Microeconomics Notes Production and Costs

Production and Costs: Distinction between the short run and the long run in microeconomics: Short run: Period of time when at least one factor of production is fixed (unchanging), and all other factors are variable (changing). Note that in the short run, the number of firms in an industry remains unchanged because it takes a firm to vary all factors of production for it to enter or leave an industry. Long run: Period of time when all factors of production are variable (changing); there are no fixed factors. Fixed factors of production (inputs): Factors of production (inputs) that are not easily changed in quantity over short periods, such as capital or land. Variable factors of production (inputs): Factors of production (inputs) that are changed in quantity easily over short periods, such as labor, office supplies, and electricity use. Production in the short run: Diminishing Returns Total Product: The total quantity of output produced. Average Product: The total quantity of output produced on average by each unit of variable input (example for labor): AP = TP/ (Units of Labor Input). Marginal Product (MP): Additional output produced by one additional unit of variable input (for example, labor). MP = ∆TP/∆Units of Labor Input. Law of diminishing returns: As more and more of a variable input (such as labor) is added to a fixed input (such as capital), the marginal product of the variable input (labor) at first increases, reaches a maximum, and then begins to fall: diminishing returns occur in the short run when at least one input is fixed. For example, a pizza restaurant has a kitchen with ovens and workspace fixed over the short run; as more cooks and pizza ingredients are used, the marginal product of each worker at first increases, but at some point, it will start to fall. It will eventually become negative due to overcrowding. This law forms the basis of production costs in the short run. The total, marginal, and average product curves have these general shapes and are related to each other as shown: 1. The TP curve rises, reaches a maximum, and then begins to fall. 2. The MP curve is the slope of the TP curve: a) MP increases as the TP curve becomes steeper. b) MP begins to fall as the TP curve becomes flatter. c) MP is equal to zero when TP is a maximum, and d) MP is negative when TP falls. 3. The MP curve intersects the AP curve at the maximum of AP. 4. The MP curve illustrates the law of diminishing returns. Relevant Diagrams: Introducing costs of Production: Explicit Cost: A cost involving payment of money made by a firm to obtain a factor of production (input) for use in production. An example is a payment for labor services (wages paid to workers). Implicit Cost: A cost involving sacrificed income (opportunity costs) for using a factor of production (input) that the firm owns for use in production. An example is the income sacrificed when becoming an entrepreneur, sacrificed rental income, and the cost of risk-taking abilities that the entrepreneur could have earned elsewhere. Economic costs are the sum of explicit and implicit costs; in economics, we mean economic costs when we refer to costs. All production costs are opportunity costs. In the case of explicit costs, opportunity costs are the value of the next best alternative that was not purchased. In the case of implicit costs, opportunity costs are the sacrificed income. Cost of Production in the short run: Fixed costs are costs that do not vary with the level of output. As output increases or decreases, fixed costs are constant. They must be paid even when the output is zero. They appear as a horizontal line. Examples include payment of rent and insurance. Variable costs are costs that vary with output. As output increases, variable costs increase. Variable costs are zero when output is zero. An example is the payment of wages for labor services. Total costs: The sum of fixed and variable costs. The TC curve is the vertical sum of the TFC and TVC curves: TC = TFC + TVC. Average costs: Costs per unit of output. Average fixed costs (AFC): Total fixed costs per output unit. AFC = TFC/Q. Average variable costs (AVC): Total variable costs per output unit. TVC/Q. Average costs: total costs per unit of output. AC = TC/Q. Marginal Costs (MC): The costs of producing an additional output unit (Q). MC = ∆TC/∆Q. The AC curve is the vertical sum of the AFC and AVC curves. Therefore, the difference between AC and AVC is equal to that of AFC. The MC curve cuts the AVC and AC curves at their minimum points. The relationship between the product curves and the cost curves in the short run: The short-run cost curves owe their shape to the law