AGEC/FNR 406 LECTURE 6

An irrigated rice field in Bangladesh

Theory of supply

Lecture Goals:

1. Review the “supply side” of economic theory

2. Identify some important exceptions tothe theory as they apply to the course

Production: the supply side

We now examine the production side of supply and demand.

Supply is an indicator of economic cost.

Demand describes the consumer side of the supply and demand equation.

Demand is an indicator of value or benefit.

Production function

Inputs may be:

1. Variable: dependent on the level of output

2. Fixed: required at a constant level regardless of the level of output

A production function describes the maximum quantity of output that can be produced using a set of inputs, using a specified technology.

Example: production function with one input

0 10 20 30 40 50 60 70

Units of input

quantity

Production exhibits decreasing returns to scale: as more inputs are added, output increases, but at a diminishing rate

6

5

4

3

2

1

0

Q = f (X)

Marginal Product(MP)

The incremental change in output arising from the use of one additional unit of variable input:

MP = Q/X

Marginal value product (MVP) = price*MP

Cost

Costs may include:

1. Private costs to individuals or firms2. Social costs to present or future society

Costs are typically measured in monetary terms, and reflect relative resource scarcity.

Cost is a measure of the present and future sacrifice of resources associated with alternative actions.

Types of Costs

Implicit Costs: opportunity costs of time andresources devoted to production

Explicit Costs: direct ($) cost of labor, rawmaterials, etc. used in production.

Costs, like inputs, can be either fixed (constant over short run) or variable (dependent on quantity produced).

Opportunity Cost

Opportunity cost is a measure of foregone opportunity.

The opportunity cost of using a resource to produce a good is defined as the value of the next best alternative that must be sacrificed.

Example: spotted owl protection vs. ??? protection

Total Cost

Total Cost (TC) = Cost of all inputs (fixed and variable) used to produce something, expressed as a function of the amounts (levels) of inputs and their unit costs (prices).

TC = pX*X + pY*Y

Marginal Cost Marginal cost (MC) is the incremental increase in total cost (in

the short run) that results from a one-unit increase in output (Q).

MC = TC/ Q

Marginal cost is an incremental measure of resource scarcity.

Marginal Factor CostThe incremental increase in total cost (in the short run) that

results from a one-unit increase in the use of a variable input (X).

MFC= TC/X

Efficient use of inputs

From a firm’s perspective, an efficient use of inputs is one in which the additional revenue gained from using one more unit of an input is exactly equal to the additional cost of using that unit of input, that is, where:

MVP = MFC

This is a requirement for private efficiency!

Firms minimize costs

Raw materials

LaborTwo part process:

1. The isocost line represents all combinations of inputs leading to the same cost of production.

L*

M*

2. The isoquant defines the efficient combination of inputs that produces a given level of output. Tangency corresponds to a single point on the supply curve.

Points to ponder 1:

The mix of inputs used in production (labor, capital, raw materials) reflects tradeoffs that firms observe in the costs of using inputs. Costs are determined by the technology of production and relative prices of resources.

If natural resources are relatively “cheap” and if pollution is not a recognized cost of production, then firms will make profligate use of resources and will not take steps to clean up pollution.

Points to ponder 2:

Firms seek to use inputs that keep costs low.

If policies make the use of some resources more expensive, or if “free disposal” becomes costly, then firms will alter their behavior to avoid costs. This has implications for forming environmental policies.