming Up Shift in SR cost curves Production and cost in the Long

Run Group Work

Table & Graph of firm’s costs.

Cost Curves of the Firm Fill in the blanks in the table. Use

your class notes to understand the abbreviations. Use the number of decimal places already shown in each column.

Use your answers to graph ATC, AVC, and MC onto the graph.

Table of Firm Costs in the SRQ TVC MC AVC TFC TC ATC

0 0 undef undef 3 undef

1 3 3 3.00 3 6

2 4 3 7 3.50

3 7 3 2.33 3 3.33

4 4 2.75 14 3.50

5 16 5 3 19 3.80

6 22 3.67 3 25 4.17

7 29 7 4.14 3 4.57

8 8 4.63 40 5.00

9 46 9 5.11 3 49

10 56 10 5.60 3 59

Graph of Firm Costs in the SR

0 1 2

2

1

4

6

8

10

12

6 5 4 3 7 8 9 10

0

Quantity

$/q

ATC, AVC, MC

3

5

7

9

11

Questions MC cut AVC between ___1/2 and ___1/2

units. While your graph may be slightly off, what do we know must be happening to AVC at the point where MC cuts it?

MC cut ATC between ___1/2 and ___1/2 units. While your graph may be slightly off, what do we know must be happening to AVC at the point where MC cuts it?

More Questions How should we interpret the

vertical distance between ATC and AVC on the graph?

Why does this distance shrink as quantity increases?