Ch 5

The Theory of Producer

Production
Market supply is the Horizontal Summation of individual supply of firms. Firms supply a good through transforming inputs into outputs. This procedure is know as production. Firms production decision depends on its technology production function: Q = Af(L, K, N, H)
Factors of production

Factors of Production
Four types of factors of production: 1.Labour (L)
human power

2.Capital (K)
man-made resources
I. II. Machinery Human Capital skills, knowledge

3.Land
natural resources oil, land

4.Entrepreneur
Decision making organization of resources

Short Run vs Long Run

Producers choice of inputs and decision about output varies with the time horizon. The time horizon of a production is not defined by the length of time.
Is one year time long enough for the following production?
Construction of a sky-high building No Wrapping a burgerYes

Short Run vs Long Run

The time horizon of a production process is defined by the input flexibility. Short Run (SR)
A period in which the quantity of at least one input is fixed, which means that the firm cannot adjust the quantity of a least one input, ie. the fixed factor. Usually, we will assume capital (K) as the fixed factor.

Long Run (LR)

A period in which the quantities of all of the inputs are variable, ie. all are variable factors.

Different industries, the period of SR/LR will be different.

Production in SR
Assumptions:
Two inputs required: Labour (L, variable), capital (K, fixed)

Production function: Q = Af(L, K) As K is fixed, Q = Af(L) ie. The total product varies with the quantities of L only.

Production in SR
Total Product (TP)
The total quantities of output can be produced given an amount of inputs.

Average Product (AP)

The average output being produced by a variable factor (labour). AP = TP/L

Marginal Product (MP)

The additional output being produced by employing one more unit of variable factor (labour). TP MPL = L

Production in SR
The Law of Diminishing Marginal Product:
As more of a variable input is added to a fixed factor, the MP of the variable input will eventually diminish, holding technology constant. Real world observation. Can be found in SR only. It is not the result of deterioration in the quality of labour, ie. it exists even with identical labour.

Total Product Curve

Q TPL

Increasing MP

decreasing MP

, negative MP

Average Product Curve

Q

AP curve can be derived from TP TP curve 1 = slope of L1 A: APL =

B: APL =
TP2 L2 = slope of TP3 L3 = slope of

TP4 TP3 B A L1 L2

D C

TPL

TP2
TP1

Q
AP3 AP4 AP2 AP1

L3

L4

C: APL =

TP4 L4 = slope of D: AP is the slope of the APL = line connecting the point and the origin

APL

L1 L2

L3

L4

Marginal Product Curve

Q MP curve can be derived from TP1 TP curve L1 = slope of A: MPL = B: MPL =
TP4 TP3 B A L1 L2 L3 L4 D C

TPL

TP2
TP1

TP2-TP1 L2-L1 = slope of TP3-TP2 L3-L2 = slope of TP4-TP3 L4-L3 = slope of

Q
MP2

C: MPL = D: MPL =

MP3
MP1 MP4 L1 L2 L3

MP is the slope of the tangent line of that point

MPL L L4

AP vs MP
AP and MP can be divided into three stages: Q
1. Before MPmax:
i. ii. MP & AP are increasing. MP > AP

MPmax APmax APL

2. Between MPmax and APmax:

i.
ii.

MP is decreasing; AP is increasing. MP > AP

L1 L2 L3

MPL
L4

3. After APmax:
i. ii. MP & AP are decreasing MP < AP

AP vs MP
Properties of AP and MP curves:
Both AP and MP are inverted U-shaped
As more and more labours are employed, both AP and MP increase. But, after reaching the maximum level, they begin to drop.

MP reaches its maximum earlier than AP reaches its maximum. MP can be negative, but AP must be positive.

Equilibrium
If a producer can sell its products at $10 per unit in the market and the wage per worker is $60 per day. Given the following input-output relationship, how many labour should be employed? VMP = product price x MP We compare the revenue generated
Labour 1 2 3 4 TP 10 18 24 28
MP VMP

10
8 6 4

$100 $80 $60 $40

by each labour and the wage revenue generated = value of MP (VMP) VMP > wage, hire VMP < wage, fire VMP = wage, optimal Only 3 labours are employed.

SR Cost of Production
Assumptions:
Two inputs required: Labour (L, variable), capital (K, fixed)
Labour Capital cost cost (STC):

SR Total Cost STC = wL +rK

where w = wage, r = rent

To increase output, the firm can increase Variable Cost L. wL increases with
output Fixed Cost TherK remains unchanged with to raise firm cannot increase K output output.

SR Cost of Production
STC = Total Fixed Cost + Total Variable Cost Example:
TFC TVC
Fixed factor

To setup a factory, a firm needs to build up a plant with cost $1M. In order to produce outputs, variable factor it also need to hire labours. Each labour costs $200 per day and each can produce 1 unit of output. What is the TFC and TVC if 500 units are produced?

