Econ 101: Principles of Microeconomics

Chapter 12 - Behind the Supply Curve - Inputs and Costs

Fall 2010

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Outline

The Production Function

Marginal Cost and Average Cost

Short-Run versus Long-Run Costs

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Overview

In this chapter we turn our attention to the rm. A rm is an organization that produces goods or services for sale. We will begin by characterizing the relationship between the rms inputs and the quantity of outputs it produces. The production function describes the relationship between the quantity of inputs and the quantity of outputs that the rm produces. Basic characteristics of the production function has implications for the cost structure for the rm, which in turn has implications for the rm ultimate supply function.

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The Production Function

The Short Run and the Long Run

It is useful to categorize rms decisions into

- Long-run decisionsinvolves a time horizon long enough for a rm to vary all of its inputs - Short-run decisionsinvolves any time horizon over which at least one of the rms inputs cannot be varied

To guide the rm over the next several years, manager must use the long-run view To determine what the rm should do next week, the short run view is best.

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The Production Function

Production in the Short Run

In the short-run, the rms inputs can be divided into one of two categories
1

Fixed inputs
- These are inputs whose quantity is constant for some period of time (regardless of how much output is produced). - Typically, xed inputs will include land and machinery, though they can also include certain types of labor (due to contracts).

Variable inputs
- These are inputs whose quantity the rm can vary, even in the short run. - Examples of variable inputs often include labor, energy, fuel, etc.

When rms make short-run decisions, there is nothing they can do about their xed inputs; i.e., they are stuck with whatever quantity they have. However, they can make choices about their variable inputs.
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The Production Function

Total Product

To x ideas, suppose we have a rm whose only variable input is labor All other inputs (capital, land, raw materials, etc.) we will assume for now are xed. Total product is the maximum quantity of output that can be produced from a given combination of inputs. The total product curve shows how the quantity of output depends on the quantity of variable input, for a given quantity of the xed input. We would generally expect the total product curve to be increasing; i.e., as the quantity of the variable input increases, we would expect total output to increase.

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The Production Function

Consider Johns Woodworking Shop Again

Units of Labor 0 1 2 3 4 5 6 7 8

Total Product 0 10 35 80 160 193 218 239 257

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The Production Function

The Total Product Curve

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The Production Function

Marginal Product
Notice that the Total Product curve is always increasing in this case, but that its slope is not the same throughout.
- Initial the slope is increasing - but eventually it starts to atten out.

The slope of the Total Product Curve is the Marginal Product of labor. Formally, Marginal Product of Labor (MPL) = = Change in Quantity of Output Change in Quantity of Labor Q L

Tells us the rise in output produced when one more worker is hired
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The Production Function

Units of Labor 0 1 2 3 4 5 6 7 8

Total Product 0 10

Marginal Product 10 25

35 45 80 80 160 33 193 25 218 21 239 18 257

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The Production Function

The Marginal Product Curve

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The Production Function

Marginal Returns To Labor

As more and more workers are hired, the MPL is at rst increasing
- This is known as increasing returns to labor - This is typically due to the returns to specialization - It can also arise due to minimum labor requirements for equipment.

Eventually, however, the MPL starts to decline

- This is known as diminishing returns to labor - This arises as the gains from specialization are exhausted and - The constraints caused by the xed inputs start to bind

This pattern of MPL (and for other inputs) is thought to hold for most industries. Consider the problem of a woodworking shop.

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Marginal Cost and Average Cost

Production and Firm Costs

Understanding the nature of a rms production function is important in that it has implications for the rms costs. In the short run, the rms costs can be divided into two broad categories:
1

Total Fixed costs (TFC): These are costs that do not depend upon the quantity of output produced.
- These costs are typically associated with xed inputs. - Examples of xed costs might be the rent paid for the rms building or equipment rentals.

Total Variable costs (TVC): These are costs that depend on the quantity output produced.
- As the name suggests, these are costs associated with the variable inputs. - In the case of Johns Woodworking shop, the TVC = w L where w denotes the wage rate.

Total Costs = TFC + TVC.

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Marginal Cost and Average Cost

Johns Cost Structure

Suppose that John has a TFC of $5000 and pays a wage rate of $1200 per week
Units of Labor 0 1 2 3 4 5 6 7 8 Total Output 0 10 35 80 160 193 218 239 257 Total Fixed Cost (TFC) $5000 $5000 $5000 $5000 $5000 $5000 $5000 $5000 $5000 Total Variable Costs (TVC) $0 $1200 $2400 $3600 $4800 $6000 $7200 $8400 $9600 Total Costs (TC) $5000 $6200 $7400 $8600 $9800 $11000 $12200 $13400 $14600

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Marginal Cost and Average Cost

The Cost Curves

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Marginal Cost and Average Cost

Marginal and Average Cost Curves

While the breakdown of Total Cost into Total Fixed and Total Variable Costs is helpful, two other measures of cost will be even more useful:
1

Marginal Cost: Measures the additional cost of producing one more unit of a good or service. Average Cost: Measures the average cost per unit of the good or service (i.e., the costs averaged over all of the output produced by the rm).

