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

What’s the Firm’s Objective? Maximize Profit Why Do Firm’s Exist? Coase (1937) Nature of Firm followed by Oliver Williamson. Going to the Market has transactions costs. Hire workers, negotiate prices and enforce contracts. A firm is essentially a device for creating long-term contracts when short-term contracts are too bothersome. Short-cut the market, so why don’t firms get bigger? . The proper balance between hierarchies and markets is constantly recalibrated by the forces of competition: entrepreneurs may choose to lower transaction costs by forming firms but giant firms eventually become sluggish and uncompetitive. Mr Coase's theory continues to explain some of the most puzzling problems in modern business. Take the rise of vast and highly diversified business groups in the emerging world, such as India's Tata group and Turkey's Koc Holding. Many Western observers dismiss these as relics of a primitive form of capitalism. But they make perfect sense when you consider the transaction costs of going to the market. Where trust in established institutions is scarce, it makes sense for companies to stretch their brands over many industries. And where capital and labour markets are inefficient, it makes equal sense for companies to allocate their own capital and train their own loyalists. But Mr Coase's narrow focus on transaction costs nevertheless provides only a partial explanation of the power of firms. The rise of the neo-Coasian school of economists has led to a fierce backlash among management theorists who champion the “resource-based theory” of the firm. They argue that activities are conducted within firms not only because markets fail, but also because firms succeed: they can marshal a wide range of resources—particularly nebulous ones such as “corporate culture” and “collective knowledge”—that markets cannot access. Companies can organise production and create knowledge in unique ways. They can also make long-term bets on innovations that will redefine markets rather than merely satisfy demand. Mr Coase's theory of “market failure” needs to be complemented by a theory of “organisational advantages”.

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

Basic Concepts of Production Theory To maximize profit a firm must produce as efficiently as possible. 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 To maximize profit a firm must produce as efficiently as possible. A firm engages in efficient production (achieves technological efficiency) if it cannot produce its current level of output with fewer inputs, given existing knowledge about technology and the organization of production.

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

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

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

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

Opportunity Costs Meredith’s firm sends her to a conference for managers and has paid her registration fee. Included in the registration fee is free admission to a class on how to price derivative securities such as options. She is considering attending, but her most attractive alternative opportunity is to attend a talk by Warren Buffett about his investment strategies, which is scheduled at the same time. Although she would be willing to pay $100 to hear his talk, the cost of a ticket is only $40. Given that there are no other costs involved in attending either event, what is Meredith’s opportunity cost of attending the derivatives talk? To calculate her opportunity cost, determine the benefit that Meredith would forgo by attending the derivatives class. Because she incurs no additional fee to attend the derivatives talk, Meredith’s opportunity cost is the foregone benefit of hearing the Buffett speech. Because she values hearing the Buffett speech at $100, but only has to pay $40, her net benefit from hearing that talk is $60 (= $100 – $40). Thus, her opportunity cost of attending the derivatives talk is $60.

Inputs in Production (Table 8.1) Input Type Payment Relation to Output Avoidable or Sunk? Employed in SR or LR? Variable Variable cost Fixed Fixed costs Quasi-fixed Quasi-fixed costs Direct Avoidable SR & LR Constant Sunk SR only Constant Avoidable If required: SR & LR

Short Run Production Q = f (L, K) = f (L) 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)

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

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) 1 52 2 112 3 170 4 220 5 258 6 286 7 304 8 314 9 318 10 -- -- 52 52 56 60 56.7 58 55 50 51.6 38 47.7 28 43.4 18 39.3 10 35.3 4 31.4 -4

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

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

Short-Run Total Cost Schedules (Table 8.5) Output (Q) Total fixed cost (TFC) Total variable cost (TVC) Total Cost (TC=TFC+TVC) $6,000 100 6,000 200 300 400 500 600 $ 0 $ 6,000 4,000 10,000 6,000 12,000 9,000 15,000 14,000 20,000 22,000 28,000 34,000 40,000

Question For a linear production function q = f(L, K) = 2L + K, what is the short-run production function given that capital is fixed at capital equals to 100? What is the marginal product of labor? Set = 100. The short-run production function is q = 2L + 100. 2. Determine the marginal products of labor by showing how q changes as L is increased by ΔL units. Δq = (2[L + ΔL] + 100) – (2L + 100) = 2ΔL. Thus, the marginal product of labor is MPL = Δq/ΔL = 2.

Total Cost Curves (Figure 8.3)

Average Costs Average fixed cost (AFC) Average variable cost (AVC) Average total cost (ATC)

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

Average & Marginal Cost Schedules (Table 8.6) Output (Q) Average fixed cost (AFC=TFC/Q) Average variable cost (AVC=TVC/Q) Average total cost (ATC=TC/Q= AFC+AVC) Short-run marginal cost (SMC=TC/Q) 100 200 300 400 500 600 -- -- -- -- $60 $40 $100 $40 30 30 60 20 20 30 50 30 15 35 50 50 12 44 56 80 10 56.7 66.7 120

Average & Marginal Cost Curves (Figure 8.4)

Short Run Average & Marginal Cost Curves (Figure 8.5)

Effects of Taxes on Costs Taxes applied to a firm shift some or all of the marginal and average cost curves. For example, suppose that the government collects a specific tax of $10 per unit of output from the firm.

Effect of a Specific Tax on Cost Curves A $10.00 tax shifts both the AC and MC by exactly $10… M C a = b + 10 Costs per unit, $ 80 A C a = b + 10 M C b A C b $10 $10 37 27 5 8 10 15 q , Units per d a y

What is the effect of a lump-sum franchise tax on the quantity at which a firm’s after tax average cost curve reaches its minimum? (Assume that the firm’s before-tax average cost curve is U-shaped.)

Answer

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

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

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 Where w is the price of the variable input TC = wL + rK

Short-Run Production & Cost Relations (Figure 8.6)

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

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

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 declines

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