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Chapter 8
Production and Costs
Chapter 8
Production and Costs
Marginal Physical Product (MPP)Marginal Physical Product (MPP)
• What is the variable input?
• What is the variable cost?
L
Q
labor
outputMPPl
So…So…
• As more labor (VARIABLE INPUT) are added to land (FIXED INPUT) the variable inputs would yield smaller and smaller additions to output
Marginal Physical ProductMarginal Physical Product
a
Part (a)
(1)VARIABLEINPUT,LABOR(workers )
(2)FIXEDINPUT,CAPITAL(units )
(4)MARGINALPHYSICALPRODUCT OFVARIABLEINPUT (units )(3)(1)
(3)QUANTITY OFOUTPUT, Q(units )
0
1
2
3
4
5
6
7
1
1
1
1
1
1
1
1
0
18
37
57
76
94
111
127
18
19
20
19
18
17
16
Marginal Phys ical Product
10 2 3 4 5 6 7Number of Workers
20
19
18
17
16MP
Crowding ProblemCrowding Problem
• The point at which MPP declines
• Shows the law of diminishing returns
Average Physical ProductivityAverage Physical Productivity
• Output divided by Inputs (usually labor)
• Good for comparing firms or countries.L
QAPP
So find that…So find that…
• MC and MPP are related
• What is the relationship?
MCMPP
MCMPP
In –class
exercise
10
Does MPP sh
ow Dim
inishing
Returns??
?
Law of Diminishing Marginal Returns Law of Diminishing Marginal Returns
a
(1)VARIABLEINPUT,LABOR(Workers )
(2)FIXEDINPUT,CAPITAL(units )
(4)MARGINAL PHYSICALPRODUCT OF VARIABLEINPUT (units )(3)(1)
(3)QUANTITY OFOUTPUT, Q(units )
0
1
2
3
4
5
6
7
8
9
10
1
1
1
1
1
1
1
1
1
1
1
0
18
37
57
76
94
111
127
137
133
125
18
19
20
19
18
17
16
10
– 4
– 8
Marginal Cost Marginal Cost
a
Part (b)
(5)TOTALFIXEDCOST(dollars )
(6)TOTALVARIABLECOST(dollars )
(7)TOTALCOST(dollars )(5) + (6)
(8)MARGINALCOST(dollars )(7)(3)or(6)(3)
$40
40
40
40
40
40
40
40
$ 0
20
40
60
80
100
120
140
$40
60
80
100
120
140
160
180
$1.11
$1.05
$1.00
$1.05
$1.11
$1.17
$1.25
Marginal Cos t (dollars )
0 18 37 57 76 111 127
Quantity of Output
1.00
1.05
1.11
1.17
1.25
94
MC
Does this relationship make sense?Does this relationship make sense?
• Yes..
• If productivity increases what would happen to costs??– Decrease (MPP increase & MC decrease)
• Productivity decreases??– Increase (MPP decreases & MC increases)
MPP determines shape of MCMPP determines shape of MC
• MPP must have a declining part because of diminishing returns
• Can also define MC as:
MPP
wageMC
In-class exercise 11
How do we calculate these costs??
Give two ways to get to the cost…
Average-Marginal Rule
• Can use to see what the ATC and AVC curve look like
• Tells us what happens when MC is above or below the “average” curves
• If MC is above AVC and ATC– AVC and ATC are rising
• If MC is below AVC and ATC– AVC and ATC are falling
From Average-Marginal Rule can infer…
• MC intersects the AVC and ATC curves at their MINIMUM POINTS
• Cannot infer anything about AFC
Average and Marginal Cost Curves Average and Marginal Cost Curves
a
Cos t
Quantity of Output
Region1
Region2
0
MC ATC
L
Part (b)
Average and Marginal Cost Curves Average and Marginal Cost Curves
a
Cos t
Quantity of Output
Region1
Region2
0
MC
AVC
L
Part (a)
So…
• MC gains it shape from???– MPP and law of diminishing marginal returns
• MC below ATC: What is ATC curve doing?– Falling
• MC above ATC: What is ATC curve doing?– Rising
Average and Marginal Cost Curves Average and Marginal Cost Curves
a
Cos t
Quantity of Output0
MC
AVC
Part (c )
ATC
AFC
MC curve cutsboth AVC andATC curves at
the ir res pectivelow points .
Tying Products to CostsTying Products to Costs
A CLOSER LOOK
Production in theshort run: at
least one fixed input
MPPVariable Input
MC
MC
When MC is belowATC, AVC
When MC is aboveATC, AVC
MPP Variable Input
Now switching to the Long Run
• When does Long Run start?– As soon as all inputs (costs) are VARIABLE– No fixed costs
• Important curves– LRTC– LRATC– LRMC
Short Run vs. Long Run
• Short Run assumes FIXED plant size
• Each plant size has a unique ATC curve associated with it– SRATC
• LRATC combines all the SRATC curves
• Which points of the SRATC???
• Minimum points
Why minimum?