Understanding the distinction between these two concepts will be key to nding the optimal level of production for the rm. Well start with average cost

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Marginal Cost and Average Cost

Average Costs
There are three types of average costs 1 Average Fixed Costs (AFC) = Total Fixed Costs divided by Output TFC AFC = (1) Q Since the numerator is xed, AFC will decline as output increases. 2 Average Variable Costs (AVC) = Total Variable Costs divided by Output TVC AVC = (2) Q
- Since TVC is initial slowing down as output increases (with increasing returns to labor), AVC will initially fall as output increases. - As TVC starts to increase more rapidly with output (with diminishing returns to labor), AVC will start to increase with output.
3

Average Total Costs (ATC) = Total Costs divided by Output TC ATC = = AFC + AVC Q
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Marginal Cost and Average Cost

Johns Average Costs

Units of Labor 1 2 3 4 5 6 7 8

Total Product 10 35 80 160 193 218 239 257

AFC $500.00 $142.86 $62.50 $31.25 $25.91 $22.94 $20.92 $19.46

AVC $120.00 $68.57 $45.00 $30.00 $31.09 $33.03 $35.15 $37.35

ATC $620.00 $211.43 $107.50 $61.25 $56.99 $55.96 $56.07 $56.81

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Marginal Cost and Average Cost

The Average Cost Curves

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Marginal Cost and Average Cost

Marginal Costs
Another way of looking at the rms cost structure is to look at its Marginal Costs; i.e., how its costs increase as output increases. Formally: TC MC = (4) Q If we look at Johns Woodworking Shop we have
Output 0 10 35 80 160 193 218 239 257
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Total Cost 5000 6200 7400 8600 9800 11000 12200 13400 14600

Q 10 25 45 80 33 25 21 18

TC 1200 1200 1200 1200 1200 1200 1200 1200

MC 120 48 27 15 36 48 57 67
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Ch. 12 Behind the Supply Curve

Marginal Cost and Average Cost

Adding in the MC Curve

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Marginal Cost and Average Cost

Patterns in the MC and AC Curves

Notice that the MC curve is

- Initially declining- this is due to increasing returns to labor - Eventually increasing- this is due to diminishing returns to labor

The minimum-cost output, Q min , is the quantity at which the average total cost is lowest.
- This is at the bottom of the ATC curve. - and occurs where ATC=MC

At outputs less than Q min , ATC > MC and ATC is falling. At outputs greater than Q min , ATC < MC and ATC is rising.

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Short-Run versus Long-Run Costs

Production Costs in the Long Run

Up until now, we have been focussing on the short-run, with some of the rms inputs held xed. In the long run, costs behave dierently
Firm can adjust all of its inputs in any way it wants In the long run, there are no xed inputs or xed costs; i.e. all inputs and all costs are variable

Firm must decide what combination of inputs to use in producing any level of output The rms goal is to earn the highest possible prot To do this, it must follow the least cost rule; i.e., to produce any given level of output the rm will choose the input mix with the lowest cost This yields a Long-Run Average Total Cost Curve; i.e., the relationship between the output and the ATC when xed costs are chosen to minimize total cost for each level of output.
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Short-Run versus Long-Run Costs

Consider Johns Woodworking Shop

Suppose that in our rst production function, we assumed that John had only one set of tools (e.g., 1 table saw, 1 drill press, and 1 router table). Well call this one unit of capital The tools (and the space to house his tools) constitute xed costs for John in the short-run. In the long-run, John must decide whether or not he wants to expand his capital stock The trade-o is that additional capital will avoid worker congestion, but imposes a large xed cost on the rm.
At low levels of production, having just one set of tools is not a binding constraint and John would rather avoid the additional capital costs. At higher levels of production, additional capital will avoid congestion problems and the capital costs are spread out over more units of production.
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Short-Run versus Long-Run Costs

Dierent Levels of Capital

Labor Units of Labor 0 1 2 3 4 5 6 7 8

Units of Capital Capital = 1 Capital = 2 Capital = 3 0 0 0 10 10 10 35 39 39 80 92 101 160 184 202 193 284 314 218 397 439 239 443 571 257 478 709

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Short-Run versus Long-Run Costs

The Corresponding ATC Figures are Given by

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Short-Run versus Long-Run Costs

Johns Capital Stock Choice

The level of capital stock John chooses depends on his expected level of output

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Short-Run versus Long-Run Costs

If Capital Stock Can be Varied Continuously, We Get

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Short-Run versus Long-Run Costs

Returns to Scale
LRATC curves for industries usually exhibit three basic phases:
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Increasing Returns to Scale: Output range with declining LRATC

This is also known as economies of scale Economies of scale often arise due to the gains from specialization. The greatest opportunities for increased specialization occur when a rm is producing at a relatively low level of output Economies of scale can also arise due to minimum size requirements for certain types of equipment.

Constant Returns to Scale: Output range with constant LRATC

Over some range of production, size may not matter and rms of the same size will be equally cost-eective.

Decreasing Returns to Scale: Output range with increasing LRATC

This is also known as diseconomies of scale As output continues to increase, most rms will reach a point where bigness begins to cause problems This is true even in the long run, when the rm is free to increase its plant size as well as its workforce Diseconomies of scale are more likely at higher output levels

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Short-Run versus Long-Run Costs

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