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- 1. Production Analysis <ul><li>Factors of Production </li></ul><ul><ul><li>Land: </li></ul></ul><ul><ul><li>materials and forces that nature gives to man—land, water, air, light, heat, etc. </li></ul></ul><ul><ul><ul><li>Renewable and non renewable; inelastic supply. </li></ul></ul></ul><ul><ul><li>Labour </li></ul></ul><ul><ul><ul><li>Time or service that individuals put into production </li></ul></ul></ul><ul><ul><ul><li>Quantity of labour vs. quality of labour </li></ul></ul></ul><ul><ul><ul><li>Division of labour. </li></ul></ul></ul><ul><ul><li>Capital: </li></ul></ul><ul><ul><li>‘ produced means of production’. </li></ul></ul><ul><ul><li>Entrepreneurship </li></ul></ul>
- 2. <ul><li>You run General Motors. </li></ul><ul><li>List 3 different costs you have. </li></ul><ul><li>List 3 different business decisions that are affected by your costs. </li></ul>A C T I V E L E A R N I N G Brainstorming the concept of costs
- 3. Total Revenue, Total Cost, Profit <ul><li>We assume that the firm’s goal is to maximize profit . </li></ul>Profit = Total revenue – Total cost 0 the amount a firm receives from the sale of its output the market value of the inputs a firm uses in production
- 4. Costs: Explicit vs. Implicit <ul><li>Explicit costs require an outlay of money, e.g. , paying wages to workers. </li></ul><ul><li>Implicit costs do not require a cash outlay, e.g. , the opportunity cost of the owner’s time. </li></ul><ul><li>Remember one of the Ten Principles: </li></ul><ul><li>The cost of something is what you give up to get it . </li></ul><ul><li>This is true whether the costs are implicit or explicit. Both matter for firms’ decisions. </li></ul>0
- 5. Explicit vs. Implicit Costs: An Example <ul><li>You need $100,000 to start your business. The interest rate is 5%. </li></ul><ul><li>Case 1: borrow $100,000 </li></ul><ul><ul><li>explicit cost = $5000 interest on loan </li></ul></ul><ul><li>Case 2: borrow $60,000, and use $40,000 of your savings </li></ul><ul><ul><li>explicit cost = $3000 (5%) interest on the loan </li></ul></ul><ul><ul><li>implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000. </li></ul></ul>0 In both cases, total (expl + impl) costs are $5000.
- 6. Economic Profit vs. Accounting Profit <ul><li>Economic profit </li></ul><ul><ul><li>= total revenue minus total costs (including explicit and implicit costs) </li></ul></ul><ul><li>Accounting profit </li></ul><ul><ul><li>= total revenue minus total explicit costs </li></ul></ul><ul><li>Accounting profit ignores implicit costs, so it’s higher than economic profit. </li></ul>0
- 7. Economists versus Accountants How an Economist Views a Firm How an Accountant Views a Firm Revenue Total opportunity costs Revenue Economic profit Implicit costs Explicit costs Explicit costs Accounting profit
- 8. <ul><li>The equilibrium rent on office space has just increased by $500/month. </li></ul><ul><li>Compare the effects on accounting profit and economic profit if </li></ul><ul><ul><li>a. you take your office space on rent </li></ul></ul><ul><ul><li>b. you own your office space </li></ul></ul>A C T I V E L E A R N I N G Economic profit vs. accounting profit
- 9. <ul><li>The rent on office space increases $500/month. </li></ul><ul><li>a. You take your office space on rent. </li></ul><ul><li>Explicit costs increase $500/month. Accounting profit & economic profit each fall $500/month. </li></ul><ul><li>b. You own your office space. </li></ul><ul><li>Explicit costs do not change, so accounting profit does not change. Implicit costs increase $500/month (opp. cost of using your space instead of renting it out), so economic profit falls by $500/month. </li></ul>A C T I V E L E A R N I N G 2 Answers
- 10. Theory of Production <ul><li>Concepts of product: </li></ul><ul><li>Total product : </li></ul><ul><li>of a factor of production is the amount of total output produced by that factor, other factors being kept constant . </li></ul>