of diminishing returns, which explains why the product and cost curves mirror each other. When the marginal product of labor increases, the extra output produced by each unit of labor increases; therefore, the extra cost of producing an additional unit of output (MC) falls. When diminishing returns set in and the marginal product of labor starts to fall due to overcrowding, for example, this means that the extra output produced by each additional unit of labor is decreasing, and therefore, the extra cost of producing each additional unit of output (MC) is rising. The same ideas account for the relationship between the AP and AVC curves. Therefore, when MP is maximum, MC is minimum, and when AP is maximum, AVC is minimum. MP intersects AP at its maximum, and MC intersects AVC at its minimum. Calculating Short- Run Costs: The table below provides data on Total Product (or Q) and TC. Calculate TFC, TVC, AFC, AVC, AC, and MC. Total Total Product (TP Cost TFC TVC AFC AVC AC MC or Q) 0 50 50 0 NA NA NA NA 2 200 50 150 25 75 100 75 5 350 50 300 10 60 70 50 9 500 50 450 5.56 50 55.56 37.50 12 650 50 600 4.17 50 54.17 50 14 800 50 750 3.57 53.57 57.14 75 15 950 50 900 3.33 60 63.33 150 Sample calculations: Row 1: As Q is 0, TC = FC and TVC = 0, Everything else is NA. TFC =50 always Row 2: TC -TFC = TVC = 200-50= 150. AFC= FC/Q = 50/2 = 25. AVC = TVC/Q = 150/2 = 75 AC = 200/2 = 100. MC = (200-50)/ (2-0) =150/2 =75. The same has been done for all other rows. The relationship between the average cost and the marginal cost curves: When the marginal cost curve lies below the average cost curve, average costs fall. When the marginal cost curve lies above the average cost curve, average costs rise. The marginal cost curve intersects the average cost curve at its minimum point. Production in the long run: Returns to scale. Constant returns to scale: As inputs increase, output increases in the same production. Increasing returns to scale: As inputs increase, output increases more than in proportion. Decreasing returns to scale: As inputs increase, output increases less than in proportion. Costs of production in the long run: economies and diseconomies of scale. Explaining the long-run average cost curve (LRAC): In the short run, a firm faces a short-run AC curve or SRAC. When its size increases by increasing all its inputs (in the long run), its SRAC shifts to the right. At first, this rightward shift is also downwards; later, it is rightward and horizontal, and even later, it is rightward and upwards. The pattern traced out by these rightward shifts of a series of SRAC curves provides the LRAC. Long–run average cost curve: A cost curve showing the relationship between a firm's average cost and the quantity of output it produces as it increases in size by varying all its inputs (in the long run); it is made up of a series of short-run average cost curves. Explaining the shape of the LRAC curve: Economies of scale: Decreases in average costs in the long run as a firm increases output by increasing all factors of production (in the long run). Economies of scale arise because larger firms are better able to take advantage of: 1. Specialization of labor or management, leading to greater efficiency. 2. Larger firms can afford the efficiency of larger machines. 3. Spreading of marketing, advertising, and research and development costs over greater quantities of output. 4. Indivisibilities of machines or production processes: they cannot be divided into smaller sizes for use by smaller firms. 5. Bulk buying of inputs or buying large quantities of inputs by larger firms that need large supplies, offered at lower prices per unit. 6. Lower–cost financing, or borrowing at lower interest rates and better terms, is often available for larger firms. Diseconomies of scale: Rising average costs in the long run as a firm increases output by increasing all input factors of production. If a firm becomes too large, they may be: 1. Management problems due to poor coordination and monitoring of the firm’s activities. 2. Communication difficulties result in inefficiencies. 3. Low worker morale and motivation if they are an unimportant part of a large firm. Firms need not always experience economies or diseconomies of scale in the long run. In the event of constant returns to scale, they will experience constant average costs. The relationship between production and costs in the long run: Falling AC due to economies of scale corresponds to increasing returns of scale: as inputs double, output more than doubles (AC must fall). Increasing AC due to diseconomies of scale corresponds to decreasing returns of scale: as inputs double, output less than doubles (AC must be rising).