Foundation of Economic Analysis 3250:600 Instructor: Richard W. Stratton Meets: Thursday 5:20 – 7:50 pm CAS 134

The University of Akron Administration This Week’s Assignments Farnham Chapter 5 (SR costs), Chapter 6 (LR costs) Homework 4 – due next week Next Week’s Assignments Farnham Chapter 7 (Perfect competition) Homework 5 - attempt 11/19/2018 The University of Akron Decision Tree

Introduction Short Run Production Short Run Costs Discussion Decision Tree Long Run Costs Introduction Short Run Production Short Run Costs Discussion

Introduction – net benefit Why are we interested in cost functions? Decisions depend on net benefits of alternative courses of action What are the relevant costs? Opportunity costs Marginal costs 11/19/2018 The University of Akron Decision Tree

Introduction – net benefit Net benefit is the additional benefit received from an activity Accounting profit Total revenue – explicit costs Economic profit Total revenue – (explicit + implicit costs) Group activity distinguishing between accounting and economic profit 11/19/2018 The University of Akron Decision Tree

Introduction – net benefit Benefits determined by Revenue function Market structure – demand facing firm Our topic for next 2 weeks Costs determined by Production function Input prices To which we now turn 11/19/2018 The University of Akron Decision Tree

The University of Akron Introduction Definition of production function Short run versus long run Fixed inputs Variable inputs 11/19/2018 The University of Akron Decision Tree

Introduction - definition Production function is the relationship of how resources (inputs) can be converted to outputs Labor (L) Capital (K) Land (R) Entrepreneurship (En) Intermediate inputs (M) Simplify – focus on L and K 11/19/2018 The University of Akron Decision Tree

Introduction - definition Production is a flow! Efficiency Technical efficiency Economic efficiency Given enough time all inputs can be changed to affect output But some take longer than others 11/19/2018 The University of Akron Decision Tree

Introduction - definition Short run The amount of at least one input cannot be changed The amount of at least one input is fixed Some input amounts can vary Long run All input amounts can be changed All input amounts can vary 11/19/2018 The University of Akron Decision Tree

Introduction - definition Simplify – focus on L and K Short run Assume Capital fixed Assume Labor can vary Long run Assume Labor and Capital can vary 11/19/2018 The University of Akron Decision Tree

Introduction – Lasting Ideas Costs derived from production Cost are a function of input prices Cost are a function of input productivity Input substitution is important Sunk costs are irrelevant 11/19/2018 The University of Akron Decision Tree

Introduction Short Run Production Short Run Costs Discussion Decision Tree Long Run Costs Introduction Short Run Production Short Run Costs Discussion

The University of Akron Short Run Production Short run production function Law of variable proportions Diminishing returns Total product Average product Marginal product 11/19/2018 The University of Akron Decision Tree

The University of Akron Short Run Production Proposition: As the amount of labor increases, capital fixed, output will at some point increase at a decreasing rate Output may actually decline Groups – is there a way to quickly test this proposition? 11/19/2018 The University of Akron Decision Tree

The University of Akron Short Run Production Suggestion Paper airplane production in a men’s room stall Diminishing returns Law of variable proportions 11/19/2018 The University of Akron Decision Tree

The University of Akron Short Run Production Important measures Total product – total production per unit of time [TP or Q] Average product – production per unit of variable input TP / L or Q / L Marginal product – additional production from one addition unit of variable input Change TP / Change L or DQ / DL 11/19/2018 The University of Akron Decision Tree

Short Run Production (algebra) Total Product Average Product – TP/L Marginal Product – DTP/DL 11/19/2018 The University of Akron

Short Run Production (table) 11/19/2018 The University of Akron

Short Run Production (graph) 11/19/2018 The University of Akron

Short Run Production (graph) 11/19/2018 The University of Akron

Short Run Production (graph) TP maximum Diminishing Returns 11/19/2018 The University of Akron

Introduction Short Run Production Short Run Costs Discussion Decision Tree Long Run Costs Introduction Short Run Production Short Run Costs Discussion

The University of Akron Short Run Costs Opportunity Cost (explicit, implicit) Net benefit Accounting and economic profit SR Total Costs Fixed Variable Total SR Average Costs Marginal Cost 11/19/2018 The University of Akron Decision Tree

The University of Akron Opportunity Cost As we have seen the real cost of an activity is the most valued activity sacrificed! Opportunity Cost Explicit costs Implicit costs 11/19/2018 The University of Akron Decision Tree

The University of Akron Short Run Total Costs If we know how much of each input is required for production Production function And the cost per unit of inputs Input costs K = $50/unit L = $100/unit We can calculate SR Total Costs 11/19/2018 The University of Akron Decision Tree

The University of Akron Short Run Total Cost Total Cost TC = FC + VC FC = $50 * 10 = $500 VC = $100 * L Fixed costs constant Variable costs Increase at decreasing rate Increase at increasing rate 11/19/2018 The University of Akron

The University of Akron Short Run Average Cost Average Total Cost ATC = AFC + AVC AFC = TFC / Q AVC = TVC / Q AFC always declining AVC U shaped Decline, reach minimum, increase ATC U shaped 11/19/2018 The University of Akron

Short Run Marginal Cost Change in TC per unit change in Q Change in VC per unit change in Q DTC / DQ = DVC / DQ MC U shaped Decline, reach minimum, increase 11/19/2018 The University of Akron

Short Run Costs (table) 11/19/2018 The University of Akron

Short Run Total Cost (graph) 11/19/2018 The University of Akron

Short Run Costs (graph) 11/19/2018 The University of Akron

Short Run Costs (stylized) $ MC ATC AVC AFC Q Q1 Q2 11/19/2018 The University of Akron

Short Run Costs (stylized) 11/19/2018 The University of Akron

Short Run Costs (stylized) 11/19/2018 The University of Akron

Introduction Short Run Production Short Run Costs Discussion Decision Tree Long Run Costs Introduction Short Run Production Short Run Costs Discussion

Discussion - Short Run Cost Constant MC MP constant DTC / DQ = DVC / DQ constant TC and VC are straight lines Impact on AVC? AVC constant and equal to MC Impact on ATC? ATC always declining 11/19/2018 The University of Akron

Discussion - Short Run Cost Decreasing MC MP increasing DTC / DQ = DVC / DQ decreasing Additional units cost less than current units If current unit profitable, wouldn’t more units also be profitable? Depends on revenue! AVC always declining ATC always declining 11/19/2018 The University of Akron

Introduction Short Run Production Short Run Costs Discussion Decision Tree Long Run Costs Introduction Short Run Production Short Run Costs Discussion