CHAPTER 7 Costs and supply ©McGraw-Hill Education, 2014

The complete theory of supply (1) Short-run and long-run cost curves and output decisions need to be carefully distinguished when we study the determinants of supply. The profit-maximizing firm will choose the lowest cost way of producing any given level output, given the technology available and factor input costs. ©McGraw-Hill Education, 2014

The complete theory of supply (2) ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

The short run Fixed factor of production – 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 Short-run total cost (STC) = short-run fixed cost (SFC) + short-run variable cost (SVC) ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

The law of diminishing marginal returns Holding all factors constant except one, the law of diminishing marginal returns implies that beyond some value of the variable input further increases in the variable input lead to steadily decreasing marginal product of that input. For example, trying to increase labour input without also increasing capital will bring diminishing marginal returns. ©McGraw-Hill Education, 2014

The firm’s short-run output decision Firm sets output at Q 1, where SMC=MR subject to checking the average condition: – if price is above SATC 1 firm produces Q 1 at a profit – if price is between SATC 1 and SAVC 1 firm produces Q 1 at a loss – if price is below SAVC 1 firm produces zero output. SAVC 1 £ Output MR Q1Q1 SATC 1 SMC = MR ©McGraw-Hill Education, 2014

Costs in the long run: 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: Average cost Output ©McGraw-Hill Education, 2014

Costs in the long run: Economies of scale Economies of scale – or increasing returns to scale – occur when long-run average costs decline as output rises: Average cost Output ©McGraw-Hill Education, 2014

Costs in the long run: Decreasing returns to scale Decreasing returns to scale occur when long-run average costs rise as output rises: Average cost Output ©McGraw-Hill Education, 2014

Costs in the long run: Constant returns to scale Constant returns to scale occur when long-run average costs are constant as output rises: Average cost Output ©McGraw-Hill Education, 2014

The firm’s long-run output decision The decision: – If the price is at or above LAC 1 the firm produces Q 1 – If the price is below LAC 1 the firm goes out of business NB: LMC always passes through the minimum point of LAC. £ Output (goods per week) MR LMC = MR ©McGraw-Hill Education, 2014

The long-run average cost curve (LAC) Output Average cost SATC 1 Each plant size is designed for a given output level. SATC 2 SATC 3 SATC 4 So there is a sequence of SATC curves, each corresponding to a different plant size. 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. ©McGraw-Hill Education, 2014

The firm’s output decisions – a summary Marginal condition Check whether to produce Short-run decisionChoose the output at which MR=SMC Produce this output unless price lower than SAVC, in which case produce zero Long-run decisionChoose the output at which MR=LMC Produce this output unless price is lower than LAC, in which case produce zero. ©McGraw-Hill Education, 2014

Some maths An example of a short-run total cost function: Where SFC=F and SVC = cQ+ Dq 2 and Thus the short-run average fixed cost decreases steadily as Q increases. ©McGraw-Hill Education, 2014

Some maths (2) Short run average variable cost is: And short run average total cost: ©McGraw-Hill Education, 2014

Concluding comments (1) In the long run, a firm can fully adjust all its inputs. In the short run, some inputs are fixed. The production function shows the maximum output that can be produced using given quantities of inputs. The total cost curve is derived from the production function, for given wages and rental rates of factors of production. The short-run marginal cost curve ( SMC ) reflects the marginal product of the variable factor, holding other factors fixed. The SMC curve cuts both the SATC and SAVC curves at their minimum points. ©McGraw-Hill Education, 2014

Concluding comments (2) The long-run total cost curve is obtained by finding, for each output, the least-cost method of production when all inputs can be varied. Average cost is total cost divided by output. LAC is typically U-shaped. Much of manufacturing has economies of scale. When marginal cost is below average cost, average cost is falling. In the long run, the firm supplies the output at which long-run marginal cost ( LMC ) equals MR provided price is not less than the level of long- run average cost at that level of output. ©McGraw-Hill Education, 2014