Economic Costs: Short- Run and Long-Run

Inputs and Outputs A firm is an organization that produces goods or services for sale A firm is an organization that produces goods or services for sale It has to transform inputs into outputs It has to transform inputs into outputs The quantity of output a firm produces depends on the quantity of inputs The quantity of output a firm produces depends on the quantity of inputs A firm’s production underlies it costs curves A firm’s production underlies it costs curves

Inputs and Outputs Think of a farm owned by George and Martha Think of a farm owned by George and Martha The land is a fixed input – quantity is fixed and can’t be varied The land is a fixed input – quantity is fixed and can’t be varied The labor is a variable input – quantity the firm (farm) can vary at any time The labor is a variable input – quantity the firm (farm) can vary at any time The quantity of an input is really fixed depends on the time horizon The quantity of an input is really fixed depends on the time horizon

Inputs and Outputs The long-run is the time period in which all inputs can be varied The long-run is the time period in which all inputs can be varied The short-run is the time period in which at least one input is fixed The short-run is the time period in which at least one input is fixed George and Martha are producing wheat and what they produce depends on the number of workers they hire George and Martha are producing wheat and what they produce depends on the number of workers they hire

Inputs and Outputs Using modern farming techniques, one worker can cultivate the 10-acre farm Using modern farming techniques, one worker can cultivate the 10-acre farm When they add one additional worker, the land can be divided equally among the workers and each worker can work 5-acres and if a third workers is hired, divide the land among 3 and so on….. When they add one additional worker, the land can be divided equally among the workers and each worker can work 5-acres and if a third workers is hired, divide the land among 3 and so on….. As each additional laborer is hired, the land is cultivated more intensively and more bushels of wheat are produced As each additional laborer is hired, the land is cultivated more intensively and more bushels of wheat are produced

Inputs and Outputs The farm’s production function is the relationship between the quantity of labor and the quantity of output, for a given amount of the fixed input The farm’s production function is the relationship between the quantity of labor and the quantity of output, for a given amount of the fixed input

Inputs and Outputs The curve is called the total product curve – shows how the quantity of output depends on the quantity of the The curve is called the total product curve – shows how the quantity of output depends on the quantity of the variable input, for variable input, for a given quantity a given quantity of the fixed input of the fixed input What do you notice What do you notice about the curve? about the curve? Why does it flattens Why does it flattens

Inputs and Outputs Why does it flatten out? Why does it flatten out? To understand, have To understand, have to look at the marginal to look at the marginal product of labor or the MPL The following table The following table shows the change in the quantity of output that is generated by adding one more worker

Outputs and Inputs The following equation is used to calculate the marginal product of labor The following equation is used to calculate the marginal product of labor

Inputs and Outputs The slope of the total product curve is equal to the marginal product of labor The slope of the total product curve is equal to the marginal product of labor Slope of the line is equal Slope of the line is equal to “rise over “run” In Martha and George’s In Martha and George’s case, the marginal product of labor steadily declines as more workers are hired It shows that there are It shows that there are diminishing returns to labor on their farm

Inputs and Outputs Diminishing returns to an input is when an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input. Diminishing returns to an input is when an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input. Crucial Point – like other concepts in economics, it is an “other things equal” proposition, each successive unit of an input will raise production by less than the last if the quantity of all other inputs is held fixed Crucial Point – like other concepts in economics, it is an “other things equal” proposition, each successive unit of an input will raise production by less than the last if the quantity of all other inputs is held fixed

Side Note…What’s a unit? What is meant by a “unit” of labor? What is meant by a “unit” of labor? The answer is…… The answer is…… It doesn’t matter! As long as you are consistent! If you are talking about hours as units, stick with hours as units, don’t switch If you are talking about hours as units, stick with hours as units, don’t switch Whatever units you use, be careful that you use the same units throughout your whole analysis! Whatever units you use, be careful that you use the same units throughout your whole analysis!

Cost Curves George and Martha know their relationship between inputs of labor and output of wheat George and Martha know their relationship between inputs of labor and output of wheat But what do they need to do to maximize their profits? But what do they need to do to maximize their profits? Have to translate the inputs and outputs into information about the relationship between the quantity of output and cost Have to translate the inputs and outputs into information about the relationship between the quantity of output and cost

Cost Curves Land is a fixed input and George and Martha pay $400 for the land – fixed cost (a cost that does not depend on the quantity of output produced, it is the cost of the fixed input) Land is a fixed input and George and Martha pay $400 for the land – fixed cost (a cost that does not depend on the quantity of output produced, it is the cost of the fixed input) George and Martha pay each worker (variable input) George and Martha pay each worker (variable input) $200 and this multiplied by the number of workers is their variable cost (cost that depends on the quantity of output produced, cost of the variable input) $200 and this multiplied by the number of workers is their variable cost (cost that depends on the quantity of output produced, cost of the variable input)

Cost Curves Adding the fixed cost and the variable cost give the total cost Adding the fixed cost and the variable cost give the total cost Total cost (TC) is the quantity of output Total cost (TC) is the quantity of output TC = FC + VC