- 11. <ul><li>Total Product Curve </li></ul>
- 12. Total Product Curve
- 13. Concepts of product <ul><li>Average Product: </li></ul><ul><li>of a factor of production is the total output produced per unit of the factor. </li></ul><ul><li>AP = TP/(number of units of the factor) </li></ul><ul><li>If the factor is L, </li></ul><ul><li>AP L = Q/L </li></ul><ul><li>[OR] </li></ul><ul><li>AP L = TP/L </li></ul>
- 14. Concepts of product <ul><li>Marginal product (MP) of variable input: </li></ul><ul><ul><li>Change in output, (ΔQ) , resulting from a unit change of the variable input </li></ul></ul><ul><ul><li>Holding all other inputs constant </li></ul></ul>
- 15. Marginal Product <ul><li>If capital is the variable input: </li></ul><ul><li>then marginal product of capital is </li></ul>If labor is the variable input: then marginal product of labour is <ul><li>MP is analogous to the concept of marginal utility, except that MP is a cardinal number. </li></ul><ul><ul><li>Distances between any levels of MP are of a known size measured in physical quantities like bushels, bottles, kilograms, litres, etc . </li></ul></ul>
- 16. The Production Function <ul><li>A production function shows the relationship between the quantity of inputs used to produce a good, and the quantity of output of that good. </li></ul><ul><li>Can be represented by a table, equation, or graph. </li></ul><ul><ul><ul><li>Q = f (L, K, D) </li></ul></ul></ul><ul><li>Example 1: Farmer cultivating wheat </li></ul><ul><ul><li>Farmer Jack cultivates wheat. </li></ul></ul><ul><ul><li>He has 5 acres of land. </li></ul></ul><ul><ul><li>He can hire as many workers as he wants. </li></ul></ul>0
- 17. Example 1: Farmer Jack’s Production Function 0 0 500 1,000 1,500 2,000 2,500 3,000 0 1 2 3 4 5 No. of workers Quantity of output 3000 5 2800 4 2400 3 1800 2 1000 1 0 0 Q (bushels of wheat) L (no. of workers)
- 18. Marginal Product <ul><li>If Jack hires one more worker, his output rises by the marginal product of labor . </li></ul><ul><li>The marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. </li></ul><ul><li>Notation: ∆ (delta) = “change in…” </li></ul><ul><li>Examples: ∆ Q = change in output, ∆ L = change in labor </li></ul><ul><li>Marginal product of labor ( MP L ) = </li></ul>0 ∆ Q ∆ L
- 19. EXAMPLE 1: Total & Marginal Product 200 400 600 800 1000 MP L 0 3000 5 2800 4 2400 3 1800 2 1000 1 0 0 Q (bushels of wheat) L (no. of workers) ∆ Q = 1000 ∆ L = 1 ∆ Q = 800 ∆ L = 1 ∆ Q = 600 ∆ L = 1 ∆ Q = 400 ∆ L = 1 ∆ Q = 200 ∆ L = 1
- 20. EXAMPLE 1: MP L = Slope of Prod Function MP L equals the slope of the production function. Notice that MP L diminishes as L increases. This explains why the production function gets flatter as L increases. 3000 5 200 2800 4 400 2400 3 600 1800 2 800 1000 1 1000 0 0 MP L Q (bushels of wheat) L (no. of workers) 0 0 500 1,000 1,500 2,000 2,500 3,000 0 1 2 3 4 5 No. of workers Quantity of output
- 21. Why MP L Is Important <ul><li>Recall one of the Ten Principles: ‘ Rational people think at the margin.’ </li></ul><ul><li>When Farmer Jack hires an extra worker, </li></ul><ul><ul><li>his costs rise by the wage he pays the extra worker </li></ul></ul><ul><ul><li>his output rises by MP L </li></ul></ul><ul><li>Comparing them helps Jack decide whether he would benefit from hiring the worker. </li></ul>
- 22. Why MP L Diminishes <ul><li>Farmer Jack’s output rises by a smaller and smaller amount for each additional worker. Why? </li></ul><ul><li>As Jack adds workers, the each worker has less land to work with, and so, will be less productive. </li></ul><ul><li>In general, MP L diminishes as L rises, regardless of whether the fixed input is land or capital (equipment, machines, etc.). </li></ul><ul><li>Diminishing Marginal Product : the marginal product of an input declines as the quantity of the input increases (other things being constant). </li></ul>
- 23.