• LRATC shows the lowest average cost at which a firm can produce any given level of output
• LRATC is the lower ENVELOPE of the SRATC curves
• Called envelope curve
Long-Run Average Total Cost Curve (LRATC)
Long-Run Average Total Cost Curve (LRATC)
a
Average Cos t (dollars )
Quantity of Output
6
5
0
B
A
D
C
SRATC1
SRATC2 SRATC3
Q1 Q2
LRATC(bluecurve)
Part (a)
Isn’t the LRATC curve smooth??
• Yes!!
• Have infinitely many SRATC curves so it would be smooth if use all curves
• Each SRATC curve touches the LRATC curve only once
Shape of LRATC
• U-shaped
• Decreasing, Flat, then Increasing
• Important when finding optimal long run output level
Long-Run Average Total Cost Curve (LRATC) Long-Run Average Total Cost Curve (LRATC)
a
Average Cos t (dollars )
Quantity of Output
Dis economiesof Scale
Cons tantReturnsto Scale
SRATC1
SRATC2
SRATC3 SRATC4
SRATC5
SRATC6
SRATC7
Economiesof Scale
A B
LRATC
Minimumeffic ient s cale
Part (b)
0
Economies of Scale
• Downward part of LRATC
• Average costs decrease as output increases
• If have a 1% increase in input usage what happens to output??– Increases by MORE than 1%
• Specialization
Constant Returns to Scale
• Flat portion of LRATC
• Costs remain the same as increase output
• If have a 1% increase in input usage what happens to output??– Output increases by EXACTLY 1%
• First point of constant returns to scale is called MINIMUM EFFICIENT SCALE
Diseconomies of Scale
• Upward sloped portion of LRATC• Costs are rising as we increase output• If have a 1% increase in input usage what happens
to output?– Increases by LESS THAN 1%
• Why???– Firm too large (bad communication or coordination
problems)
Long-Run Average Total Cost Curve (LRATC) Long-Run Average Total Cost Curve (LRATC)
a
Average Cos t (dollars )
Quantity of Output
Dis economiesof Scale
Cons tantReturnsto Scale
SRATC1
SRATC2
SRATC3 SRATC4
SRATC5
SRATC6
SRATC7
Economiesof Scale
A B
LRATC
Minimumeffic ient s cale
Part (b)
0
Are economies, diseconomies, and constant returns to scale in SR, LR, or both???
• LONG RUN ONLY!!!
• Why?– Inputs necessary for production are able to be changed– No fixed inputs
Is this the same as diminishing returns?
• NO
• Diminishing returns is from using ONE plant size intensely– Short run
• Economies of scale is from CHANGING plant size– Long run
Review
• Economies of Scale– LRATC falling
• Constant Returns to Scale– LRATC flat
• Diseconomies of Scale– LRATC rising
Why does economies of scale exist?
• Large firms offer more opportunity for workers to specialize
• Growing firms can take advantage of efficient mass production techniques– Smooth cost over more units produced
Why does diseconomies of scale exist?
• Communication problems
• Shirking
• Management problems
Why is minimum efficient scale important?
• Lowest output level at which ATC are minimized
• Which has a cost advantage??– Small firm at minimum efficient scale point– Larger firm producing more output but still within
constant returns to scale area– Neither
Long-Run Average Total Cost Curve (LRATC) Long-Run Average Total Cost Curve (LRATC)
a
Average Cos t (dollars )
Quantity of Output
Dis economiesof Scale
Cons tantReturnsto Scale
SRATC1
SRATC2
SRATC3 SRATC4
SRATC5
SRATC6
SRATC7
Economiesof Scale
A B
LRATC
Minimumeffic ient s cale
Part (b)
0
Minimum Efficient Scale for Six Industries Minimum Efficient Scale for Six Industries
a
14.16.63.41.91.40.2
%RefrigeratorsCigarettesBeer brewingPetroleum refiningPaintsShoes
INDUSTRY
MES AS APERCENTAGEOF U.S.CONSUMPTION
SOURCE: F. M. Scherer, AlanBechens te in, Erich Kaufer, and R. D.Murphy, The Economics of MultiplantOperation (Cambridge , Mas s .: HarvardUnivers ity Pres s , 1975), p. 80.
Where would you expect to find less firms? (using MES)
• Firms with higher MES• Why??
– Produce until MES
– If MES is higher then each firm will be producing more…so need less firms to cover quantity wanted by economy
• Many SHOE companies (MES = .2)• Few REFRIGERATOR companies (MES = 14)
Efficient Number of Firms• 100 divided by MES• 100% of goods are wanted by consumers• MES is the percentage of consumption each firm will
provide• Cigarette firm’s MES = 6.6
– Need 15 firms
• Petroleum firm’s MES = 1.9– Need 52 firms
• Thus a larger MES means less firms needed
What cause SRTC, LRTC, and MC to shift?
• Taxes– Does it affect FC??
• Only if it is a lump sum tax (tax for existing)• If it is a per unit tax then FC doesn’t change
– How does it change curves??
• Input prices– How does it change curves??
• Technology– Either improves production process (use less inputs)
or lower input prices– How does it change curves??
Homework
• Chapter 8– Questions: 3, 5, 10, and 11
• Working with numbers and graphs– Questions 3, 6, and 7
In-class exercise 12
Do we understand Chapter 8??