Chapter 8
Production and Cost in the Short Run

McGraw-Hill/Irwin

Copyright © 2013 by The McGraw-Hill Companies, Inc. All...
Learning Objectives
 Explain general concepts of production and cost
analysis
 Examine the structure of short-run produc...
Basic Concepts of
Production Theory
 Production function
~ A schedule showing the maximum amount of
output that can be pr...
Basic Concepts of
Production Theory
 Technical efficiency
~ Achieved when maximum amount of output is
produced with a giv...
Basic Concepts of
Production Theory
 Inputs are considered variable or fixed depending
on how readily their usage can be ...
Basic Concepts of
Production Theory
 Short run
~ Current time span during which at least one
input is a fixed input

 Lo...
Sunk Costs
 Sunk cost
~ Payment for an input that, once made, cannot
be recovered should the firm no longer wish
to emplo...
Avoidable Costs
 Avoidable costs
~ Input costs the firm can recover or avoid
paying should it no longer wish to employ th...
Inputs in Production
Input Type

Payment

Relation
to Output

(Table 8.1)

Avoidable
or Sunk?

Employed in
SR or LR?

Vari...
Short Run Production
 In the short run, capital is fixed
~ Only changes in the variable labor input can
change the level ...
Average & Marginal Products
 Average product of labor
~ AP = Q/L

 Marginal product of labor
~ MP = Q/L
 When AP is r...
Total, Average, & Marginal Products
of Labor, K = 2 (Table 8.3)
Number of
workers (L)

Total product (Q) Average product
(...
Total, Average, & Marginal Products
K = 2 (Figure 8.1)

8-13
Short Run Production Costs
 Total fixed cost (TFC)
~ Total amount paid for fixed inputs
~ Does not vary with output

 To...
Short-Run Total Cost Schedules
(Table 8.5)
Output (Q)

Total fixed cost
(TFC)

Total variable cost
(TVC)

Total Cost
(TC=T...
Total Cost Curves

(Figure 8.3)

8-16
Average Costs
 Average fixed cost (AFC)
TFC
AVC 
Q

 Average variable cost (AVC)
TVC
AFC 
Q

 Average total cost (ATC...
Short Run Marginal Cost
 Short run marginal cost (SMC) measures
rate of change in total cost (TC) as output
varies

TVC ...
Average & Marginal Cost Schedules
(Table 8.6)
Output
(Q)

Average
Average
fixed cost
variable cost
(AFC=TFC/Q) (AVC=TVC/Q)...
Average & Marginal Cost Curves
(Figure 8.4)

8-20
Short Run Average & Marginal
Cost Curves (Figure 8.5)

8-21
Short Run Cost Curve Relations
 AFC decreases continuously as output
increases
~ Equal to vertical distance between ATC &...
Short Run Cost Curve Relations
 SMC is U-shaped
~ Intersects AVC & ATC at their minimum
points
~ Lies below AVC & ATC whe...
Relations Between Short-Run
Costs & Production
 In the case of a single variable input,
short-run costs are related to th...
Short-Run Production & Cost
Relations (Figure 8.6)

8-25
Relations Between Short-Run
Costs & Production
 When marginal product (average
product) is increasing, marginal cost
(ave...
Summary
 Technical efficiency occurs when a firm produces
maximum output for a given input combination and
technology; ec...
Summary
 The total product curve gives the economically efficient
amount of labor for any output level when capital is
fi...
Summary
 Short-run total cost, TC, is the sum of total variable
cost, TVC, and total fixed cost, TFC: TC = TVC + TFC
 Av...
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Tmprocost chap008

  1. 1. Chapter 8 Production and Cost in the Short Run McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
  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

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