Choosing output REVENUES COSTS AR Demand curve AC (short & long run)

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Presentation transcript:

Chapter 8 Developing the theory of supply: Costs and production David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

Choosing output REVENUES COSTS AR Demand curve AC (short & long run) Technology & costs of hiring factors of production Demand curve AR MR TC curves (short & long run) AC (short & long run) CHECK: produce in SR? close down in LR? See the introduction to Chapter 8 in the main text, and Figure 8-1. Animation effects offer a suggested sequence for discussion, summarising the material in this chapter. MC Choose output level

The production function The amount of output produced depends upon the inputs used in the production process A factor of production (“input”) is any good or service used to produce output The production function specifies the maximum output which can be produced given inputs See Section 8-1 in the main text.

Short run vs. long run The short run is the period in which a firm can make only partial adjustment of inputs e.g. the firm may be able to vary the amount of labour, but cannot change capital. The long run is the period in which a firm can adjust all inputs to changed conditions. The long-run total cost curve describes the minimum cost of producing each output level when the firm is free to vary all input levels. See Section 8-3 in the main text.

Average cost The average cost of production is total cost divided by the level of output. Long-run average cost (LAC) is often assumed to be U-shaped: LAC Average cost Output See Section 8-3 in the main text.

Economies of scale Economies of scale – or increasing returns to scale – occur when long-run average costs decline as output rises: LAC Average cost Output See Section 8-4 in the main text, and Figure 8-3(a).

Decreasing returns to scale – occur when long-run average costs rise as output rises: LAC Average cost Output See Section 8-4 in the main text, and Figure 8-3(c).

Constant returns to scale – occur when long-run average costs are constant as output rises: LAC Average cost Output See Section 8-4 in the main text, and Figure 8-3(b).

The firm’s long-run output decision The decision: If the price is at or above LAC1, the firm produces Q1. If the price is below LAC1 the firm goes out of business NB: LMC always passes through the minimum point of LAC. AC1 £ Output (goods per week) MR LAC LMC Q1 LMC = MR See Section 8-6 in the main text, and Figure 8-6.

The short run Fixed factor of production Fixed costs Variable costs a factor whose input level cannot be varied Fixed costs costs that do not vary with output levels Variable costs costs that do vary with output levels STC = SFC + SVC See Section 8-7 in the main text.

The marginal product of labour The marginal product of labour is the increase in output obtained by adding 1 unit of the variable factor but holding constant the inputs of all other factors. Labour is often assumed to be the variable factor with capital fixed. See Section 8-7 in the main text.

The law of diminishing returns Holding all factors constant except one, the law of diminishing returns says that: beyond some value of the variable input, further increases in the variable input lead to steadily decreasing marginal product of that input. e.g. trying to increase labour input without also increasing capital will bring diminishing returns. See Section 8-7 in the main text.

The firm’s short-run output decision Firm sets output at Q1, where SMC=MR subject to checking the average condition: if price is above SATC1 firm produces Q1 at a profit if price is between SATC1 and SAVC1 firm produces Q1 at a loss if price is below SAVC1, firm produces zero output. SAVC1 £ Output MR SAVC SMC Q1 SATC SATC1 SMC = MR See Section 8-8 in the main text, and Figure 8-9.

The long-run average cost curve LAC SATC1 Each plant size is designed for a given output level LAC In the long-run, plant size itself is variable, and the long-run average cost curve LAC is found to be the ‘envelope’ of the SATCs SATC2 SATC3 SATC4 So there is a sequence of SATC curves, each corresponding to a different optimal output level. Average cost See Section 8-9 in the main text, and Figure 8-10. Output

The firm’s output decisions – a summary See Table 8-10 in the main text.