TFC = $1M (capital cost) TVC = $200 x 500 = $100,000

SR Cost of Production
SR Marginal Cost (SMC)
Change in total variable cost when the output level changes by one unit. Change in total variable cost = Change in total cost Change in total cost when the output level TVC STC changes by one unit.
SMC = Q =

SR Cost of Production
SR Average Total Cost (ATC)
SR total cost divided by the quantity of output STC = TFC +TVC ATC = average fixed cost(AFC) + average variable cost (AVC)
STC TFC TVC ATC = Q = Q + Q
AFC

AVC

SR Total Cost Curve

We start from deriving the TVC curve. Assume w = 1, wL (Cost) = L TVC curve is the transformation of SR TP Curve Q TP
TVC
Q2
L

Q1

L (Cost)

L2

L1

L1

L2

SR Total Cost Curve

TFC is not vary with the quantity of output
C

TFC Q

SR Total Cost Curve

STC = TFC + TVC STC curve = vertical summation of TFC STC and TVC curve
C TFC TFC

TFC TVC

TFC

The difference between SAC and AVC is AFC.

SR Marginal Cost Curve

There are two ways to derive SMC curve
1. Draw tangent lines for the STC 2. Transform the SR MP Curve
TVC wL wL L 1 SMC = Q = Q = Q = w Q = w MP L

SMC Curve is the invert of SR MP Curve

SR Marginal Cost Curve

Q MPmax

Inverted U-shaped
C MPL L L4 SMC U-shaped SMCmin
L1 L2 L3 L4

L1

L2

L3

SR Average Cost Curve

We start from deriving the AVC curve. There are two ways to derive AVC curve
1. Draw a line from the origin to a point on TVC 2. Transform the SR AP Curve
TVC wL L 1 AVC = Q = Q = w Q = w AP L

AVC Curve is the invert of SR AP Curve

SR Average Cost Curve

Q APmax APL C
L1 L2 L3 L4

Inverted U-shaped
L

AVC AVCmin
L1 L2 L3 L4

U-shaped

SR Average Cost Curve

TFC AFC = Q

As TFC is fixed, Q increases, AFC drops

C AFC will not cut the x-axis

AFC Q

SR Average Cost Curve

ATC = AFC + AVC ATC curve = vertical summation of AFC and AVC curve SAC & AVC will not intersect C
AFC

ATC AFC AVC AFC

AFC Q

The difference between ATC and AVC is AFC. The difference reduces as Q increases.

AC vs MC
1. SMC reaches its minimum earlier than C AVC and ATC. 2. SMC passes through the minimum of AVC and ATC from below.

SMC ATC ATCmin AVC

AVCmin SMCmin

Comparative Static
How an increase in variable input price (wage) affect the cost curves? Wage increases = variable cost increases TVC increases STC = TVC + TFC STC increases AVC = TVC/Q AVC increases ATC = AVC + AFC ATC TVC increases SMC = Q SMC increases

Comparative Static
TVC2

C C
TVC1

SMC2 SMC1 AVC2 AVC1

Comparative Static
How an increase in fixed input price (rent) affect the cost curves? rent increases = fixed cost increases TFC increases STC = TVC + TFC STC ATC ATC = AVC + AFC increases increases

Comparative Static
C
STC2 STC1

C SMC1 ATC2 ATC1

TFC2 TFC1

LR Total Cost Curve

In the LR, all the factors become variable All the costs are variable cost LR Total Cost (LTC) = Total Variable Cost
C
LTC

LR Marginal Cost
LR Marginal Cost (LMC)
Change in total cost when the output level changes by one unit.
C TC MC = Q

LMC

LR Average Cost
LR Average Cost (LAC)
LR total cost divided by the quantity of output
C LTC LAC = Q LAC

LR Average Cost Curve

Two ways to explain the shape of LAC 1. Economies of scale
When the scale of production increases, the average cost decreases Quasi-fixed cost: electricity expenses, advertising expenses, management costs When the scale of production increases, the average cost increases; diseconomies of scale When Q increases, the firm experiences economies of scale first. If Q keeps on increasing, the firm will enter the stage of

LR Average Cost
When Q increases, the firm experiences economies of scale first; LAC drops. After that the firm reaches the optimal scale, which allows the firm produces at its lowest AC. If Q keeps on increasing, the firm will enter the stage of diseconomies of scale; LAC increases.
C
Econ. Optimal of scale scale DIsecon. of scale

LAC

LR Average Cost Curve

2. Returns to scale
Increasing Returns to Scale (IRS)
When all the inputs doubled, the output increases by more than double. eg. 3Q = f(2L, 2K)

Constant Returns to Scale (CRS)

When all the inputs doubled, the output double. eg. 2Q = f(2L, 2K)

decreasing Returns to Scale (DRS)

When all the inputs doubled, the output increases by less than double. eg. 1.5Q = f(2L, 2K)

LR Average Cost
When Q increases, the firm experiences IRS; LAC drops After that the firm enters CRS; AC remains the same. If Q keeps on increasing, the firm will enter the stage of DRS; LAC increases
C
IRS CRS DRS

LAC

LAC vs SAC
In period 1, the firm has capital = K1. AC =SAC1 In period 2, the firm raises capital = K2. AC =SAC2 In period 3, the firm raises capital = K3. AC =SAC3 In period 4, the firm raises capital = K4. AC =SAC4 In LR, the firm can vary the amount of capital freely. AC = LAC The LAC envelope all the SAC from below, which means LAC C must be lower than SAC in any period. SAC
4

SAC1 SAC2 SAC 3

LAC