- 24. Production Function with One Variable Input <ul><li>Law of Variable Proportions (a.k.a. Law of Diminishing Returns) </li></ul><ul><li>The law deals with the short run production function </li></ul><ul><li>Explains the short-run changes in P </li></ul><ul><li>Quantity of one factor of production is changed; other factors held constant </li></ul><ul><ul><li>Varying proportion of the factors--‘variable proportions’ </li></ul></ul><ul><li>“ As the proportion of one factor in a combination of factors is increased, first the marginal, and then the average product of that factor will diminish. ” </li></ul>
- 25. Law of Variable Proportions
- 26. Law of Variable Proportions <ul><li>TP, MP, and AP in the 3 stages </li></ul>
- 27. Law of Variable Proportions <ul><li>The Optimum Stage of Production: </li></ul><ul><li>Stage II is the choice of a rational producer. </li></ul><ul><li>Stage I: </li></ul><ul><li>Fixed factors too much in proportion to variable factor. </li></ul><ul><li>Stage II: </li></ul><ul><li>Fixed factors and variable factor in ideal proportion. </li></ul><ul><li>Stage III: </li></ul><ul><li>Fixed factor too little in proportion to variable factor. </li></ul>
- 28. Production Function with Two Variable Inputs <ul><li>Isoquant : </li></ul><ul><li>“ An isoquant is the locus of different combinations of two factors of production, such that every combination yields the same quantity of output.” </li></ul><ul><li>Each combination on an isoquant produces the same quantity of output. </li></ul><ul><li>Iso-product curve, equal-product curve, production-indifference curve. </li></ul><ul><li>Similar to indifference curve, but cardinal value used. </li></ul>
- 29. Production Function with Two Variable Inputs <ul><li>Factor Combinations </li></ul>Factor Combination Labour Capital A 1 12 B 2 8 C 3 5 D 4 3 E 5 2
- 30. Production Function with Two Variable Inputs <ul><li>Construct isoquant from the preceding table. </li></ul><ul><li>Isoquant Map: </li></ul><ul><ul><li>Family of Isoquants </li></ul></ul><ul><ul><li>Each isoquant represents a different quantity of output </li></ul></ul><ul><ul><ul><li>Therefore, an Isoquant map represents the production function of a product with two factors. </li></ul></ul></ul>
- 31. Production Function with Two Variable Inputs <ul><li>Marginal Rate of Technical Substitution: </li></ul><ul><li>“ MRTS of labour for capital (MRTS LK ) is the number of units of capital that can be replaced by one unit of labour, the quantity of output remaining the same.” </li></ul><ul><li>MRTS LK = ∆K / ∆L </li></ul><ul><li>∆ K / ∆L = MP L / MP K </li></ul><ul><li>Therefore, MRTS LK = MP L / MP K </li></ul>
- 32. Production Function with Two Variable Inputs <ul><li>∆ K / ∆L = MP L / MP K </li></ul><ul><li>Proof: </li></ul><ul><li>On an isoquant, </li></ul><ul><li>Loss of output due to reduction of K </li></ul><ul><li>= </li></ul><ul><li>Gain in output due to addition of L </li></ul><ul><li>(∆K * MP K ) = (∆L * MP L ) </li></ul><ul><li> ∆ K / ∆L = MP L / MP K </li></ul>
- 33. Production Function with Two Variable Inputs <ul><li>Diminishing Marginal Rate of Technical Substitution : </li></ul><ul><li>As we go on replacing K with L, the quantity of K that can be replaced by one additional unit of L goes on decreasing. </li></ul><ul><li>This is due to: </li></ul><ul><li>the principle of diminishing returns. </li></ul>
- 34. Production Function with Two Variable Inputs <ul><li>General Properties of Isoquants: </li></ul><ul><li>Slope downward to the right </li></ul><ul><li>Can’t touch or intersect one another </li></ul><ul><li>Convex to the origin </li></ul>
- 35. Production Function with Two Variable Inputs <ul><li>Iso-Cost Line : </li></ul><ul><li>Iso-cost line is the locus of different combinations of factors that a firm can buy with a constant outlay. </li></ul><ul><li>Also known as outlay line. </li></ul>
