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Chapter 7Costs and supply

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005

PowerPoint presentation by Alex Tackie and Damian Ward

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The production function

• The amount of output produced depends upon the inputs used in the production process

• A factor of production (“input”) is any good or service used to produce output

• The production function specifies the maximum output which can be produced given inputs

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Short run vs. long run• The short run is the period in which a firm can

make only partial adjustment of inputs• e.g. the firm may be able to vary the amount of

labour, but cannot change capital.

• The long run is the period in which a firm can adjust all inputs to changed conditions.

• The long run total cost curve describes the minimum cost of producing each output level when the firm is free to vary all input levels.

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Average costThe average cost of production is total cost divided by the level of output.

Long-run average cost (LAC) is often assumed to be U-shaped:

LAC

Ave

rage

cos

t

Output

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Economies of scaleEconomies of scale – or increasing returns to scale – occur when long-run average costs decline as output rises:

LAC

Ave

rage

cos

t

Output

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Decreasing returns to scale

occur when long-run average costs rise as output rises:

LAC

Ave

rage

cos

t

Output

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Constant returns to scale

occur when long-run average costs are constant as output rises:

LACAve

rag

e co

st

Output

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The firm’s long-run output decision

• The decision:– If the price is at or

above LAC1 the firm produces Q1

– If the price is below LAC1 the firm goes out of business

• NB: LMC always passes through the minimum point of LAC.

AC1

£

Output(goods per week)

MR

LAC

LMC

Q1

LMC = MR

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Figure 7.5: The firm’s long-run output decision

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The short run

• Fixed factor of production– a factor whose input level cannot be varied

• Fixed costs– costs that do not vary with output levels

• Variable costs– costs that do vary with output levels

• STC = SFC + SVC

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The marginal product of labour

• The marginal product of labour is the increase in output obtained by adding 1 unit of the variable factor but holding constant the inputs of all other factors.

• Labour is often assumed to be the variable factor – with capital fixed.

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Figure 7.6: The productivity of labour and diminishing

marginal returns

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The law of diminishing returns

• Holding all factors constant except one, the law of diminishing returns says that:

• beyond some value of the variable input• further increases in the variable input

lead to steadily decreasing marginal product of that input.• e.g. trying to increase labour input without

also increasing capital will bring diminishing returns.

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The firm’s short-run output decision

• Firm sets output at Q1, where SMC=MR

• subject to checking the average condition:– if price is above

SATC1 firm produces Q1 at a profit

– if price is between SATC1 and SAVC1 firm produces Q1 at a loss

– if price is below SAVC1 firm produces zero output.

SAVC1

£

Output

MR

SAVC

SMC

Q1

SATC

SATC1

SMC = MR

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Figure 7.8: The firm’s short-run output decision

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The long-run average cost curve LAC

Output

Ave

rage

cos

t

SATC1

Each plant sizeis designed fora given outputlevel

SATC2

SATC3

SATC4

So there is a sequence of SATCcurves, eachcorresponding toa different optimal output level.

LAC

In the long-run, plant size itself is variable, and the long-run average cost curve LAC is found to be the ‘envelope’ of the SATCs

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The firm’s output decisions – a summary

Marginal condition

Check whether to produce

Short-run decision Long-run decision

Choose the output level at which MR = SMC Choose the output level at which MR = LMC

Produce this output unless price lower than SAVC. If it is, produce zero Produce this output unless price is lower than LAC. If it is, produce zero.