The document discusses the production decisions of firms. It explains that firms make production choices by considering their production technology, costs, and available inputs. It then provides details on the technology of production, including production functions, short-run vs long-run factors, and how average and marginal products are determined. It also discusses costs of production, including fixed vs variable costs and how marginal cost is determined.
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The document discusses the production decisions of firms. It explains that firms make production choices by considering their production technology, costs, and available inputs. It then provides details on the technology of production, including production functions, short-run vs long-run factors, and how average and marginal products are determined. It also discusses costs of production, including fixed vs variable costs and how marginal cost is determined.
The document discusses the production decisions of firms. It explains that firms make production choices by considering their production technology, costs, and available inputs. It then provides details on the technology of production, including production functions, short-run vs long-run factors, and how average and marginal products are determined. It also discusses costs of production, including fixed vs variable costs and how marginal cost is determined.
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online from Scribd
The document discusses the production decisions of firms. It explains that firms make production choices by considering their production technology, costs, and available inputs. It then provides details on the technology of production, including production functions, short-run vs long-run factors, and how average and marginal products are determined. It also discusses costs of production, including fixed vs variable costs and how marginal cost is determined.
Copyright:
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Producers Behaviour
Production The theory of the firm describes how a firm makes costminimizing production decisions and how the firms resulting cost varies with its output.
The Production Decisions of a Firm
The production decisions of firms are analogous to the purchasing decisions of consumers, and can likewise be understood in three steps: 1. 2. 3. Production Technology Cost Constraints Input Choices
THE TECHNOLOGY OF PRODUCTION
factors of production Inputs into the production process (e.g., labor, capital, and materials).
The Production Function
q F (K , L)
production function Function showing the highest output that a firm can produce for every specified combination of inputs. Remember the following: Inputs and outputs are flows. This Equation applies to a given technology. Production functions describe what is technically feasible when the firm operates efficiently.
THE TECHNOLOGY OF PRODUCTION
The Short Run versus the Long Run
short run Period of time in which quantities of one or more production factors cannot be changed. fixed input Production factor that cannot be varied.
long run Amount of time needed to make all production inputs variable.
PRODUCTION WITH ONE VARIABLE INPUT (LABOR)
Production with One Variable Input
Amount of Labor (L)
0 1 2 3 4 5 6 7 8 9 10
Amount of Capital (K)
10 10 10 10 10 10 10 10 10 10 10
Total Output (q)
0 10 30 60 80 95 108 112 112 108 100
Average Product (q/L)
10 15 20 20 19 18 16 14 12 10
Marginal Product (q/L)
10 20 30 20 15 13 4 0 4 8
PRODUCTION WITH ONE VARIABLE INPUT (LABOR)
Average and Marginal Products
average product Output per unit of a particular input.
marginal product
Additional output produced as an input is increased by one unit.
Average product of labor = Output/labor input = q/L Marginal product of labor = Change in output/change in labor input = q/L Elasticity of production: A measure of proportionality between changes in inputs and resulting changes in output
EL
Q L L Q
PRODUCTION WITH ONE VARIABLE INPUT (LABOR)
The Slopes of the Product Curve
Production with One Variable Input
The total product curve in (a) shows the output produced for different amounts of labor input. The average and marginal products in (b) can be obtained (using the data in Table 6.1) from the total product curve. At point A in (a), the marginal product is 20 because the tangent to the total product curve has a slope of 20. At point B in (a) the average product of labor is 20, which is the slope of the line from the origin to B. The average product of labor at point C in (a) is given by the slope of the line 0C.
PRODUCTION WITH ONE VARIABLE INPUT (LABOR)
The Slopes of the Product Curve
Production with One Variable Input (continued)
To the left of point E in (b), the marginal product is above the average product and the average is increasing; to the right of E, the marginal product is below the average product and the average is decreasing. As a result, E represents the point at which the average and marginal products are equal, when the average product reaches its maximum. At D, when total output is maximized, the slope of the tangent to the total product curve is 0, as is the marginal product.
all possible combinations of inputs that yield the same output. (isoquants.pdf)
PRODUCTION WITH TWO VARIABLE INPUTS
Isoquants isoquant map
Graph combining a number of isoquants, used to describe a production function.
Production with Two Variable Inputs
A set of isoquants, or isoquant map, describes the firms production function. Output increases as we move from isoquant q1 (at which 55 units per year are produced at points such as A and D), to isoquant q2 (75 units per year at points such as B) and to isoquant q3 (90 units per year at points such as C and E).
