1. 8-1 Learning Objectives  Explain general concepts of production and cost analysis  Examine the structure of short-run production based on the relation among total, average, and marginal products  Examine the structure of short-run costs using graphs of the total cost curves, average cost curves, and the short-run marginal cost curve  Relate short-run costs to the production function using the relations between (i) average variable cost and average product, and (ii) short-run marginal cost and marginal product

2. 8-2 What’s the Firm’s Objective?  Maximize Profit  Why Do Firm’s Exist? Firm is an Institutional Arrangement to minimize transactions costs.  Coase (1937) Nature of Firm followed by Oliver Williamson.  Going to the Market has transactions costs.  Hire workers, negotiate prices and enforce contracts. A firm is essentially a device for creating long-term contracts when short-term contracts are too bothersome. Short-cut the market, so why don’t firms get bigger?

3. 8-3 Basic Concepts of Production Theory  Production function ~A schedule showing the maximum amount of output that can be produced from any specified set of inputs, given existing technology  Variable proportions production ~Production in which a given level of output can be produced with more than one combination of inputs  Fixed proportions production ~Production in which one, and only one, ratio of inputs can be used to produce a good

4. 8-4 Basic Concepts of Production Theory  To maximize profit a firm must produce as efficiently as possible.  Technical efficiency ~Achieved when maximum amount of output is produced with a given combination of inputs and technology  Economic efficiency ~Achieved when firm is producing a given output at the lowest possible total cost

5. 8-5  Inputs are considered variable or fixed depending on how readily their usage can be changed  Variable input ~An input for which the level of usage may be varied to increase or decrease output  Fixed input ~An input for which the level of usage cannot be changed and which must be paid even if no output is produced  Quasi-fixed input ~A “lumpy” or indivisible input for which a fixed amount must be used for any positive level of output ~None is purchased when output is zero Basic Concepts of Production Theory

6. 8-6  Short run ~Current time span during which at least one input is a fixed input  Long run ~Time period far enough in the future to allow all fixed inputs to become variable inputs  Planning horizon ~Set of all possible short-run situations the firm can face in the future Basic Concepts of Production Theory

7. 8-7 Sunk Costs  Sunk cost ~Payment for an input that, once made, cannot be recovered should the firm no longer wish to employ that input ~Irrelevant for all future time periods; not part of the economic cost of production in future time periods ~Should be ignored for decision making purposes ~Fixed costs are sunk costs

8. 8-8 Avoidable Costs  Avoidable costs ~Input costs the firm can recover or avoid paying should it no longer wish to employ that input ~Matter in decision making and should not be ignored ~Variable costs and quasi-fixed costs are avoidable costs

9. 8-9 Opportunity Costs  Meredith’s firm sends her to a conference for managers and has paid her registration fee. Included in the registration fee is free admission to a class on how to price derivative securities such as options. She is considering attending, but her most attractive alternative opportunity is to attend a talk by Warren Buffett about his investment strategies, which is scheduled at the same time. Although she would be willing to pay $100 to hear his talk, the cost of a ticket is only $40. Given that there are no other costs involved in attending either event, what is Meredith’s opportunity cost of attending the derivatives talk?

10. 8-10 Inputs in Production (Table 8.1) Input TypePaymentRelation to Output Avoidable or Sunk? Employed in SR or LR? VariableVariable cost FixedFixed costs Quasi-fixedQuasi-fixed costs Direct Constant Avoidable Sunk SR & LR SR only If required: SR & LR

11. 8-11 Short Run Production  In the short run, capital is fixed ~Only changes in the variable labor input can change the level of output  Short run production function Q = f (L, K) = f (L)

12. 8-12 Average & Marginal Products  Average product of labor ~ AP = Q/L  Marginal product of labor ~ MP =  Q/  L  When AP is rising, MP is greater than AP  When AP is falling, MP is less than AP  When AP reaches it maximum, AP = MP  Law of diminishing marginal product ~As usage of a variable input increases, a point is reached beyond which its marginal product decreases

13. 8-13 Total, Average, & Marginal Products of Labor, K = 2 (Table 8.3) Number of workers (L) Total product (Q)Average product (AP=Q/L) Marginal product (MP=  Q/  L) 00 152 2112 3170 4220 5258 6286 7304 8314 9318 10314 -- 55 51.6 52 56 56.7 47.7 43.4 39.3 35.3 31.4 -- 50 38 52 60 58 28 18 10 4 -4

14. 8-14 Total, Average, & Marginal Products K = 2 (Figure 8.1)

15. 8-15 Short Run Production Costs  Total fixed cost (TFC) ~Total amount paid for fixed inputs ~Does not vary with output  Total variable cost (TVC) ~Total amount paid for variable inputs ~Increases as output increases  Total cost (TC) TC = TFC + TVC

16. 8-16 Short-Run Total Cost Schedules (Table 8.5) Output (Q)Total fixed cost (TFC) Total variable cost (TVC) Total Cost (TC=TFC+TVC) 0$6,000 100 6,000 200 6,000 300 6,000 400 6,000 500 6,000 600 6,000 $ 0 14,000 22,000 4,000 6,000 9,000 34,000 $ 6,000 20,000 28,000 10,000 12,000 15,000 40,000

17. 8-17 Question  For a linear production function q = f(L, K) = 2L + K, what is the short-run production function given that capital is fixed at capital equals to 100? What is the marginal product of labor?

