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??