PRODUCTION WITH TWO VARIABLE INPUTS
Diminishing Marginal Returns
Holding the amount of capital fixed at a particular levelsay 3, we can see that each additional unit of labor generates less and less additional output.
PRODUCTION WITH TWO VARIABLE INPUTS Substitution Among Inputs
marginal rate of technical substitution (MRTS) Amount by which the quantity of one input can be reduced when one extra unit of another input is used, so that output remains constant. MRTS = Change in capital input/change in labor input = K/L (for a fixed level of q)
Marginal Rate of Technical Substitution
Like indifference curves, isoquants are downward sloping and convex. The slope of the isoquant at any point measures the marginal rate of technical substitutionthe ability of the firm to replace capital with labor while maintaining the same level of output.
On isoquant q2, the MRTS falls from 2 to 1 to 2/3 to 1/3.
(MP ) / (MP ) (K / L) MRTS L K
PRODUCTION WITH TWO VARIABLE INPUTS
Production FunctionsTwo Special Cases
Isoquants When Inputs Are Perfect Substitutes
When the isoquants are straight lines, the MRTS is constant. Thus the rate at which capital and labor can be substituted for each other is the same no matter what level of inputs is being used. Points A, B, and C represent three different capital-labor combinations that generate the same output q3. (ex-musical instruments)
PRODUCTION WITH TWO VARIABLE INPUTS
fixed-proportions production function Production function with L-shaped isoquants, so that only one combination of labor and capital can be used to produce each level of output.
Production FunctionsTwo Special Cases
The fixed-proportions production function describes situations in which methods of production are limited. (Leontief production function) Fixed-Proportions Production Function
When the isoquants are Lshaped, only one combination of labor and capital can be used to produce a given output (as at point A on isoquant q1, point B on isoquant q2, and point C on isoquant q3). Adding more labor alone does not increase output, nor does adding more capital alone. (e.g. one labor + one jackhammer)
Ridge Lines Revisiting Cobb-Douglas Production function Elasticity of output (are the values of exponents in the Cobb-Douglas function)
Cobb-Douglas Production Function
Q L K
Homogeneous of degree 1+ 2
RETURNS TO SCALE returns to scale Rate at which output increases as inputs are increased proportionately.
increasing returns to scale
Situation in which output more than doubles when all inputs are doubled.
constant returns to scale
Situation in which output doubles when all inputs are doubled.
Situation in which output less than doubles when all inputs are doubled.
decreasing returns to scale
RETURNS TO SCALE
Describing Returns to Scale
Returns to Scale
When a firms production process exhibits constant returns to scale as shown by a movement along line 0A in part (a), the isoquants are equally spaced as output increases proportionally.
However, when there are increasing returns to scale as shown in (b), the isoquants move closer together as inputs are increased along the line.
COST OF PRODUCTION
MEASURING COST: WHICH COSTS MATTER?
Economic Cost versus Accounting Cost accounting cost Actual expenses plus depreciation charges for capital equipment. economic cost Cost to a firm of utilizing economic resources in production, including opportunity cost.
Opportunity Cost opportunity cost Cost associated with opportunities that are forgone when a firms resources are not put to their best alternative use.
MEASURING COST: WHICH COSTS MATTER?
Sunk Costs sunk cost Expenditure that has been made and cannot be recovered. Because a sunk cost cannot be recovered, it should not influence the firms decisions.
For example, consider the purchase of specialized equipment for a plant. Suppose the equipment can be used to do only what it was originally designed for and cannot be converted for alternative use. The expenditure on this equipment is a sunk cost. Because it has no alternative use, its opportunity cost is zero. Thus it should not be included as part of the firms economic costs.
MEASURING COST: WHICH COSTS MATTER?
Fixed Costs and Variable Costs total cost (TC or C) Total economic cost of production, consisting of fixed and variable costs. fixed cost (FC) Cost that does not vary with the level of output and that can be eliminated only by shutting down. variable cost (VC) as output varies. Cost that varies
The only way that a firm can eliminate its fixed costs is by shutting down.
MEASURING COST: WHICH COSTS MATTER?
Fixed Costs and Variable Costs Shutting Down Shutting down doesnt necessarily mean going out of business. By reducing the output of a factory to zero, the company could eliminate the costs of raw materials and much of the labor. The only way to eliminate fixed costs would be to close the doors, turn off the electricity, and perhaps even sell off or scrap the machinery.
Fixed or Variable? How do we know which costs are fixed and which are variable?
