1. McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: Production and Cost in the Short Run

2. Managerial Economics 8-2 Basic Concepts of Production Theory Production function Maximum amount of output that can be produced from any specified set of inputs, given existing technology Technical efficiency Achieved when maximum amount of output is produced with a given combination of inputs Economic efficiency Achieved when firm is producing a given output at the lowest possible total cost Dr. Chen’s notes: Please tell the difference b/w tech. efficiency and econ. efficiency. When the economic efficiency is achieved, the firm also maximizes its profit.

3. Managerial Economics 8-3 Basic Concepts of Production Theory 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 changed quite readily Fixed input An input for which the level of usage cannot readily be changed and which must be paid even if no output is produced

4. Managerial Economics 8-4 Short-Run vs. Long-Run Short run At least one input is fixed All changes in output achieved by changing usage of variable inputs Long run All inputs are variable Output changed by varying usage of all inputs Dr. Chen’s notes: In economics, short run or long run is not qualified by time; it is determined by whether all the inputs can be varied or not. To a hamburger stand, two months might be long run because all inputs (labor, capital, land...etc) can be varied in the period. However, two months are short run to a power plant which cannot change the size of generators for a larger capacity generation in the period.

5. Managerial Economics 8-5 Short Run Production In the short run, capital is generally considered as “fixed” Only changes in the variable labor input can change the level of output Short run production function Dr. Chen’s notes: Although most textbooks define capital as the fixed input in the short run, it is incorrect to conclude that capital must be the fixed input. Consider the software industry. To Microsoft, labor input (programmers) is relatively “fixed”, compared with capital input (equipment, machines). When labor (L) is the only variable input, it will be easier to see how the output changes at different levels of input.

6. Managerial Economics 8-6 Average & Marginal Products Average product of labor AP = Q/L Marginal product of labor MP =  Q/  L Law of diminishing return (marginal product) As usage of a variable input increases, its marginal product will eventually decrease Held in the short-run Dr. Chen’s notes: Why MP eventually declines? In the SR, the fixed input(s) will be crowded by the increasing variable inputs. The additional variable input cannot reach the productivity with constraint. The next three slides illustrate the relationship among MP, AP and TP.

7. Managerial Economics 8-7 Total, Average, & Marginal Products of Labor, K = 2 (Table 8.2) 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

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

9. Managerial Economics 8-9 Total, Average & Marginal Product Curves Panel A Panel B Total product Average product Marginal product Q1Q1 L1L1 L1L1 L2L2 Q2Q2 L2L2 L0L0 Q0Q0 L0L0 Dr. Chen’s notes: See? MP can be negative when labor input > L 2 !

10. Managerial Economics 8-10 Short Run Production Costs Total variable cost (TVC) Total amount paid for variable inputs Increases as output increases Total fixed cost (TFC) Total amount paid for fixed inputs Does not vary with output Total cost (TC) TC = TVC + TFC Dr. Chen’s notes: Costs are related to production. In the SR, total costs count fixed costs and variable costs.

11. Managerial Economics 8-11 Short-Run Total Cost Schedules (Table 8.4) 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 Dr. Chen’s notes: How to define TFC? When output rate is zero (Q=0), the total costs remain as the total fixed costs.

12. Managerial Economics 8-12 Total Cost Curves (Figure 8.3)

13. Managerial Economics 8-13 Average Costs

14. Managerial Economics 8-14 Short Run Marginal Cost Short run marginal cost (SMC) measures rate of change in total cost (TC) as output varies Dr. Chen’s notes: Why do we need to study ATC and SMC? Average total costs allow us to verify whether the firm earns profits (i.e. ATC < unit price, for a positive economic profit); marginal costs determine the optimal output decision (i.e. MR=MC). In reality, marginal costs are not always available for firms. In order to maximize profit by MR=MC, the best alternative of MC is AVC, average variable costs. The next few slides illustrate the relationship among SMC, ATC, and AVC. Figure 8.5 is the most important graph for short-run cost analysis.

15. Managerial Economics 8-15 Average & Marginal Cost Schedules (Table 8.5) 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

16. Managerial Economics 8-16 Average & Marginal Cost Curves (Figure 8.3)

17. Managerial Economics 8-17 Short Run Average & Marginal Cost Curves (Figure 8.5)

18. Managerial Economics 8-18 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

19. Managerial Economics 8-19 Short Run Cost Curve Relations 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 Dr. Chen’s notes: The relationship b/w marginal and average will be explained in the next slide.

20. Managerial Economics 8-20 Why SMC intersects AVC and ATC at their minimum points? It is easy to see the relationship b/w marginal and average in the following example. Assume that your current average test score is 80. If you study hard and get 90 from your next test (marginal score), how will be your new average test score? Definitely higher than 80, right? When your marginal score is higher than your average score, your average score is rising. In contrast, if you continue to perform worse (marginal score is less than average score), then your average score is falling. AVC is increasing when SMC  AVC; AVC is decreasing when SMC  AVC. SMC must pass the minimum of AVC (Check Figure 8.5 again) Same to ATC

21. Managerial Economics 8-21 Short-Run Production & Cost Relations (Figure 8.6)

22. Managerial Economics 8-22 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