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# Tmprocost chap008

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### Tmprocost chap008

2. 2. Learning Objectives  Explain general concepts of production and cost analysis  Examine the structure of short-run production based on the relation among total, average, and marginal products  Examine the structure of short-run costs using graphs of the total cost curves, average cost curves, and the short-run marginal cost curve  Relate short-run costs to the production function using the relations between (i) average variable cost and average product, and (ii) short-run marginal cost and marginal product 8-2
3. 3. Basic Concepts of Production Theory  Production function ~ A schedule showing the maximum amount of output that can be produced from any specified set of inputs, given existing technology  Variable proportions production ~ Production in which a given level of output can be produced with more than one combination of inputs  Fixed proportions production ~ Production in which one, and only one, ratio of inputs can be used to produce a good 8-3
4. 4. Basic Concepts of Production Theory  Technical efficiency ~ Achieved when maximum amount of output is produced with a given combination of inputs and technology  Economic efficiency ~ Achieved when firm is producing a given output at the lowest possible total cost 8-4
5. 5. Basic Concepts of Production Theory  Inputs are considered variable or fixed depending on how readily their usage can be changed  Variable input ~ An input for which the level of usage may be varied to increase or decrease output  Fixed input ~ An input for which the level of usage cannot be changed and which must be paid even if no output is produced  Quasi-fixed input ~ A “lumpy” or indivisible input for which a fixed amount must be used for any positive level of output ~ None is purchased when output is zero 8-5
6. 6. Basic Concepts of Production Theory  Short run ~ Current time span during which at least one input is a fixed input  Long run ~ Time period far enough in the future to allow all fixed inputs to become variable inputs  Planning horizon ~ Set of all possible short-run situations the firm can face in the future 8-6
7. 7. Sunk Costs  Sunk cost ~ Payment for an input that, once made, cannot be recovered should the firm no longer wish to employ that input ~ Irrelevant for all future time periods; not part of the economic cost of production in future time periods ~ Should be ignored for decision making purposes ~ Fixed costs are sunk costs 8-7
8. 8. Avoidable Costs  Avoidable costs ~ Input costs the firm can recover or avoid paying should it no longer wish to employ that input ~ Matter in decision making and should not be ignored ~ Variable costs and quasi-fixed costs are avoidable costs 8-8
9. 9. Inputs in Production Input Type Payment Relation to Output (Table 8.1) Avoidable or Sunk? Employed in SR or LR? Variable Variable cost Direct Avoidable SR & LR Fixed Fixed costs Constant Sunk SR only Quasi-fixed Quasi-fixed costs Constant Avoidable If required: SR & LR 8-9
10. 10. Short Run Production  In the short run, capital is fixed ~ Only changes in the variable labor input can change the level of output  Short run production function Q = f (L, K) = f (L) 8-10
11. 11. Average & Marginal Products  Average product of labor ~ AP = Q/L  Marginal product of labor ~ MP = Q/L  When AP is rising, MP is greater than AP  When AP is falling, MP is less than AP  When AP reaches it maximum, AP = MP  Law of diminishing marginal product ~ As usage of a variable input increases, a point is reached beyond which its marginal product decreases 8-11
12. 12. Total, Average, & Marginal Products of Labor, K = 2 (Table 8.3) Number of workers (L) Total product (Q) Average product (AP=Q/L) Marginal product (MP=Q/L) 0 0 -- -- 1 52 52 52 2 112 56 60 3 170 56.7 58 4 220 55 50 5 258 51.6 38 6 286 47.7 28 7 304 43.4 18 8 314 39.3 10 9 318 35.3 4 10 314 31.4 -4 8-12
13. 13. Total, Average, & Marginal Products K = 2 (Figure 8.1) 8-13
14. 14. Short Run Production Costs  Total fixed cost (TFC) ~ Total amount paid for fixed inputs ~ Does not vary with output  Total variable cost (TVC) ~ Total amount paid for variable inputs ~ Increases as output increases  Total cost (TC) TC = TFC + TVC 8-14
