1 ECONOMICS chapter 4 & 5 Chapter 4- Understanding Demand Chapter 5- Understanding Supply.
Chapter 5
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Transcript of Chapter 5
Chapter 5
Production and Cost
2
Production
• Business firm – an organization– Owned and operated by private
individuals– Specializes in production
• Production– Process of combining inputs to make
goods and services• Technology
– Method of combining inputs to produce goods or services
3
The Production Function
• Indicates the maximum amount of output a firm can produce over some period of time from each combination of inputs
• Figure 1 The Firm’s Production Function
Different
Combinations of
Inputs
Different
Quantities
of Output
Production
Function
4
Short-Run versus Long-Run Decisions
• Long run– A time horizon long enough for a firm to
vary all of its inputs– Variable inputs - can be adjusted up or
down as the quantity of output changes• Short run
– A time period during which at least one of the firm’s inputs is fixed
– Fixed inputs - cannot be adjusted as output changes in the short run
5
Production in the Short-Run
• Total product– Maximum quantity of output that can be
produced from a given combination of inputs
• Marginal product of labor: MPL=ΔQ/ΔL– Additional output produced when one
more worker is hired
6
Total and Marginal Product
30
90
130
160
184196 Total Product
Q from hiring fourth worker = 30
Q from hiring third worker = 40
Q from hiring second worker = 60
Q from hiring first worker = 30
increasing marginal returns
diminishing marginal returns
Units of Output
Number of Workers62 3 4 51
• Figure 2 Total and Marginal Product
7
Marginal Returns To Labor
• Increasing marginal returns to labor– MPL increases as more labor is hired
• Diminishing marginal returns to labor– MPL decreases as more labor is hired
• Law of Diminishing Marginal Returns – As more and more of any input is added
to a fixed amount of other inputs, its marginal product will eventually decline
8
Thinking About Costs
• Total cost– The opportunity cost of the owners -
everything they must give up in order to produce that amount of output
• Sunk cost– A cost that has been paid or must be
paid, regardless of any future action being considered
– Should not be considered when making decisions
9
Explicit vs. Implicit Costs
• Explicit cost– Money actually paid out for the use of
inputs
• Implicit cost– The cost of inputs for which there is no
direct money payment
10
Costs in the Short Run
• Fixed costs – Costs of a firm’s fixed inputs
– Remain constant as output changes
• Variable costs – Costs of a firm’s variable inputs
– Change with output
11
Total Costs in the Short Run
• Total fixed cost (TFC)– The cost of all inputs that are fixed in the
short run
• Total variable cost (TVC)– The cost of all variable inputs used in
production
• Total cost (TC=TFC+TVC)– The costs of all inputs—fixed and
variable
12
Total Cost Curves
TC
0
Dollars
135
195
255
315
375
$435
30 90 130 160
Units of Output
184
TFC
TFC
TVC
• Figure 3 The Firm’s Total Cost Curves
13
Average Costs
• Average fixed cost (AFC=TFC/Q)– Total fixed cost divided by the quantity of
output produced
• Average variable cost (AVC=TVC/Q)– Cost of the variable inputs per unit of
output
• Average total cost (ATC=TC/Q)– Total cost per unit of output
14
Marginal Cost
• Marginal Cost (MC)–Increase in total cost from producing one more unit or output
ΔQ
ΔTCMC
• MC curve is U-shaped –When MPL rises, MC falls –When MPL falls, MC rises. –MPL rises and then falls, MC will fall and then rise.