- 36. Production Function with Two Variable Inputs <ul><li>Slope of the iso-cost line: </li></ul><ul><li>slope of the isocost line = ratio of prices of the two factors </li></ul><ul><ul><li>Proof: </li></ul></ul><ul><ul><li>C Total Outlay (i.e., amount of money spent) r Price of Capital; w Price of Labour </li></ul></ul><ul><ul><li>Maximum quantity of Capital = OB </li></ul></ul><ul><ul><li>Maximum quantity of Labour = OL </li></ul></ul><ul><li>Therefore, slope of the Isocost line = OB/OL </li></ul>
- 37. Production Function with Two Variable Inputs <ul><li>If C is used to buy only Labour, </li></ul><ul><li>C = OL * w </li></ul><ul><li>OL = C / w </li></ul><ul><li>If C is used to buy only Capital, </li></ul><ul><li>C = OB * r </li></ul><ul><li>OB = C / r </li></ul>
- 38. Production Function with Two Variable Inputs <ul><li>Therefore, </li></ul><ul><li>OB/OL = (C/r) ÷ (C/w) </li></ul><ul><li>(C/r) * (w/C) </li></ul><ul><li>w/r </li></ul><ul><li>Thus, OB / OL = w / r </li></ul><ul><li>Slope of isocost line = Ratio of prices of the two factors </li></ul>
- 39. Production Function with Two Variable Inputs <ul><li>Shifts in Iso-Cost Line </li></ul><ul><li>Three causes of shifts-- </li></ul><ul><ul><li>Shifts due to changes in cost of one factor at a time </li></ul></ul><ul><ul><li>Shifts due to changes in cost of both factors </li></ul></ul><ul><ul><li>Shifts due to changes in outlay </li></ul></ul>
- 40. Production Function with Two Variable Inputs <ul><li>Two approaches to deciding output and cost of production: </li></ul><ul><ul><li>Maximising output for a given outlay. </li></ul></ul><ul><ul><li>Minimising the outlay for a given quantity of output. (least-cost combination of factors) </li></ul></ul><ul><li>Both involve isoquants and iso-cost lines. </li></ul>
- 41. Production Function with Two Variable Inputs <ul><li>Maximising Output for a given outlay: </li></ul>
- 42. Production Function with Two Variable Inputs <ul><li>Minimising outlay for a given output: </li></ul>
- 43. Production Function with Two Variable Inputs <ul><li>Expansion Path : </li></ul><ul><li>“ The expansion path is the locus of the various least-cost combinations of the two factors as the firm ‘expands’ its output.” </li></ul><ul><li>Diagram of Expansion Path. </li></ul><ul><li>Note that an expansion path only shows us the cheapest (i.e., most efficient) way of producing each level of output. It does not tell us where exactly on the path a producer is situated. </li></ul>
- 44. Production Function with Two Variable Inputs <ul><li>Returns to Scale </li></ul><ul><li>‘ Scale ’ refers to the proportion of the factors used. </li></ul><ul><li>Proportional change in all the factors is called a change in the scale. </li></ul><ul><li>Returns to scale refers to how output responds to an equiproportionate change in all inputs. </li></ul>
- 45. Production Function with Two Variable Inputs <ul><li>Returns to Scale </li></ul><ul><li>Increasing Returns to Scale: </li></ul><ul><li>If the change in output is in greater proportion than the change in input, returns to scale are said to be increasing. </li></ul><ul><li>In other words, if an increase in scale leads to an increase in the output by a greater proportion, the returns to scale are said to be increasing. </li></ul><ul><li>Diagram: (Q2/Q1) > (OA2/OA1) </li></ul>
- 46. Production Function with Two Variable Inputs <ul><li>Returns to Scale </li></ul><ul><li>Constant Returns to Scale : </li></ul><ul><li>If the change in output is equal in proportion to the change in input, returns to scale are said to be constant. </li></ul><ul><li>If an increase in scale leads to an increase in the output by the same proportion, the returns to scale are said to be constant. </li></ul><ul><li>Diagram: (Q2/Q1) = (OA2/OA1) </li></ul>
- 47. Production Function with Two Variable Inputs <ul><li>Returns to Scale </li></ul><ul><li>Decreasing Returns to Scale: </li></ul><ul><li>If the change in output is in a smaller proportion than the change in input, returns to scale are said to be decreasing. </li></ul><ul><li>In other words, if an increase in scale leads to an increase in the output by a smaller proportion, the returns to scale are said to be decreasing. </li></ul><ul><li>Diagram: (Q2/Q1) < (OA2/OA1) </li></ul>