18. 8-18 Total Cost Curves (Figure 8.3)

19. 8-19 Average Costs  Average fixed cost (AFC)  Average variable cost (AVC)  Average total cost (ATC)

20. 8-20 Short Run Marginal Cost  Short run marginal cost (SMC) measures rate of change in total cost (TC) as output varies

21. 8-21 Average & Marginal Cost Schedules (Table 8.6) Output (Q) Average fixed cost (AFC=TFC/Q) Average variable cost (AVC=TVC/Q) Average total cost (ATC=TC/Q= AFC+AVC) Short-run marginal cost (SMC=  TC/  Q) 0 100 200 300 400 500 600 -- 15 12 $60 30 20 10 -- 35 44 $40 30 56.7 -- 50 56 $100 60 50 66.7 -- 50 80 $40 20 30 120

22. 8-22 Average & Marginal Cost Curves (Figure 8.4)

23. 8-23 Short Run Average & Marginal Cost Curves (Figure 8.5)

24. 8-24 Effects of Taxes on Costs  Taxes applied to a firm shift some or all of the marginal and average cost curves.  For example, suppose that the government collects a specific tax of $10 per unit of output from the firm.

25. 8-25 Effect of a Specific Tax on Cost Curves Costs per unit, $ 1558100 q, Units per day 80 37 27 $10 AC a = AC b + 10 A C b MC b MC a =MC b A $10.00 tax shifts both the AC and MC by exactly $10…

26. 8-26  What is the effect of a lump-sum franchise tax on the quantity at which a firm’s after tax average cost curve reaches its minimum? (Assume that the firm’s before- tax average cost curve is U-shaped.)

27. 8-27 Answer

28. 8-28 Short Run Cost Curve Relations  AFC decreases continuously as output increases ~Equal to vertical distance between ATC & AVC  AVC is U-shaped ~Equals SMC at AVC’s minimum  ATC is U-shaped ~Equals SMC at ATC’s minimum

29. 8-29  SMC is U-shaped ~Intersects AVC & ATC at their minimum points ~Lies below AVC & ATC when AVC & ATC are falling ~Lies above AVC & ATC when AVC & ATC are rising Short Run Cost Curve Relations

30. 8-30 Relations Between Short-Run Costs & Production  In the case of a single variable input, short-run costs are related to the production function by two relations Where w is the price of the variable input TC = wL + rK

31. 8-31 Short-Run Production & Cost Relations (Figure 8.6)

32. 8-32 Relations Between Short-Run Costs & Production  When marginal product (average product) is increasing, marginal cost (average cost) is decreasing  When marginal product (average product) is decreasing, marginal cost (average variable cost) is increasing  When marginal product = average product at maximum AP, marginal cost = average variable cost at minimum AVC

33. 8-33 Summary  Technical efficiency occurs when a firm produces maximum output for a given input combination and technology; economic efficiency is achieved when the firm produces a given output at the lowest total cost ~Production inputs can be variable, fixed, or quasi-fixed inputs  Short run refers to the current time span during which one or more inputs are fixed; Long run refers to the period far enough in the future that all fixed inputs become variable inputs  Sunk costs are irrelevant for future decisions and are not part of economic cost of production in future time periods; avoidable costs are payments a firm can recover or avoid, thus they do matter in decisions

34. 8-34 Summary  The total product curve gives the economically efficient amount of labor for any output level when capital is fixed in the short run  Average product of labor is the total product divided by the number of workers: AP = Q/L  Marginal product of labor is the additional output attributable to using one additional worker with the use of capital fixed: MP = ∆Q/∆L  The law of diminishing marginal product states that as the number of units of the variable input increases, other inputs held constant, a point will be reached beyond which the marginal product of the variable input declines

35. 8-35 Summary  Short-run total cost, TC, is the sum of total variable cost, TVC, and total fixed cost, TFC: TC = TVC + TFC  Average fixed cost, AFC, is TFC divided by output: AFC = TFC/Q ; average variable cost, AVC, is TVC divided by output: AVC = TVC/Q ; average total cost ( ATC ) is TC divided by output: ATC = TC/Q  Short-run marginal cost, SMC, is the change in either TVC or TC per unit change in output Q  The link between product curves and cost curves in the short run when one input is variable is reflected in the relations, AVC = w/AP and SMC = w/MP, where w is the price of the variable input