Over a very short time horizonsay, a few monthsmost costs are fixed. Over such a short period, a firm is usually obligated to pay for contracted shipments of materials. Over a very long time horizonsay, ten yearsnearly all costs are variable. Workers and managers can be laid off (or employment can be reduced by attrition), and much of the machinery can be sold off or not replaced as it becomes obsolete and is scrapped.
MEASURING COST: WHICH COSTS MATTER?
Marginal and Average Cost Marginal Cost (MC) A Firms Costs Rate of Output (Units per Year) Fixed Cost (Dollars per Year) (FC) (1) Variable Cost (Dollars per Year) (VC) (2) Total Cost (Dollars per Year) (TC) (3) Marginal Cost (Dollars per Unit) (MC) (4) Average Fixed Cost (Dollars per Unit) (AFC) (5) Average Variable Cost (Dollars per Unit) (AVC) (6) Average Total Cost (Dollars per Unit) (ATC) (7)
0 1 2 3 4 5
50 50 50 50 50 50
0 50 78 98 112 130
50 100 128 148 162 180
-50 28 20 14 18
-50 25 16.7 12.5 10
-50 39 32.7 28 26
-100 64 49.3 40.5 36
6 7 8 9 10 11
50 50 50 50 50 50
150 175 204 242 300 385
200 225 254 292 350 435
20 25 29 38 58 85
8.3 7.1 6.3 5.6 5 4.5
25 25 25.5 26.9 30 35
33.3 32.1 31.8 32.4 35 39.5
MEASURING COST: WHICH COSTS MATTER?
Marginal and Average Cost Average Total Cost (ATC) average total cost (ATC) Firms total cost divided by its level of output. average fixed cost (AFC) Fixed cost divided by the level of output. average variable cost (AVC) Variable cost divided by the level of output.
COST IN THE SHORT RUN
The Determinants of Short-Run Cost The change in variable cost is the per-unit cost of the extra labor w times the amount of extra labor needed to produce the extra output L. Because VC = wL, it follows that
The extra labor needed to obtain an extra unit of output is L/q = 1/MPL. As a result,
Diminishing Marginal Returns and Marginal Cost
Diminishing marginal returns means that the marginal product of labor declines as the quantity of labor employed increases. As a result, when there are diminishing marginal returns, marginal cost will increase as output increases.
COST IN THE SHORT RUN
The Shapes of the Cost Curves Cost Curves for a Firm
In (a) total cost TC is the vertical sum of fixed cost FC and variable cost VC. In (b) average total cost ATC is the sum of average variable cost AVC and average fixed cost AFC. Marginal cost MC crosses the average variable cost and average total cost curves at their minimum points.
COST IN THE SHORT RUN
The Shapes of the Cost Curves The Average-Marginal Relationship Consider the line drawn from origin to point A in (a). The slope of the line measures average variable cost (a total cost of $175 divided by an output of 7, or a cost per unit of $25). Because the slope of the VC curve is the marginal cost , the tangent to the VC curve at A is the marginal cost of production when output is 7. At A, this marginal cost of $25 is equal to the average variable cost of $25 because average variable cost is minimized at this output.
COST IN THE LONG RUN
The Isocost Line Producing a Given Output at Minimum Cost
Isocost curves describe the combination of inputs to production that cost the same amount to the firm. Isocost curve C1 is tangent to isoquant q1 at A and shows that output q1 can be produced at minimum cost with labor input L1 and capital input K1. Other input combinations L2, K2 and L3, K3yield the same output but at higher cost.
COST IN THE LONG RUN
Choosing Inputs Recall that in our analysis of production technology, we showed that the marginal rate of technical substitution of labor for capital (MRTS) is the negative of the slope of the isoquant and is equal to the ratio of the marginal products of labor and capital:
It follows that when a firm minimizes the cost of producing a particular output, the following condition holds:
We can rewrite this condition slightly as follows:
COST IN THE LONG RUN
Cost Minimization with Varying Output Levels expansion path Curve passing through points of tangency between a firms isocost lines and its isoquants.
The Expansion Path and Long-Run Costs
To move from the expansion path to the cost curve, we follow three steps: 1. Choose an output level represented by an isoquant. Then find the point of tangency of that isoquant with an isocost line.
2. From the chosen isocost line determine the minimum cost of producing the output level that has been selected. 3. Graph the output-cost combination.
LONG-RUN VERSUS SHORT-RUN COST CURVES
The Inflexibility of Short-Run Production The Inflexibility of Short-Run Production
When a firm operates in the short run, its cost of production may not be minimized because of inflexibility in the use of capital inputs. Output is initially at level q1. In the short run, output q2 can be produced only by increasing labor from L1 to L3 because capital is fixed at K1. In the long run, the same output can be produced more cheaply by increasing labor from L1 to L2 and capital from K1 to K2.
