Today Production and cost in the Short Run

How Costs Vary with Output

Recall: Short-Run & Long-Run Short run: When an economic agent may 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. Long run: Period of time needed so that all inputs are variable in quantity. Everything can be adjusted. (Includes the possibility of closing the firm.)

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

Graphing Total Product LTP L TP TP

Definition of Marginal Product Marginal Product of Labor (MP L ) =  TP/  L.

Add MP to the Table LTPMP 0 0n/a

6 Graphing Marginal Product LMP 0 na L TP TP 1 Marginal product can be seen as the slope of the total product curve.

Graphing Marginal Product LMP 0 n/a L TP TP 1 L MP

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). Not an economic assumption. Allows for increasing MP at initial levels of output. Applies to SR situations only (why?) Implies the slope of TP must eventually fall.

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 Variable factors in the SR: Labor Raw materials such as milk, rennet. We will ignore these.

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. QTVCTFCTC

Graph of TVC, TFC, TC Add total fixed costs vertically on top of TVC to get TC. TC is positive when Q = 0. $ Q TVC TC TFC TFC

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? QTVCAVCTCATC 00n/a10n/a

Graph of AVC, ATC ATC and AVC both are U- shaped. AVC lies everywhere below ATC. Why? $/Q Q AVC ATC

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? QTVCMCAVCTCATC 00n/an/a10n/a

Graph of MC Graph MC half- way between the old & new Q for greater accuracy. $/Q Q AVC ATC 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? Work on cost problem on handout if there is time.