- 48. Production Function with Two Variable Inputs <ul><li>Returns to Scale </li></ul><ul><li>In reality, all three types of returns to scale are found in within a firm. </li></ul><ul><li>Diagram </li></ul>
- 49. Cost-Benefit Analysis in an Advertisement
- 50. Cost Concepts <ul><li>Fixed Costs; Variable Costs; Total Cost </li></ul><ul><li>Average Fixed Cost; Average Variable Cost; Average Total Cost [a.k.a. Average Cost] </li></ul><ul><li>Marginal Cost </li></ul>
- 51. EXAMPLE 1: Farmer Jack’s Costs <ul><li>Farmer Jack must pay $1,000 per month for the land, regardless of how much wheat he grows. </li></ul><ul><li>The market wage for a farm worker is $2,000 per month. </li></ul><ul><li>So Farmer Jack’s costs are related to how much wheat he produces…. </li></ul>
- 52. Fixed and Variable Costs <ul><li>Fixed cost ( FC ) – </li></ul><ul><li>does not vary with the quantity of output produced. </li></ul><ul><ul><li>For Farmer Jack, FC = $1000 for his land </li></ul></ul><ul><ul><li>Other examples: cost of equipment, loan payments </li></ul></ul><ul><li>Variable cost ( VC ) – </li></ul><ul><li>varies with the quantity produced. </li></ul><ul><ul><li>For Farmer Jack, VC = wages he pays workers </li></ul></ul><ul><ul><li>Other example: cost of materials </li></ul></ul><ul><li>Total cost ( TC ) </li></ul><ul><li>FC + VC </li></ul>0
- 53. EXAMPLE 1: Farmer Jack’s Costs Total Cost 3000 5 2800 4 2400 3 1800 2 1000 1 0 0 Cost of labor Cost of land Q (bushels of wheat) L (no. of workers) 0 $11,000 $9,000 $7,000 $5,000 $3,000 $1,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000
- 54. EXAMPLE 1: Farmer Jack’s Total Cost Curve Q (bushels of wheat) Total Cost 0 $1,000 1000 $3,000 1800 $5,000 2400 $7,000 2800 $9,000 3000 $11,000
- 55. Marginal Cost <ul><li>Marginal Cost ( MC ): </li></ul><ul><li>is the increase in Total Cost due the production of one more unit of the output. </li></ul>∆ TC ∆ Q MC =
- 56. EXAMPLE 1: Total and Marginal Cost $10.00 $5.00 $3.33 $2.50 $2.00 Marginal Cost ( MC ) $11,000 $9,000 $7,000 $5,000 $3,000 $1,000 Total Cost 3000 2800 2400 1800 1000 0 Q (bushels of wheat) ∆ Q = 1000 ∆ TC = $2000 ∆ Q = 800 ∆ TC = $2000 ∆ Q = 600 ∆ TC = $2000 ∆ Q = 400 ∆ TC = $2000 ∆ Q = 200 ∆ TC = $2000
- 57. EXAMPLE 1: The Marginal Cost Curve MC usually rises as Q rises, as in this example. $11,000 $9,000 $7,000 $5,000 $3,000 $1,000 TC MC 3000 2800 2400 1800 1000 0 Q (bushels of wheat) $10.00 $5.00 $3.33 $2.50 $2.00
- 58. Why MC Is Important <ul><li>Farmer Jack is rational and wants to maximize his profit. To increase profit, should he produce more or less wheat? </li></ul><ul><li>To find the answer, Farmer Jack needs to “think at the margin.” </li></ul><ul><li>If the cost of producing additional wheat ( MC ) is less than the revenue he would get from selling it, then Jack’s profits rise if he produces more. </li></ul>
- 59. EXAMPLE 2 <ul><li>The next example is more general, applies to any type of firm, producing any good with any types of inputs. </li></ul>
- 60. Example 2: Costs 7 6 5 4 3 2 1 0 TC VC FC Q $0 $100 $200 $300 $400 $500 $600 $700 $800 0 1 2 3 4 5 6 7 Q Costs FC VC TC 0 620 480 380 310 260 220 170 $100 520 380 280 210 160 120 70 $0 100 100 100 100 100 100 100 $100
- 61. EXAMPLE 2: Marginal Cost Recall, Marginal Cost ( MC ) is the change in total cost from producing one more unit: Usually, MC rises as Q rises, due to diminishing marginal product. Sometimes (as here), MC falls before rising. (In other examples, MC may be constant.) 620 7 480 6 380 5 310 4 260 3 220 2 170 1 $100 0 MC TC Q 140 100 70 50 40 50 $70 ∆ TC ∆ Q MC =
- 62. EXAMPLE 2: Average Fixed Cost 100 7 100 6 100 5 100 4 100 3 100 2 100 1 $100 0 AFC FC Q Average fixed cost ( AFC ) is the fixed cost per unit of the quantity of output: AFC = FC / Q Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units. 0 14.29 16.67 20 25 33.33 50 $100 n.a.
