1. Production, Costs and Supply Chapter 4 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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3. The Biggest Machine in the World (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 This is the control room of the California Independent System Operator (Cal-ISO, or just ISO) in Folsom, California, producing and delivering power to 80 percent of the state’s households and businesses.

4. What’s Next (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 Cal-ISO and its computers must control as many as 800 electrical generators and 30,000 miles of high-voltage transmission lines, seeing to it that total power produced always equals exactly the amount people wish to use. Furthermore, they must do so in a way that minimizes their cost. We will touch on almost all of Cal-ISO’s cost-related problems in this chapter.

5. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5

6. Production (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 Production is the act of transforming resources into goods and services that are more valuable. For example, oil is extracted from the ground, refined into gasoline, and used as transportation fuel, or, a hair stylist uses time, scissors, and chemicals to make a customer feel more attractive and self-confident, which is potentially of great value for a job interview, or, an intermediary finds a previously undiscovered low-cost source of a good that allows her to resell it for less than competitors would charge.

7. Outputs, Inputs, and Business Firms (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 A firm combines inputs to produce output. A firm’s production function is the relationship between it’s inputs and output.

8. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8

9. Opportunity Cost and Its Complications - The Economist, the Accountant, and the Newlywed (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 When economists and accountants discuss costs they sometimes sound as if they come from different planets. The economist calls the cost of some action the most valuable alternative forgone by the decision maker. Opportunity cost reasoning sharpens our understanding of resource allocation.

10. Opportunity Cost and Its Complications - Exactly What Is the Forgone Alternative? (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 The opportunity cost of self-financing your business is the return on your best alternative investment, but what might that investment be, and what does “best” mean? Before giving up on the concept of opportunity costs, think of how often they are easy to identify. For many productive inputs, market prices reliably measure opportunity costs. Opportunity cost reasoning also helps us understand broader issues. For example, opportunity cost might even help explain why higher earners spend less time asleep on average than those who make less.

11. Substitution: The Short Run and the Long (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 The short run is defined as the length of time during which the decision maker can vary some inputs, although others remain fixed. In the long run all inputs are variable. Short run and long run are not fixed lengths of time. One can lease a storefront, furnish it, and hire staff to open a manicure salon in a matter of weeks. A new power plant can take eight years from siting to operation.

12. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12

13. Production with One Variable Input – Marginal Cost Again (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 Consider a steam boiler. The size of the boiler is fixed but the amount of fuel added to the boiler will determine how much steam is produced. To the right is the total product curve for fuel.

14. Production with One Variable Input – Marginal Cost Again (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 If we know the cost of fuel, we can turn the total product curve into a total variable and a marginal cost curve. The slope of the total variable cost curve at any point is the marginal cost of production. The only part of the marginal cost curve that matters for production is the upward sloping portion. If the market price were $1.50, output should be expanded to the point where P=MC in order to maximize profit.

15. Production with One Variable Input – Average Variable Cost (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 From the total variable cost (TVC) curve we can derive the average variable cost (AVC) curve. For any point on the TVC curve, the AVC is equal to the slope of a ray from the origin to that point.

16. Production with One Variable Input – Marginal Cost One More Time (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 When MC<AVC, the AVC Is declining. When MC>AVC, The AVC is increasing. When MC=AVC, AVC is at its Minimum.

17. Production with One Variable Input (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 Here are the short-run cost curves all together. If the price for this firm’s product was $2.24, the profit maximizing firm would expand production to the point where P=MC, or 79.5 units.

18. The Short-Run Supply Curve (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18 A firm’s short-run supply curve is the portion of its MC curve above the AVC curve. When price falls below the firm’s minimum AVC, the firm will shut-down and produce nothing in the short-run.

19. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19

20. Isoquants and Isocosts - Isoquants (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20 Isoquants show the various combinations of two inputs that can be used to produce a given level of output. The isoquants drawn here show the various combinations of boiler capacity (K) and fuel (F) that can be used to produce steam.

21. Isoquants and Isocosts - Isocosts (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 An isocost line shows the various combinations of inputs that will cost a given amount to purchase. If fuel is available a $2 per unit and capital at $4 per unit, the two isocost lines at the right show the combinations of fuel and capital that can be purchased for $20 and $40.

22. Isoquants and Isocosts - Isocosts (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 If the price of fuel changes the isocost line pivots as shown at the right. Another way to say this is that the slope of the isocost line changes.

23. Minimizing the Cost of a Given Output (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 The cost minimizing way to produce 10,000 cubic feet of steam per hour is determined by where an isocost line is just tangent to the isoquant for Q=10,000. When K = 4.46 and F = 5.95, 10,000 cubic feet of steam will be produced at the least total cost.

24. Minimizing the Cost of a Given Output (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 The least cost mix of inputs will by the one for which: The marginal product of the last dollar spent on F must equal that of the last dollar spent on K.

25. The Expansion Path and Long-Run Total Cost (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 The expansion path identifies the lowest long- run total cost of producing any level of output.

26. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26

27. The Shape of Long-Run Average Cost (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27 As long as the long-run average cost curve is sloping downward, as from A to C, the firm is experiencing economies of scale. When the long-run average cost curve slopes upward, as from C to B, the firm is experiencing diseconomies of scale.

28. Long-Run Average Cost and Competition – Natural Monopoly (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28 Consider the short and long- run average cost curves for the natural gas industry with a total market consumption of 2 billion cubic feet per day (bcfd). This illustrates a natural monopoly because the long- run average cost declines all the way up to the size of the market.

29. Long-Run Average Cost and Competition – Why Might LRAC Slope Upward? (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 Diseconomies of scale might arise because larger firms place such demands on management that even the most talented executives would eventually lose the ability to control costs. Alfred Marshall reasoned that a single manager or a small group of them would ultimately be unable to monitor the performance of a large workforce or to efficiently coordinate the many different activities that take place in a large firm.

30. Long-Run Average Cost and Competition – Shifts in LRAC (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30 An improvement in technology might cause a firms LRAC to shift down with the minimum point moving to the left.

31. Learning (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31 This learning curve illustrates the idea that experience results in a decline in the time needed to produce aircraft.