LONG-RUN VERSUS SHORT-RUN COST CURVES
Long-Run Average Cost
Long-Run Average and Marginal Cost
When a firm is producing at an output at which the longrun average cost LAC is falling, the long-run marginal cost LMC is less than LAC. Conversely, when LAC is increasing, LMC is greater than LAC. The two curves intersect at A, where the LAC curve achieves its minimum.
LONG-RUN VERSUS SHORT-RUN COST CURVES
Long-Run Average Cost long-run average cost curve (LAC) Curve relating average cost of production to output when all inputs, including capital, are variable. short-run average cost curve (SAC) Curve relating average cost of production to output when level of capital is fixed.
long-run marginal cost curve (LMC) Curve showing the change in long-run total cost as output is increased incrementally by 1 unit.
LONG-RUN VERSUS SHORT-RUN COST CURVES
Economies and Diseconomies of Scale As output increases, the firms average cost of producing that output is likely to decline, at least to a point. This can happen for the following reasons:
1. If the firm operates on a larger scale, workers can specialize in the activities at which they are most productive. 2. Scale can provide flexibility. By varying the combination of inputs utilized to produce the firms output, managers can organize the production process more effectively. 3. The firm may be able to acquire some production inputs at lower cost because it is buying them in large quantities and can therefore negotiate better prices. The mix of inputs might change with the scale of the firms operation if managers take advantage of lower-cost inputs.
LONG-RUN VERSUS SHORT-RUN COST CURVES
Economies and Diseconomies of Scale At some point, however, it is likely that the average cost of production will begin to increase with output. There are three reasons for this shift: 1. At least in the short run, factory space and machinery may make it more difficult for workers to do their jobs effectively. 2. Managing a larger firm may become more complex and inefficient as the number of tasks increases. 3. The advantages of buying in bulk may have disappeared once certain quantities are reached. At some point, available supplies of key inputs may be limited, pushing their costs up.
LONG-RUN VERSUS SHORT-RUN COST CURVES
Economies and Diseconomies of Scale economies of scale Situation in which output can be doubled for less than a doubling of cost. diseconomies of scale Situation in which a doubling of output requires more than a doubling of cost. Increasing Returns to Scale: Output more than doubles when the quantities of all inputs are doubled. A doubling of output requires less than a doubling of cost.
Economies of Scale:
LONG-RUN VERSUS SHORT-RUN COST CURVES
Economies and Diseconomies of Scale Economies of scale are often measured in terms of a cost-output elasticity, EC. EC is the percentage change in the cost of production resulting from a 1-percent increase in output:
To see how EC relates to our traditional measures of cost, rewrite the equation as follows:
LONG-RUN VERSUS SHORT-RUN COST CURVES
The Relationship Between Short-Run and Long-Run Cost
Long-Run Cost with Economies and Diseconomies of Scale
The long-run average cost curve LAC is the envelope of the short-run average cost curves SAC1, SAC2, and SAC3. With economies and diseconomies of scale, the minimum points of the shortrun average cost curves do not lie on the long-run average cost curve.
PRODUCTION WITH TWO OUTPUTS ECONOMIES OF SCOPE
Economies and Diseconomies of Scope economies of scope Situation in which joint output of a single firm is greater than output that could be achieved by two different firms when each produces a single product.
diseconomies of scope Situation in which joint output of a single firm is less than could be achieved by separate firms when each produces a single product.
PRODUCTION WITH TWO OUTPUTS ECONOMIES OF SCOPE
The Degree of Economies of Scope To measure the degree to which there are economies of scope, we should ask what percentage of the cost of production is saved when two (or more) products are produced jointly rather than individually.
degree of economies of scope (SC) Percentage of cost savings resulting when two or more products are produced jointly rather than Individually.
DYNAMIC CHANGES IN COSTS THE LEARNING CURVE
The Learning Curve
A firms production cost may fall over time as managers and workers become more experienced and more effective at using the available plant and equipment. The learning curve shows the extent to which hours of labor needed per unit of output fall as the cumulative output increases.
learning curve Graph relating amount of inputs needed by a firm to produce each unit of output to its cumulative output.
ESTIMATING AND PREDICTING COST
Average Cost of Production in the Electric Power Industry
The average cost of electric power in 1955 achieved a minimum at approximately 20 billion kilowatt-hours. By 1970 the average cost of production had fallen sharply and achieved a minimum at an output of more than 33 billion kilowatthours.