- 63. EXAMPLE 2: Average Variable Cost 520 7 380 6 280 5 210 4 160 3 120 2 70 1 $0 0 AVC VC Q Average variable cost ( AVC ) is the variable cost per unit of the output: AVC = VC / Q As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises. 0 74.29 63.33 56.00 52.50 53.33 60 $70 n.a.
- 64. EXAMPLE 2: Average Total Cost [a.k.a. Average Cost] ATC 620 7 480 6 380 5 310 4 260 3 220 2 170 1 $100 0 TC Q 0 Average total cost ( ATC ) is the total cost per unit of the output: ATC = TC / Q Also, ATC = AFC + AVC 88.57 80 76 77.50 86.67 110 $170 n.a. 74.29 14.29 63.33 16.67 56.00 20 52.50 25 53.33 33.33 60 50 $70 $100 n.a. n.a. AVC AFC
- 65. EXAMPLE 2: Average Total Cost Usually, as in this example, the ATC curve is U-shaped. 88.57 80 76 77.50 86.67 110 $170 n.a. ATC 620 7 480 6 380 5 310 4 260 3 220 2 170 1 $100 0 TC Q 0 $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs
- 66. EXAMPLE 2: The Various Cost Curves Together 0 AFC AVC ATC MC $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs
- 67. A C T I V E L E A R N I N G 3 : Costs <ul><li>Fill in the blank spaces of this table. </li></ul>210 150 100 30 10 VC 43.33 35 8.33 260 6 30 5 37.50 12.50 150 4 36.67 20 16.67 3 80 2 $60.00 $10 1 n.a. n.a. n.a. $50 0 MC ATC AVC AFC TC Q 60 30 $10
- 68. <ul><li>First, deduce FC = $50 and use FC + VC = TC . </li></ul>A C T I V E L E A R N I N G 3 : Answers Use AFC = FC / Q Use AVC = VC / Q Use relationship between MC and TC Use ATC = TC / Q 210 150 100 60 30 10 $0 VC 43.33 35 8.33 260 6 40.00 30 10.00 200 5 37.50 25 12.50 150 4 36.67 20 16.67 110 3 40.00 15 25.00 80 2 $60.00 $10 $50.00 60 1 n.a. n.a. n.a. $50 0 MC ATC AVC AFC TC Q 60 50 40 30 20 $10
- 69. EXAMPLE 2: Why ATC Is Usually U-Shaped 0 As Q rises: Initially, falling AFC pulls ATC down. Eventually, rising AVC pulls ATC up. $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs
- 70. EXAMPLE 2: ATC and MC 0 When MC < ATC , ATC is falling. When MC > ATC , ATC is rising. The MC curve crosses the ATC curve at the ATC curve’s minimum. That is, when MC=AC, ATC is at its minimum. ATC MC $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs
- 71. Costs in the Short Run & Long Run <ul><li>Short run: Some inputs are fixed ( e.g., factories, land). The costs of these inputs are FC . </li></ul><ul><li>Long run: All inputs are variable ( e.g., firms can build more factories, or sell existing ones) </li></ul><ul><li>In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q ( e.g ., the factory size with the lowest ATC ). </li></ul>
- 72. EXAMPLE 3: LRATC with 3 factory Sizes Firm can choose from 3 factory sizes: S , M , L . Each size has its own SRATC curve. The firm can change to a different factory size in the long run, but not in the short run. ATC S ATC M ATC L Q Avg Total Cost
- 73. EXAMPLE 3: LRATC with 3 factory Sizes LRATC To produce less than Q A , firm will choose size S in the long run. To produce between Q A and Q B , firm will choose size M in the long run. To produce more than Q B , firm will choose size L in the long run. ATC S ATC M ATC L Q Avg Total Cost Q A Q B
- 74. A Typical LRATC Curve In the real world, factories come in many sizes, each with its own SRATC curve. So a typical LRATC curve looks like this: Q ATC LRATC
- 75. How ATC Changes As the Scale of Production Changes Economies of scale : ATC falls as Q increases. Constant returns to scale : ATC stays the same as Q increases. Diseconomies of scale : ATC rises as Q increases. LRATC Q ATC
- 76. How ATC Changes As the Scale of Production Changes <ul><li>Economies of scale occur when increasing production allows greater specialization: workers more efficient when focusing on a narrow task. </li></ul><ul><ul><li>More common when Q is low. </li></ul></ul><ul><li>Diseconomies of scale are due to coordination problems in large organizations. E.g ., management becomes stretched, can’t control costs. </li></ul><ul><ul><li>More common when Q is high. </li></ul></ul>
