1. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply Decisions

2. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply Supply is the ability and willingness to sell (produce) specific quantities of a good at alternative prices in a given time period, ceteris paribus.

3. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Capacity Constraints: The Production Function Factors of production are needed to produce a good or service.

4. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Factors of Production Factors of production are the resource inputs used to produce goods and services. Land, labor, capital, entrepreneurship.

5. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Production Function A technological relationship expressing the maximum quantity of a good attainable from different combinations of factor inputs.

6. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Production Function Production functions tell us just how much output we can produce with varying amounts of factor inputs.

7. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Production Function The output of any factor of production depends on the amount of other resources available to it.

8. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 0 12345678 LABOR INPUT (machine operators per day) A 5 10 15 20 25 30 35 40 45 50 55 JEANS OUTPUT (pairs per day) Short-Run Production Function Total output (per day) The rate of output depends on how many inputs are used. B C D E F GH I

9. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficiency Every point on the production function represents the most output that can be produced with a given number of workers. Producing any less means production is inefficient.

10. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Capacity A production function shows how much output that can be produced with a given amount of inputs.

11. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Capacity Land and capital constraints place a ceiling on potential output. To produce at capacity, a firm needs to use its inputs efficiently.

12. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Physical Product (MPP) The change in total output associated with one additional unit of input.

13. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Physical Product (MPP) An improved ratio of labor to other factors of production results in increasing marginal physical product.

14. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Physical Product (MPP) A worker's productivity (MPP) depends in part on the amount of other resources in the production process.

15. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Law of Diminishing Returns The marginal physical product of a variable input declines as more of it is employed with a given quantity of other (fixed) inputs.

16. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Resource Constraints Marginal physical product may initially increase due to specialization of labor.

17. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Resource Constraints As more labor is hired, each unit of labor has less capital and land to work with. As a result, marginal physical product begins to decline.

18. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Resource Constraints The relative scarcity of other inputs (capital and land) constrains the marginal physical product of labor.

19. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Negative MPP Marginal physical product may become negative if too much labor is added to a fixed level of capital and land.

20. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Short Run vs. Long Run Short run –The period in which the quantity (and quality) of some inputs cannot be changed. Long run –A period of time long enough for all inputs to be varied (no fixed costs).

21. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Costs of Production A production function tells us how much a firm could produce but not how much it will want to produce.

22. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Costs of Production The most desired rate of output is one that maximizes total profit. –Profit is the difference between total revenue and total cost.

23. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Total Cost The market value of all resources used to produce a good or service.

24. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Total Costs of Production

25. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Fixed Costs Costs of production that do not change with the rate of output. Fixed costs cannot be avoided in short run. Includes the cost of plant, equipment, and property taxes.

26. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Variable Costs Costs of production that change when the rate of output is altered. Any short-run change in total costs are a result of changes in variable costs.

27. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Variable Costs Examples of variable costs include labor and material costs.

28. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 1530456075 RATE OF OUTPUT (pairs of jeans per day) 0 100 200 300 400 500 600 700 800 900 1,000 1,100 $1,200 PRODUCTION COSTS (dollars per day) Total cost G B A Variable costs Fixed costs The Costs of Jeans Production

29. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Which Costs Matter? Should the firm consider both fixed and variable costs when making production and pricing decisions? To answer this question, the concepts of average and marginal cost need to be introduced.

30. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Total Cost (ATC) Total cost divided by quantity produced in a given time period.

31. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Total Cost (ATC)

32. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Total Cost (ATC) Average costs start high, fall, then rise once again, giving the ATC curve a distinctive U shape.

33. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 2 4 6 8 10 12 14 16 18 20 22 $24 01020304050 I J K L M N O ATC COST (dollars per pair) RATE OF OUTPUT (pairs per day) Average Total Cost (ATC)

34. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Cost (MC) The change in total cost when one more unit of output is produced.

35. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Cost (MC)

36. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Cost (MC) 10203040500 $80 70 60 50 40 30 20 10 RATE OF OUTPUT (pairs per day) Added output is increasingly expensive to produce when marginal costs are rising. MARGINAL COST (per pair)

37. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Cost (MC) Marginal costs rise because of the law of diminishing marginal product.

38. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply Horizons The supply decision has two dimensions. –A short-run horizon which concerns the production decision. –A long-run horizon which concerns the investment decision.

39. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Short Run Production Decision The nature of the supply decision varies with the relevant time frame.

40. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Short Run Production Decision The short run production decision is the selection of the short-run rate of output (with existing plant and equipment).

41. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Short Run The short run is characterized by the existence of fixed costs.

42. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Focus on Marginal Cost Marginal cost is a basic determinant of short-run supply (production) decisions. Covering marginal cost is a minimal condition for supplying additional output.

43. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Focus on Marginal Cost Fixed costs are unavoidable in the short-run and are thus ignored when making short-run production decisions. To remain in business in the long-run, firms must cover average total costs as well.

44. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Long Run Investment Decision The decision to build, buy or lease plant and equipment, and...... to enter or exit an industry.

45. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. No Fixed Costs In the long run, businesses have no lease or purchase commitments. There are no fixed costs in the long run.

46. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic vs. Accounting Costs Economic costs need not conform to actual dollar costs.

47. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Accounting Costs Accounting costs are the direct dollar costs of producing goods or services. Includes any actual out-of-pocket expense.

48. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Cost The essential economic question is how many resources are used in production. Economic cost is the dollar value of all resources used to produce a good or service – the opportunity cost of resource use.

49. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Cost Opportunity costs are counted by economists but not necessarily by accountants. Economic costs and accounting costs will diverge whenever any factor of production is not paid an explicit cost.

50. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Costs The economist considers both explicit and implicit costs. Economic cost = explicit costs + implicit costs

51. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Cost of Homework Some output of pocket expenses is incurred – perhaps paying someone to write term papers. There are implicit costs too – the value of the next best use of your time represents the opportunity cost of doing homework.

52. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Profit In economic terms, profit is the difference between total revenue and total economic costs. Profit = total revenue – total cost

53. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Profit Economists keep a consistent eye on profit by keeping track of both explicit and implicit costs.

54. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Invest in Labor or Capital? The U.S. labor force continues to grow by more than a million workers per year.

55. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Invest in Labor or Capital? If capital investments don't keep pace, these added workers will strain production facilities. –If this occurs, the law of diminishing marginal productivity would push wages lower and reduce living standards.

56. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Invest in Labor or Capital? Some possible ways of increasing productivity include the following: –Increasing education –Vocational training –Increased capital investment

57. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Invest in Labor or Capital? Improvements in productivity reduce costs. The ATC and MC curves shift down when productivity increases.

58. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Improvements in Productivity Reduce Costs Cost curves shift down MC 2 ATC 2 When the production function shifts up RESOURCE INPUTS (units per time period) 0 TOTAL OUTPUT (units per time period) MC 1 ATC 1 RATE OF OUTPUT (units per time period) 0 COST (dollars per unit)

59. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply Decisions End of Chapter 5