INTRODUCTION TO MICROECONOMICS Topic 5 Production These slides are copyright © 2010 by Tavis Barr. This work is licensed under a Creative Commons Attribution- ShareAlike 3.0 Unported License. See for further information.

Topic Outline ● Production Defined ● From Society to Firm ● The Production Function ● The Cost Function ● Returns to Scale

Production Defined ● Production turns resources into other resources ● Intermediate goods get used again in production ● Final goods get used by consumers Production Process Natural LaborCapital Resources (Distribution) Consumption Intermediate goods Final goods

Production Defined ● Most abstractly, resources are labor, land, and natural resources ● The available quantites of these are fixed ● Intermediate goods get produced and then used up, leaving a net production of zero at the end of the day Production Process Natural LaborCapital Resources (Distribution) Consumption Intermediate goods Final goods

From Society to Firm ● Production Possibilities frontier allows some basic analysis – Scarcity – Trade-offs – Opportunity Cost – Simple exchange

From Society to Firm ● Production Possibilities Frontier doesn't say anything about how production is organized – Capitalism? – Communism? – Theocracy? – Anarchy?

From Society to Firm Command Economy ● No one is atonomous ● All producers responsible to plan Market Economy ● Firms are autonomous (but regulated) ● Decisions centralized within firm Traditional Households ● Each producer is autonomous ● Head of household may wield power More organized/centralized Less organized/centralized

From Society to Firm Command Economy Market Economy Traditional Households More organized/centralized Less organized/centralized Problems with over- centralization: ● Accountability unclear ● Inflexibility

From Society to Firm Command Economy Market Economy Traditional Households More organized/centralized Less organized/centralized Problems with under- centralization ● Coase: Transaction costs – Finding buyers – Determining prices – Determining quality ● Williamson: Cheating – People know their specific task best – May hoard information, use to their advantage

Production Functions ● Our study will focus on the firm – Firm decision maker hires labor, buys inputs, sells outputs – What is the most profitable amount to produce? – What is the socially optimal amount to produce? ● We need a lot of tools before we can get answers ● Much of this will be applicable to households and governments

Production Functions ● A production function lists how much output you can get from a given set of inputs. – For example, a lemonade stand might have the following numbers among its production function: CupsGallonsHoursGlasses LemonsSugarWaterLaborLemonade

Production Functions ● Production function for a lemonade stand: CupsGallonsHoursGlasses LemonsSugarWaterLaborLemonade ● Production can involve hundreds of inputs. We simplify to two, usually capital and labor – Others are generally intermediate goods

Production Functions ● Production can involve hundreds of inputs. We simplify to two, usually capital and labor – Others are generally intermediate goods ● Heck, it's useful to simplify to one – Figuring out best combination of two inputs is not rocket science but it is work – We will assume that one good is flexible in the short run and the other not

Production Functions ● A fixed input is one whose quantity cannot be changed to produce more or less. – Factory that cannot be replaced – Contract for inputs such as electricity

Production Functions ● A fixed input is one whose quantity cannot be changed to produce more or less. ● We define the short run as the time period over which some inputs are fixed ● In the long run, all inputs are variable (not fixed) ● The long run is not a set length of time; it could be days or decades

Production Functions ● With one input, we can map input to output: Hrs. LaborWidgets ● Line shows positive relationship (more input leads to more output)

Production Functions ● We define marginal product as the increase in output resulting from one more unit of input Hrs. LaborWidgetsMP

Production Functions ● We define marginal product as the increase in output resulting from one more unit of input ● This measure will be useful in analyzing decision making – What happens if I hire one more worker? – If I use one more machine?

Production Functions ● We define marginal product as the increase in ouput resulting from one more unit of input ● Generally, marginal products are decreasing (negatively related to output) – In same sized factory, more labor has smaller and smaller effect

Production Functions ● We define average product as the output divided by amount of input Hrs. LaborWidgetsAP

Production Functions ● We define average product as the output divided by amount of input ● Average product is a measure of efficiency: How much is a typical worker producing?

Production Functions ● We define average product as the output divided by amount of input ● Average product is a measure of efficiency: How much is a typical worker producing?