15
Average and Marginal Costs
MC
AVCATCAFC
Units of Output
Dollars
$4
3
2
1
30 90 130 160 1960
• Figure 4 Average and Marginal Costs
184
16
Average and Marginal Costs
• At low levels of output– MC - below the AVC and ATC curves– AVC and ATC slope downward
• At higher levels of output– MC - above the AVC and ATC curves– AVC and ATC slope upward
• U-shaped curves• MC curve will intersect the minimum
points of the AVC and ATC curves
17
Production and Cost in the Long Run
• All inputs and all costs are variable• Least Cost Rule
– To produce any given level of output, the firm will choose the input mix with the lowest cost
• Long-run total cost (LRTC)– The cost of producing each quantity of
output when the least-cost input mix is chosen in the long run
18
Production and Cost in the Long Run
• Long-run average total cost (LRATC)–The cost per unit of output
•in the long run•all inputs are variable
Q
LRTCLRATC
• LRTC ≤ TC• LRATC ≤ ATC
19
Average Cost and Plant Size
• Plant - Collection of fixed inputs at a firm’s disposal
• Short run– Cannot change the plant size– Move along ATC curve
• Long run– Choose among ATC curves– Can change the plant size – Produce at lowest possible ATC
20
Graphing the LRATC Curve
LRATCATC1
Use 0 automated
lines
ATC3ATC0
C
BA
ATC2
D
E
175 196184
Dollars
1.00
2.00
3.00
$4.00
Units of Output
30 90 130 160 250 3000
Use 1 automated
lines
Use 2 automated
lines
Use 3 automated
lines
• Figure 5 Long-Run Average Total Cost
21
The Shape of LRATC
• Economies of scale - LRATC decreases as output increases– LRATC curve slopes downward
• More likely to occur at lower levels of output• Spreading costs of Lumpy inputs
• Diseconomies of scale - LRATC increases as output increases– LRATC curve slopes upward
• More likely at higher output levels
22
The Shape of LRATC
• Constant returns to scale - LRATC is unchanged as output increases– LRATC curve is flat
• U-shape of LRATC curve– Economies of scale at relatively low
levels of output– Constant returns to scale at some
intermediate levels of output– Diseconomies of scale at relatively high
levels of output
23
The Shape Of LRATC
Pizzas Served per Day
LRATC
Economies of Scale Constant Returns to
Scale
Diseconomies of Scale
0
Dollars
2.00
4.00
6.00
$8.00
200 250
• Figure 6 The Shape Of LRATC
24
The Urge to Merge
• Minimum efficient scale (MES)– The lowest output level at the minimum
cost per unit in the long run
• Mergers– Significant, unexploited economies of
scale
– Because the market has too many firms for each to operate near its MES
25
The Urge to Merge• Figure 7 LRATC for a Typical Firm in a Merger-Prone Industry
Dollars
Quantity
per Month
A
B
C
LRATC
$240
200
80
8,00010,000
20,000
1. With market quantity demanded fixed at 60,000, and six firms of equal market share, each operates at A
2. But any one firm can cut price slightly, increase market share, and operate with lower cost per unit, such as at the MES (point B)
3. Other firms lose market share and end up at C
5. Mergers to create three large firms would enable each
to operate at its MES with less likelihood of price wars and losses
4. Price war - other firms must match the first-mover’s
price; each firm ends up back at A - they suffer losses
26
Appendix: Isoquant Analysis
• Every point on an isoquant represents an input mix that produces the same quantity of output
• Isoquants slope downward– An increase in one input requires a
decrease in the other input to keep total production unchanged
• Higher isoquants – Greater levels of output than lower
isoquants
27
Q=4,000
Appendix: An Isoquant Map• Figure A.1 An Isoquant Map
A
B
C
Labor
(workers)
Land (hectares)
11
3
5
5
Q=2,000
F
Q=6,000
28
Appendix: MRTS
• Marginal rate of technical substitution– The rate at which a firm can substitute
one input for another while keeping output constant
– Decreases as we move rightward along an isoquant
– Is the slope of the isoquant
MRTS = MPN/MPL
29
Appendix: Isocost Lines
• An isocost line– all combinations of the two inputs– same total cost for the firm
• Isocost lines always slope downward– To use more of one input - must use less
of the other input; to keep total cost unchanged
• The slope of an isocost line: PN / PL; constant • Higher isocost lines
– Greater total costs for the firm
30
Appendix: Isocost Lines• Figure A.2 Isocost Lines
Labor
(workers)
Land
(hectares)
10
3
9
5 7.5 10
20
15
TC=$5,000
TC=$7,500
TC=$10,000
C
31
Appendix: The Least-Cost Input Combination
• The point where an isocost line is tangent to the isoquant for that output level
• MRTS=MPN/MPL=PN /PL
• MPN/PN = MPL/PL
• Many variable inputs– the marginal product per dollar of any
input will be equal to the marginal product per dollar of any other input
32
Q=4,000
Appendix: Isocost LinesFigure A.3 The Least-Cost Input Combination for a Given Output Level
10
5
20
15
TC=$5,000TC=$7,500
TC=$10,000
C
J
K
The input combinations at
J, C, and K can all be used
to produce 4,000 units of output.
The input combination at
C - where the isoquant is
tangent to the isocost line,
is the least expensive
Land
(hectares)5 7.5 10
Labor
(workers)
10
5
20
15