COSTS OF PRODUCTION Chapters 11

Short-Run vs. Long Run Firms typically have several types of inputs that they can adjust to adjust production. Long-run - When firms are able to adjust all of their inputs including physical plant. Short-run – When firms are able to adjust only some of their inputs (usually energy, labor, and raw material costs).

Productivity Average Productivity of Labor is output per work. Marginal Productivity of Labor is the extra production that is obtained from an extra unit of labor.

Short Run Production Function ΔLabor ΔTP ΔLabor ΔTP Total Product

Production in the Short-Run Given a set of fixed inputs (like plant and capital equipment), a firm can vary other inputs (typically labor) and to vary production. Typically, as you add workers, you get more output. Up to a point each additional worker adds synergy and adding more workers leads to more and more extra pay-off. But at some point, capacity constraints bind, diminishing returns sets in, and the addition of extra workers will generate less and less extra production.

Productivity Labor productivity depends on the number of workers First, increasing, then, decreasing Average product of labor begins decreasing when marginal product of labor drops below average. Note: Marginal Product crosses through average product at the peak of average product. As long as the next worker adds more product than the average worker, they will increase the average. Once diminishing returns set in, additional workers may add less to output than the average worker, reducing the overall average.

MPL, APL L MPL APL

Small Scale Schedule

Large Scale Schedule

Fixed Costs vs. Variable Costs In short-run, we distinguish between the costs that are adjustable as production is adjusted (variable costs) and costs that are unchanged regardless of production (fixed costs). Variable costs (Wages of production workers, supply and raw materials costs) Fixed costs (Depreciation costs, Financial costs, wages of non- production workers).

Types of Costs Total Fixed Costs – Invariant to the number of goods produced (in the short-run) Average Fixed Costs – Decreasing in the number of goods produced. Total Variable Costs- Increasing in the number of goods produced. Total Costs: Fixed Costs + Variable Costs

Bakery: Wages $10 per Worker, $5 Wheat per Loaf

Total Variable Costs are increasing at an accelerating rate. Reason: Diminishing returns to variable inputs.

Costs: Average vs. Marginal Total Costs are the sum of all relevant costs for a firm. Average Costs: Costs per unit of output. Marginal Cost: Extra Cost per Extra Unit of Output.

Cost Schedules

Average and Marginal Costs Average Fixed Costs decreases as production increases AVC, ATC, MC all increase as diminishing returns kick in MC equals AVC and ATC when each of the latter are at their minimum level.

Long Run Costs In the short-run, the size of a firms physical plant is a fixed factor. Over-time, the plant size can adjust. In the bakery example, extra ovens can be added.

Minimizing Costs in the Long Run Consider average total cost schedules at different numbers of ovens. Each oven will have a production level that generates the minimum average total cost. To minimize average costs in the long-run, choose the number of ovens which will have the lowest, minimum average total cost.

Average Total Cost Schedules at Different Scales of Production

Minimum of the different cost Schedules

Connect the Dots Long Run Average Total Costs

If we adjust capital scale continuously, the collection of minimum points is the Long Run Average Total cost cuve LR ATC Short-run ATC

Economies of Scale When firms are able to adjust all of their inputs, they can choose a size that will minimize costs. If a firm is able to achieve some economies of scale, increasing size will reduce the average total cost. Sources of Economies of Scale Production requires major expenditure on items needed to produce even zero products Ex. Software, pharmaceuticals Production requires many specific steps which can be most efficiently done through specialization Ex. Airplanes, automobiles

Long Run ATC increasing returns to scale. Output Costs LR ATC Economies of Scale

Returns to Scale Scale Economies is not always likely to characterize production. If each production unit can act autonomously with identical costs then we may experience constant returns to scale. Firms at some point experience diseconomies of scale or increasing long run average total costs. Sources of diseconomies of scale Limits of managerial attention. Limits of some other fixed resource.

Long Run ATC decreasing returns to scale. Output Costs LR ATC Constant Returns Scale Diseconomies

Overall Cost Function LR ATC Minimum Efficient Scale

MES and Market Structure If MES is relatively large in comparison with the market demand: $ Q D LRAC The market is most efficiently served by a single firm---natural monopoly!

MES and Market Structure If MES is relatively small in comparison with market demand: $ Q Many small firms in the market.

Learning Outcomes Students should be able to Define and calculate various types of economic costs. Fixed, variable, total, average, marginal. Describe the shape of various relevant cost curves Average Total (in LR and SR), Average Fixed, Marginal Costs Describe the relationship between production, productivity (marginal and average) and the law of diminishing returns.