15. 15. Short-Run Total Cost Schedules (Table 8.5) Output (Q) Total fixed cost (TFC) Total variable cost (TVC) Total Cost (TC=TFC+TVC) 0 \$ 6,000 6,000 4,000 10,000 200 6,000 6,000 12,000 300 6,000 9,000 15,000 400 6,000 14,000 20,000 500 6,000 22,000 28,000 600 6,000 34,000 40,000 0 \$6,000 100 \$ 8-15
16. 16. Total Cost Curves (Figure 8.3) 8-16
17. 17. Average Costs  Average fixed cost (AFC) TFC AVC  Q  Average variable cost (AVC) TVC AFC  Q  Average total cost (ATC) TC ATC   AFC  AVC Q 8-17
18. 18. Short Run Marginal Cost  Short run marginal cost (SMC) measures rate of change in total cost (TC) as output varies TVC TC SMC   Q Q 8-18
19. 19. Average & Marginal Cost Schedules (Table 8.6) Output (Q) Average Average fixed cost variable cost (AFC=TFC/Q) (AVC=TVC/Q) Average total cost (ATC=TC/Q= AFC+AVC) -- Short-run marginal cost (SMC=TC/Q) 0 -- -- 100 \$60 \$40 \$100 \$40 200 30 30 60 20 300 20 30 50 30 400 15 35 50 50 500 12 44 56 80 600 10 56.7 66.7 -- 120 8-19
20. 20. Average & Marginal Cost Curves (Figure 8.4) 8-20
21. 21. Short Run Average & Marginal Cost Curves (Figure 8.5) 8-21
22. 22. Short Run Cost Curve Relations  AFC decreases continuously as output increases ~ Equal to vertical distance between ATC & AVC  AVC is U-shaped ~ Equals SMC at AVC’s minimum  ATC is U-shaped ~ Equals SMC at ATC’s minimum 8-22
23. 23. Short Run Cost Curve Relations  SMC is U-shaped ~ Intersects AVC & ATC at their minimum points ~ Lies below AVC & ATC when AVC & ATC are falling ~ Lies above AVC & ATC when AVC & ATC are rising 8-23
24. 24. Relations Between Short-Run Costs & Production  In the case of a single variable input, short-run costs are related to the production function by two relations w w AVC  and SMC  AP MP Where w is the price of the variable input TC = wL + rK 8-24
25. 25. Short-Run Production & Cost Relations (Figure 8.6) 8-25
26. 26. Relations Between Short-Run Costs & Production  When marginal product (average product) is increasing, marginal cost (average cost) is decreasing  When marginal product (average product) is decreasing, marginal cost (average variable cost) is increasing  When marginal product = average product at maximum AP, marginal cost = average variable cost at minimum AVC 8-26
27. 27. Summary  Technical efficiency occurs when a firm produces maximum output for a given input combination and technology; economic efficiency is achieved when the firm produces a given output at the lowest total cost ~ Production inputs can be variable, fixed, or quasi-fixed inputs  Short run refers to the current time span during which one or more inputs are fixed; Long run refers to the period far enough in the future that all fixed inputs become variable inputs  Sunk costs are irrelevant for future decisions and are not part of economic cost of production in future time periods; avoidable costs are payments a firm can recover or avoid, thus they do matter in decisions 8-27
28. 28. Summary  The total product curve gives the economically efficient amount of labor for any output level when capital is fixed in the short run  Average product of labor is the total product divided by the number of workers: AP = Q/L  Marginal product of labor is the additional output attributable to using one additional worker with the use of capital fixed: MP = ∆Q/∆L  The law of diminishing marginal product states that as the number of units of the variable input increases, other inputs held constant, a point will be reached beyond which the marginal product of the variable input 8-28 declines
29. 29. Summary  Short-run total cost, TC, is the sum of total variable cost, TVC, and total fixed cost, TFC: TC = TVC + TFC  Average fixed cost, AFC, is TFC divided by output: AFC = TFC/Q; average variable cost, AVC, is TVC divided by output: AVC = TVC/Q; average total cost (ATC) is TC divided by output: ATC = TC/Q  Short-run marginal cost, SMC, is the change in either TVC or TC per unit change in output Q  The link between product curves and cost curves in the short run when one input is variable is reflected in the relations, AVC = w/AP and SMC = w/MP, where w is the price of the variable input 8-29