- 77. Summary <ul><li>Implicit costs do not involve a cash outlay, yet are just as important as explicit costs to firms’ decisions. </li></ul><ul><li>Accounting profit is revenue minus explicit costs. Economic profit is revenue minus total (explicit + implicit) costs. </li></ul><ul><li>The production function shows the relationship between output and inputs. </li></ul>
- 78. Summary <ul><li>The marginal product of labor is the increase in output from a one-unit increase in labor, holding other inputs constant. The marginal products of other inputs are defined similarly. </li></ul><ul><li>Marginal product usually diminishes as the input increases. Thus, as output rises, the production function becomes flatter, and the total cost curve becomes steeper. </li></ul><ul><li>Variable costs vary with output; fixed costs do not. </li></ul>
- 79. Summary <ul><li>Marginal cost is the increase in total cost from an extra unit of production. The MC curve is usually upward-sloping. </li></ul><ul><li>Average variable cost is variable cost divided by output. </li></ul><ul><li>Average fixed cost is fixed cost divided by output. AFC always falls as output increases. </li></ul><ul><li>Average total cost (sometimes called “cost per unit”) is total cost divided by the quantity of output. The ATC curve is usually U-shaped. </li></ul>
- 80. Summary <ul><li>The MC curve intersects the ATC curve at minimum average total cost. When MC < ATC, ATC falls as Q rises. When MC > ATC, ATC rises as Q rises. </li></ul><ul><li>In the long run, all costs are variable. </li></ul><ul><li>Economies of scale: ATC falls as Q rises. Diseconomies of scale: ATC rises as Q rises. Constant returns to scale: ATC remains constant as Q rises. </li></ul>
- 81. CONCLUSION <ul><li>Costs are critically important to many business decisions, including production, pricing, and hiring. </li></ul><ul><li>These slides have introduced the various cost concepts. </li></ul><ul><li>The following unit will show how firms use these concepts to maximize profits in various market structures. </li></ul>
- 82. Law of Diminishing Marginal Returns <ul><li>A firm’s costs will depend on </li></ul><ul><ul><li>Prices it pays for inputs </li></ul></ul><ul><ul><li>Technology of combining inputs into output </li></ul></ul><ul><li>In short run firm can change its output by adding variable inputs to fixed inputs </li></ul><ul><ul><li>Output may at first increase at an increasing rate </li></ul></ul><ul><ul><li>However, given a constant amount of fixed inputs, output will at some point increase at a decreasing rate </li></ul></ul><ul><ul><ul><li>Occurs because at first variable input is limited compared with fixed input </li></ul></ul></ul><ul><ul><ul><ul><li>As additional workers are added, productivity remains very high </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Output, or TP, increases at an increasing rate </li></ul></ul></ul></ul><ul><ul><ul><ul><li>However, as more of variable input is added, it is no longer as limited </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Eventually, TP will still be increasing, but at a decreasing rate </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>MP L will still be positive, but declining </li></ul></ul></ul></ul></ul>
- 83. Law of DMR <ul><li>Diminishing marginal returns starts at point A </li></ul><ul><ul><li>MP L is at a maximum </li></ul></ul><ul><li>To the left of point A there are increasing returns and at point A constant returns exist </li></ul><ul><li>Between points A and B, where MP L is declining, diminishing marginal returns exist </li></ul><ul><li>To the right of point B, marginal productivity is both diminishing and negative (MP L < 0), which violates Monotonicity Axiom </li></ul>
- 84. Law of DMR <ul><li>TP curve will at some point increase only at a decreasing rate (concave) due to Law of Diminishing Marginal Returns </li></ul>

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