Introduction to Economics Egor Sidorov

1.Production function and output 2.Costs within the short run 3.Costs within the long run

3 Inputs and outputs ─Economics assumes that firms do their best to achieve maximum efficiency: i.e. producing maximum output with the available inputs and at minimum costs. ─Output level depends on: ─technology (T), ─capital stock (K), ─land stock (R) ─and amount of labour input (L).

Production function ─function that specifies the maximum output of a firm, given the available combinations of inputs. Production function reflects the technology level. L K L, thous. hrs. K, mil. USD Q, thous. pieces Q=f(L, K), other factors remain equal Q = f(R, L, K, T,…)

Labor Labor Total and marginal physical product TPP (Total physical product)MPP (Marginal physical product) Law of diminishing returns Mathematically marginal product is the first derivation of production function ─Assuming that land and capital remain unchanged within the short run and the only variable factor is labor, one can observe the following: 1500

Law of diminishing returns ─Marginal product is the extra output produced by one more unit of an input. ─In a production system where one input is variable and the rest are fixed, at some point, additional unit of variable input yields smaller and smaller increases in output (i.e. marginal product decreases). MP = TP / F

Returns to scale ─Law of diminishing returns concerns the changes of only one input while the rest remain fixed. ─Returns to scale refers to changes in output subsequent to a proportional change in all inputs: ─Constant returns to scale, ─Increasing returns to scale (Economies of scale), ─Decreasing returns to scale (Diseconomies of scale). ─E.g. one can refer to economies of scale if quantity of all input factors are increased by some amount (e.g. by 10 percent) and costs subsequently increase by a lesser amount (e.g. by 8 percent).

Total, average and marginal physical product ─Average Physical Product is the total product divided by the number of units of variable input employed. ─Marginal Physical Product of a variable input is the change in total output due to a one unit change in the variable input LTPPTPPAPPAPPMPPMPP APP = TP / F MPP = TP / F

Short vs long run ─Short run is a time frame when the firm can change only part of its production factors (the so-called variable production factors), while at least one production factor remain unchanged (the so-called fixed production factors). ─E.g. the faculty building is a fixed production factor, while professors represent variable production factors within the short run ► ─Long-run assumes no fixed factors of production, so all factors are variable.

Technological change Labor TPTP Intel 386 Pentium I, II, III, IV Core 2 Duo Quantity of transistors (mil)

Optimal (least costly) input combination ─Isoquant curve refers to all combinations of inputs producing the same output (TP1). TP1 Capital Labor ─Capital and labor cost money. Economists try to figure out which one of possible technological combinations is the cheapest for the necessary level of output. Technical Rate of Substitution – rate, at which the quantity of one input has to be reduced when one extra unit of another input is used, so that output remains constant A

Isocost curve (equal cost curve) ─Isocost is a budget line of a firm, showing all combinations of inputs which the firm can “afford” E.g. the cost of maintaining excavator is equal to employing 15 workers. Our budget allows us either lease 2 excavators or to hire 30 workers.

Optimal production point ─Optimal production point is established by putting together our technological possibilities (isoquant) and our budget (isocost). ─The tangent point shows the optimal combination of inputs given the current technological conditions

1.Production function and output 2.Costs within the short run 3.Costs within the long run

Costs within the short run ─Firms buy labor, capital and land on the production factor markets in order to maintain production. ─Total costs of a firm consist of: ─Fixed costs (FC) are not dependent on the level of output (e.g., rent payments). ─Variable costs (VC) change in proportion to level of output.

Fixed and variable costs ─The growth of variable costs is usually non-linear. In many cases it is connected with the different level of variable factors’ exploitation Q C (USD) VC FC Proportional (linear) Degressive Progressive

Q Total (TC) and Marginal Costs (MC) ─Marginal cost is the change in total cost that arises when the quantity produced changes by one unit. ─What are marginal costs of transporting additional passenger on the plane? Q TC (Total costs)MC (Marginal costs) Mathematically marginal product is the first derivation of the cost function 1500 TC MC MC = TC / Q

Unit costs ─Average costs (AC, AVC a AFC) are derived as TC, VC or FC divided by volume of output. ─Average fixed costs (AFC) – the downward slope of the curve shows that it is sensible to distribute fixed costs among the greater amount of products TC Q AC AFC AVC AC AC = TC / Q AC = AVC + AFC

Technological optimum ─When MC is below AC, AC is decreasing ─MC crosses AC in the lowest point, after it AC begin to increase Q AC, MC AVC AC MC ─Minimum production costs refer to the point where marginal cost curve crosses average cost curve.

1.Production function and output 2.Costs within the short run 3.Costs within the long run

Total costs within the long run ─The total costs curve within the long run has the same shape as within the short run. ─Within the short run the shape of TC curve is determined by returns to production factor. ─Within the long run the shape of the curve is determined by the returns to scale

Average costs within the long run ─The long-run AC curve reflects the technological changes. ─LRAC shows the lowest AC of production for different periods and for different technologies AC AC2 AC3

Understanding costs: accounting vs. economic definitions ─Accountant’s viewpoint: ─Explicit costs are costs that the firm actually pays e.g. for hiring employees or buying raw materials. ─Manager’s and economist’s viewpoint : ─Implicit costs (opportunity costs) occur when one foregoes an alternative action but does not make an actual payment. Managers and economists should consider them before making decisions

Thank you for attention! Refernces: SAMUELSON, P. A., NORDHAUS, W. D. Ekonomie 18. vydání. Praha: Svoboda, KRAFT, J., RITSCHELOVÁ, I. Ekonomie pro environmentální management. Ústí n. L.: UJEP, MCDOUGAL LITTELL. Economics: Concept and Choices. Canada: McDougal Littell,