Transcript IPPTChap008x

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
8-1
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
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market, so why don’t firms get bigger?
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
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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
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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 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
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Basic Concepts of
Production Theory
 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
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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
8-7
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
8-8
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?
8-9
Inputs in Production
Input Type
Payment
Relation
to Output
(Table 8.1)
Avoidable
or Sunk?
Employed in
SR or LR?
Variable
Variable cost
Direct
Avoidable
SR & LR
Fixed
Fixed costs
Constant
Sunk
SR only
Quasi-fixed
Quasi-fixed costs
Constant
Avoidable
If required:
SR & LR
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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)
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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
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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)
0
0
--
--
1
52
52
52
2
112
56
60
3
170
56.7
58
4
220
55
50
5
258
51.6
38
6
286
47.7
28
7
304
43.4
18
8
314
39.3
10
9
318
35.3
4
10
314
31.4
-4
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Total, Average, & Marginal Products
K = 2 (Figure 8.1)
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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
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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
6,000
4,000
10,000
200
6,000
6,000
12,000
300
6,000
9,000
15,000
400
6,000
14,000
20,000
500
6,000
22,000
28,000
600
6,000
34,000
40,000
0
$6,000
100
$
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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?
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Total Cost Curves
(Figure 8.3)
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Average Costs
 Average fixed cost (AFC)
TFC
AVC 
Q
 Average variable cost (AVC)
TVC
AFC 
Q
 Average total cost (ATC)
TC
ATC 
 AFC  AVC
Q
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Short Run Marginal Cost
 Short run marginal cost (SMC) measures
rate of change in total cost (TC) as output
varies
TVC TC
SMC 

Q
Q
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Average & Marginal Cost Schedules
(Table 8.6)
Output
(Q)
Average
Average
fixed cost
variable cost
(AFC=TFC/Q) (AVC=TVC/Q)
Average total
cost
(ATC=TC/Q=
AFC+AVC)
--
Short-run
marginal cost
(SMC=TC/Q)
0
--
--
100
$60
$40
$100
$40
200
30
30
60
20
300
20
30
50
30
400
15
35
50
50
500
12
44
56
80
600
10
56.7
66.7
--
120
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Average & Marginal Cost Curves
(Figure 8.4)
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Short Run Average & Marginal
Cost Curves (Figure 8.5)
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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.
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Costs per unit, $
Effect of a Specific Tax on Cost
Curves
80
A $10.00 tax shifts
both the AC and
MC by exactly
$10…
MC a = MC b + 10
MC b
$10
AC a = AC b + 10
37
$10
AC b
27
0
5
8
10
15
q, Units per d ay
8-25
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 beforetax average cost curve is U-shaped.)
8-26
Answer
8-27
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
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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
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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
w
w
AVC 
and SMC 
AP
MP
Where w is the price of the variable input
TC = wL + rK
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Short-Run Production & Cost
Relations (Figure 8.6)
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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
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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
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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
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declines
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
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