Cost Curves The total cost curve is a curve that shows how total cost depends on the quantity of output The total cost curve is a curve that shows how total cost depends on the quantity of output

Cost Curves Like the total product curve, the total cost curve slopes upward – due to variable cost Like the total product curve, the total cost curve slopes upward – due to variable cost The more output produced, the higher the farm’s The more output produced, the higher the farm’s total cost The total cost curve The total cost curve gets steeper The slope of total cost The slope of total cost curve is greater at the amount of output produced increased

Economic Costs: Short- Run and Long-Run Notes

Inputs and Outputs It has to transform inputs into outputs It has to transform inputs into outputs The quantity of output a firm produces depends on the quantity of inputs The quantity of output a firm produces depends on the quantity of inputs A firm’s production underlies it costs curves A firm’s production underlies it costs curves

Inputs and Outputs Think of a farm owned by George and Martha Think of a farm owned by George and Martha The land is a fixed input – The land is a fixed input – The labor is a variable input – The labor is a variable input – The quantity of an input is really fixed depends on the time horizon The quantity of an input is really fixed depends on the time horizon

Inputs and Outputs The long-run is The long-run is The short-run is The short-run is George and Martha are producing wheat and what they produce depends on the number of workers they hire George and Martha are producing wheat and what they produce depends on the number of workers they hire

Inputs and Outputs Using modern farming techniques, one worker can cultivate the 10-acre farm Using modern farming techniques, one worker can cultivate the 10-acre farm When they add one additional worker, the land can be divided equally among the workers and each worker can work 5-acres and if a third workers is hired, divide the land among 3 and so on….. When they add one additional worker, the land can be divided equally among the workers and each worker can work 5-acres and if a third workers is hired, divide the land among 3 and so on….. As each additional laborer is hired, the land is cultivated more intensively and more bushels of wheat are produced As each additional laborer is hired, the land is cultivated more intensively and more bushels of wheat are produced

Inputs and Outputs The farm’s production function is the relationship between the quantity of labor and the quantity of output, for a given amount of the fixed input The farm’s production function is the relationship between the quantity of labor and the quantity of output, for a given amount of the fixed input

Inputs and Outputs The curve is called the total product curve – The curve is called the total product curve – What do you notice What do you notice about the curve? about the curve?

Inputs and Outputs Why does it flatten out? Why does it flatten out? To understand, have To understand, have to look at the marginal to look at the marginal product of labor or the MPL The following table The following table shows the change in the quantity of output that is generated by adding one more worker

Outputs and Inputs The following equation is used to calculate the marginal product of labor The following equation is used to calculate the marginal product of labor

Inputs and Outputs The slope of the total product curve is equal to the marginal product of labor The slope of the total product curve is equal to the marginal product of labor Slope of the line is equal Slope of the line is equal to “rise” over “run” In Martha and George’s In Martha and George’s case, the marginal product of labor steadily declines as more workers are hired It shows that there are It shows that there are diminishing returns to labor on their farm

Inputs and Outputs Diminishing returns to an input is Diminishing returns to an input is Crucial Point – like other concepts in economics, it is an “other things equal” proposition, each successive unit of an input will raise production by less than the last if the quantity of all other inputs is held fixed Crucial Point – like other concepts in economics, it is an “other things equal” proposition, each successive unit of an input will raise production by less than the last if the quantity of all other inputs is held fixed

Side Note…What’s a unit? What is meant by a “unit” of labor? What is meant by a “unit” of labor? The answer is…… The answer is…… If you are talking about hours as units, stick with hours as units, don’t switch If you are talking about hours as units, stick with hours as units, don’t switch Whatever units you use, be careful that you use the same units throughout your whole analysis! Whatever units you use, be careful that you use the same units throughout your whole analysis!

Cost Curves George and Martha know their relationship between inputs of labor and output of wheat George and Martha know their relationship between inputs of labor and output of wheat But what do they need to do to maximize their profits? But what do they need to do to maximize their profits? Have to translate the inputs and outputs into information about the relationship between the quantity of output and cost Have to translate the inputs and outputs into information about the relationship between the quantity of output and cost

Cost Curves Land is a fixed input and George and Martha pay $400 for the land – fixed cost Land is a fixed input and George and Martha pay $400 for the land – fixed cost George and Martha pay each worker George and Martha pay each worker $200 and this multiplied by the number of workers is their variable cost $200 and this multiplied by the number of workers is their variable cost

Cost Curves Adding the fixed cost and the variable cost give the total cost Adding the fixed cost and the variable cost give the total cost

Cost Curves

Like the total product curve, the total cost curve slopes upward – due to variable cost Like the total product curve, the total cost curve slopes upward – due to variable cost The more output produced, the higher the farm’s The more output produced, the higher the farm’s total cost The total cost curve The total cost curve gets steeper The slope of total cost The slope of total cost curve is greater at the amount of output produced increased