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1
Chapter 8 – Production & Cost
in the Short Run
Basic Concepts of Production Theory
� Production function� Maximum amount of output that can be produced from any
specified set of inputs, given existing technology
� The relationship between labor, capital, and output
� Technical efficiency� Achieved when maximum amount of output is produced
with a given combination of inputs
� Economic efficiency� Achieved when firm is producing a given output at the
lowest possible total cost
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 changed quite
readily
� Fixed input� An input for which the level of usage cannot readily be
changed and which must be paid even if no output is produced
� Quasi-fixed input� An input employed in a fixed amount for any positive level of
output that need not be paid if output is zero
2
Basic Concepts of Production Theory
� Short run� At least one input is fixed
� Generally capital
� All changes in output achieved by changing usage of variable inputs
� Long run� All inputs are variable� Output changed by varying usage of all inputs
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 )= =
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
3
Total, Average, and Marginal Products of
Labor
435.33189
1039.33148
1843.43047
2847.72866
3851.62585
50552204
5856.71703
60561122
5252521
--00
Marginal Product (MP = ∆Q/∆L
Average Product (AP = Q/L)
Total Product (Q)# Workers (L)
TP, AP, and MP Graphs
� Total Product – Increasing at a decreasing rate
TP, AP, and MP Graphs
� AP increases if MP>AP� AP decreases if MP<AP
4
Increase in Capital
� An increase in K will increase MP and AP
Short Run Production Costs
� Total variable cost (TVC)� Total amount paid for variable inputs� Increases as output increases
� Total fixed cost (TFC)� Total amount paid for fixed inputs� Does not vary with output
� Total cost (TC)
� TC = TVC + TFC
Short Run Total Costs
40000340006000600
28000220006000500
20000140006000400
1500090006000300
1200060006000200
1000040006000100
6000060000
Total Costs (TC = TFC + TVC)
Total Variable Costs (TVC)
Total Fixed Costs (TFC)
Output (Q)
5
Total Costs
� Total Variable Costs as� TVC = w*L
� Where w is the wage rate and L is amount of labor
� Total Fixed Costs as� TFC = r*K
� Where r is the rental rate and K is amount of capital
� Total Costs as� TC = w*L + r*K
TC, TVC, and TFC
� Notice the difference between TC and TVC is TFC
Average Costs
� Average Variable Costs (AVC)� = TVC/Q
� Average Fixed Costs (AFC)� = TVC/Q
� Average Total Costs (ATC)� = TC/Q or ATC = AFC + AVC
6
Short Run Total Costs
66.756.710600
564412500
503515400
503020300
603030200
1004060100
---0
Average Costs (ATC = AFC + AVC)
Average Variable Costs (AVC)
Average Fixed Costs (AFC)
Output (Q)
Short Run Marginal Cost
� Short run marginal cost (SMC) measures rate of change in total cost (TC) as output varies
∆ ∆= =∆ ∆TC TVC
SMCQ Q
Short Run Marginal Costs
(40000-28000)/(600-500) = 12040000600
(28000-20000)/(500-400) = 8028000500
(20000-15000)/(400-300) = 5020000400
(15000-12000)/(300-200) = 3015000300
(12000-10000)/(200-100) = 2012000200
(10000-6000)/(100-0) = 4010000100
-60000
Short-Run Marginal CostTotal Costs (TC = TFC + TVC)
Output (Q)
7
Cost Curves
� What do we notice about SMC, ATC, and AVC?
Cost Curves
� AVC and ATC increase when SMC is greater. SMC intersects both lines at their minimum point
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
8
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
� In the case of a single variable input, short-run costs are related to the production function by two relations� AVC = TVC/Q = (w*L)/(AP*L) = w/AP
� SMC = ∆TVC/∆Q= ∆(w*L)/∆Q = w/MP� Remember MP = ∆Q/∆L
Relations Between Short-Run Costs &
Production
Production and Costs (w=$1000)
12056.678.3317.6560034
804412.5022.7350022
50352028.5740014
303033.3333.333009
20305033.332006
404025251004
----00
SMC=w/MPAVC=w/APMP=∆Q/∆LAP=Q/LQ Labor
9
Production Curves
� When MP>AP what is true about costs?
� When MP<AP?
Cost Curves
� When MP>AP each worker is producing more, thus AVC is decreasing
� When MP<AP each worker produces less and AVC is increases
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