Production Functions ● Another example of a production function FarmersWheat

Production Functions ● Another example of a production function FarmersWheat MP

Production Functions ● Another example of a production function FarmersWheat MP AP

Production Functions General Relationship between marginal and average products ● When MP>AP, AP is rising ● When MP<AP, AP is falling ● When MP=AP, AP is maximum (or minimum)

Cost Function ● A cost function tells us how much it costs to produce a certain level of output Input Combinations Amount of Output Cost of Inputs Production Function Many possible inputs Figure out cheapest Cost Function

● For example, suppose there is one input (labor) and it costs $10/hr: WidgetsLaborTotal Cost 15$50 29$90 312$ $ $200

Cost Function ● Cost function uses cheapest input combo ● If there is only one input, then only one choice

Cost Function ● We can break the short-run cost down into two components: – Fixed cost (FC) is the cost of fixed inputs. This cannot be altered in the short run to change the level of output. – Variable cost (VC) is the cost of variable inputs. To change its output in the short run, the firm must change its use of variable inputs. – Total cost equals fixed cost plus variable cost

Cost Function Example: ● Steaks are made with: – Cooks (variable input) – A kitchen (fixed input) ● Cooks cost $15/hr ● Kitchen costs $60/hr SteaksCooksVCFCTC 12$ $ $ $ $

Cost Function ● The marginal cost is the increase in total cost from producing one more unit WidgetsTCMC 1$50- 2$90$40 3$120$30 4$140$20 5$200$60

Cost Function ● The marginal cost is the increase in total cost from producing one more unit ● Marginal cost is also useful in decision making – If I produce one more, how much will it cost?

Cost Function ● The average cost is the cost per unit of output produced, i.e., total cost divided by output WidgetsTCAC 1$50$50 2$90$45 3$120$40 4$140$35 5$200$40

Cost Function ● The average cost is the cost per unit of output produced, i.e., total cost divided by output ● Average cost is also a measure of efficiency: The lower the cost for each unit, the better – Notice with average product, higher is better

Cost Function ● The average cost is the cost per unit of output produced, i.e., total cost divided by output ● Average cost is also a measure of efficiency: The lower the cost for each unit, the better – Notice with average product, higher is better

Cost Function ● The average variable cost (AVC) is the variable cost per unit of output produced, i.e., variable cost divided by output SteaksVCAVCTCAC 1$ $ $ $ $

Cost Function ● The AVC measures how efficiently the variable inputs are being used SteaksVCAVCTCAC 1$ $ $ $ $

Cost Function ● Another example of total, marginal, and average cost: CarsTC 1$1000 2$1500 3$1900 4$2200 5$3000 6$4500

Cost Function ● Another example of total, marginal, and average cost: CarsTCMC 1$ $ $ $ $ $

Cost Function ● Another example of total, marginal, and average cost: CarsTCMCAC 1$ $ $ $ $ $

Cost Function The relationship between average and marginal cost ● If MC < AC, then AC is falling ● If MC > AC, then AC is rising ● If MC=AC, then AC is minimized (or maximized)

Cost Function ● Remember, in the short run, some inputs are fixed ● We define fixed cost as the cost of all fixed inputs, and variable cost as the cost of all variable inputs ● In the long run, there are no fixed costs

Cost Function ● Because some inputs are fixed, the range of production is constrained in the short run – A certain sized factory may have trouble producing beyond its designed capacity – If a company has a fixed contract for electricity, additional energy may be more expensive ● Therefore, marginal cost eventually rises in the short run when output moves away from target level

Cost Function ● Because some inputs are fixed, the range of production is constrained in the short run ● Therefore, marginal cost eventually rises in the short run when output moves away from target level ● In the long run..... who knows?

Returns to Scale ● In short run, because fixed inputs were made with a target level of output in mind, average costs are higher outside that range ● In long run, there is no such constraint ● We have different ways of describing how average costs might behave

Returns to Scale ● Double output at less than double costs ● Bigger is more efficient ● Double output, double costs ● Size doesn't matter ● Double output at more than double costs ● Smaller is more efficient INCREASING RETURNS TO SCALE CONSTANT RETURNS TO SCALE DECREASING RETURNS TO SCALE MC < AC MC = AC MC < AC

Returns to Scale Increasing Returns to Scale Constant Returns to Scale Decreasin g Returns to Scale

Returns to Scale Returns to scale are difficult to measure in practice ● Output and costs change at the same time; difficult to separate ● Depends on the nature of competition (to be discussed more later) RTS in French industry, '77- '97 Source: Sara Maioli, A Joint Estimation of Markups and Returns to Scale in 30 French Industries Constant Increasing