CH. 11: OUTPUT AND COSTS Measure of relationship between output and cost Production function Shows relationship between inputs and output Law of diminishing marginal returns Cost function Shows relationship between output and cost Short run vs long run cost Economies of Scale and Scope

Short run vs. Long run The Short Run A time frame in which one or more resources used in production is fixed. For most firms, capital is fixed in the short run. Other resources used by the firm (such as labor, raw materials, and energy) are variable in the short run. Short-run decisions are easily reversed. The Long Run A time frame in which the quantities of all resources can be varied. No fixed inputs in the long run.

Decision Time Frames Sunk Costs. A cost incurred by the firm that cannot be escaped after it is incurred If a firm’s plant has no resale value, the amount paid for it is a sunk cost. If a firm pays for research and development, the cost is sunk after incurred – regardless of whether the R&D had a successful outcome Sunk costs are irrelevant to a firm’s decisions since the firm cannot escape sunk costs after they have been incurred.

SR Measures of Production Total product (TP) Units of output produced in a given period. Marginal product of labor (MPL) D TP resulting from one additional unit of L, ceteris paribus. DTP/DL Average product of labor (APL) TP/L

Relationship between TP, MP and AP The Total Product Curve

Relationship between TP, MP and AP The Total Product Curve

Relationship between TP, MP and AP Almost all production processes are like the one shown here Initially increasing marginal returns Eventually diminishing marginal returns

Relationship between TP, MP and AP Increasing marginal returns MP rises as use of input increases Results from increased specialization and division of labor. Diminishing marginal returns MP falls as use of input increases Occurs because amount of capital per worker falls. The law of diminishing returns As a firm uses more of a variable input with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes.

Short-Run Technology Constraint IF MP>AP, what happens to AP if L is increased? If MP<AP, what happens to AP if L is increased? MP=AP when AP is at a maximum.

SR Cost Total cost (TC) is the cost of all resources used. Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output. Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output. TC = TFC + TVC

SR Total Cost Curves

SR Costs Marginal Cost the increase in total cost that results from a one-unit increase in total product. DTC/DTP If labor is the only variable input, MC=W/ MPL Over the output range with increasing marginal returns, marginal cost falls as output increases. Over the output range with diminishing marginal returns, marginal cost rises as output increases.

SR Costs Average Costs Average fixed cost (AFC) = TFC/TP Average variable cost (AVC) = TVC/TP If labor is the only variable input, AVC=W/APL Average total cost (ATC) is total cost per unit of output. ATC = TC/TP = AFC + AVC.

SR Costs Marginal vs. AVC and ATC If MC<AVC, AVC decreases as TP increases If MC>AVC, AVC increases as TP increases If MC<ATC, ATC decreases as TP increases If MC>ATC, ATC increases as TP increases

SR Cost Curves The ATC curve is U-shaped. If MC<AVC, AVC is falling. If MC>AVC, AVC is rising. MC always interesects ATC at min of ATC AVC at min of AVC AFC always decreases as output increases .

Relationship between production and cost

Short-Run Cost Shifts in Cost Curves The position of a firm’s cost curves depend on two factors: Technology Prices of productive resources What is effect on ATC, MC, AVC of Increase in price of labor. Increase in fixed costs Increase in productivity of labor.

Fill in the table below TP TC TFC TVC ATC AVC MC 100 1 150 2 190 3 240 100 1 150 2 190 3 240 4 300 5 400

Fill in the table below TP TC TFC TVC ATC AVC MC 100 -- 1 150 50 2 190 100 -- 1 150 50 2 190 90 95 45 40 3 240 140 80 46.66 4 300 200 75 60 5 400

Long-Run Cost In the long run, all inputs are variable and all costs are variable. The Production Function Shows the relationship between the maximum output attainable and the quantities of both capital and labor.

Long-Run Cost Marginal product of capital (MPk) the increase in TP from one more unit of capital, ceteris paribus. A firm’s production function exhibits diminishing marginal returns to labor as well as diminishing marginal returns to capital (for a given quantity of labor). For each plant size, diminishing marginal product of labor creates a set of short run, U-shaped costs curves for MC, AVC, and ATC.

LR Cost The long-run average cost curve is the relationship between the lowest attainable average total cost and output when both the plant size and labor are varied. K=1 K=2 K=3 K=4 What’s the low cost method for producing 5 sweaters? 13 sweaters? 25 sweaters?

LR Cost The long-run average cost (LRAC) curve.

LR Cost Economies of scale Diseconomies of scale falling long-run average cost as output increases. Diseconomies of scale rising long-run average cost as output increases. Constant returns to scale constant long-run average cost as output increases.

Long-Run Cost

Long-Run Cost Minimum efficient scale is the smallest quantity of output at which the long-run average cost reaches its lowest level. LRATC MES

Market Structure and Minimum Efficient Scale As MES rises relative to consumer demand, the number of firms in the industry will fall. Cases to consider: Microsoft Steel industry Printing industry Farming