ProductionProductionandand

CostsCosts

Microeconomics - Dr. D. Foster

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Supply side of the market

Why firms exist. Production and cost relationships. Model of perfect competition. Model of monopoly. Regulation

Later: Monopolistic competition, oligopoly, game theory, factor markets, general equilibrium

Why do firms exist?

They combine resources to produce goods and services.

Why not use markets?

Transaction costs are high.

Role of managers - monitor workers to minimize shirking. Chinese barge-pullers.

Firm’s objective: maximize profitmaximize profit

Costs & Profits All costs are “opportunity costs.” Costs may be explicit or implicit. Total cost = TC = all relevant

costs. (Economic) Profit = TR-TC

– If positive, firms will enter.– If negative, firms will exit.– If zero, the market is stable.

Accounting profit may/will not equal Economic Profit.

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Short Run vs. Long Run

We are interested in the short run: At least one input is fixed

Fixed - capital; variable – labor

In the Long Run, all factors are variable.

Next - Production & Next - Production & Cost relationshipsCost relationships

Production Relationships

From 0 to L1 there are “increasing returns.” From L1 onwards, there are “diminishing

marginal returns.” After L3 additional workers lower output. Why?

L1L3

Labor

Output

Total Product = TP (=Q)

Production Relationships

L1L3

Labor

Output

TP (=Q)

Marginal Product = MP

L2

Average Product = AP

Average Product = AP = TP/L;this shows how much the average worker adds to output.

Marginal Product = MP = ΔTP/ΔL;this shows how much the last worker (unit) adds to output.

Cost Relationships As noted, TC = TFC + TVC

TFC is fixed, by definition.TVC can be written as w*L, where

w is the (constant) wage rate. Average Fixed Cost, AFC = TFC/Q Average Variable Cost,

AVC = TVC/Q . . . or, = wL/Q = w/APAs AP rises, AVC falls . . .

Average Total Cost, ATC = TC/Q = AFC + AVC

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Cost Relationships Marginal Cost, MC = ΔTC/ΔQ or, can

be written as = ΔTVC/ΔQ (Why?)

… = Δ(wL)/ΔQ = w(ΔL)/ΔQ = w/MP

AFCquantity (TP)

AVC

ATCMC$

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Complete Complete the the

Production Production and Cost and Cost

WorksheetsWorksheets

Key FormulasMP = ΔTP/ΔLAP = TP/LTC = TFC + TVCTVC = w*L

AFC = TFC/QAVC = TVC/Q = wL/Q = w/APATC = TC/Q = AFC + AVCMC = ΔTC/ΔQ = ΔTVC/ΔQ = Δ(wL)/ΔQ = w(ΔL)/ΔQ = w/MP

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ProductionProductionandand

CostsCosts

Microeconomics - Dr. D. Foster

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