Unit Two: Production Relationships

1. Unit Two: Production Relationships Topic: Production Relationships Chapter 22

2. Learning Targets • I will understand short-run and long-run cost, production and revenue relationships for a firm.

3. Basic Vocabulary • Economic/opportunity cost – the value of a resource in its best alternative use • Explicit costs – monetary payments for resource use • Implicit costs – includes opportunity cost • Normal profit – minimum amount of money you must make (including opp. cost) • Economic cost = explicit + implicit + normal profit • Economic profit = TR – economic cost

4. Sunk Costs • Non-refundable money spent by firms on start-up resources, research and development, etc. • Ignored, because profit is motive; “don’t cry over spilled milk.”

5. Practice Jane quits her job where she earned $29,000/year to start a commuter bus company. She cashes in $40,000 in bonds (on which she was earning 10% interest/year). There are 1000 people who would be willing to pay $400/yr for the service. Of each yearly payment, $280 goes to maintenance, gas, etc. • What is Jane’s TR from her bus company? • What are Jane’s explicit costs? • What are Jane’s accounting profits? • What are Jane’s economic profits?

6. Short-run Production • Short-run (SR): all resources are variable except plant size. • Total product (TP) or output: total quantity of goods produced • Marginal product (MP): additional output associated with an increase of a variable resource (Δ TP) • Average product (AP): output per unit of resource input (TP / # of resources)

7. Short-run Production • TP increases at an increasing rate, then increases at a decreasing rate, reaches a maximum and then decreases. • Draw! • MP reflects changes in TP (slope of the TP curve); when TP is increasing at an increasing rate, MP is increasing; when TP is increasing at a decreasing rate, MP is still positive, but decreasing; when TP is at its maximum, MP is zero; when TP is decreasing, MP becomes negative. • Draw!

8. Short-run Production • AP increases, reaches a maximum and then decreases as additional units of labor are added. • When MP is greater than AP, AP is increasing; when MP is less than AP, AP is decreasing; MP intersects AP when AP is at its maximum. • Draw! • Law of diminishing returns (law of diminishing MP): as units of a variable resource are added to a fixed resource, at some point, the MP of each additional unit of variable resource will start to decline.

9. Short-run Costs • Fixed costs or total fixed costs (FC or TFC): do not vary with output. • Variable costs or total variable costs (VC or TVC): vary with output. • Total cost (TC) = TFC + TVC • TVC will increase at a decreasing rate initially; when MP begins to decline, larger increases in variable resources are needed to produce more output, therefore, TVC increases by increasing amounts at this point (law of diminishing returns). • Draw!

10. Short-run Costs • Average fixed cost (AFC) = TFC/Q • Average variable cost (AVC) = TVC/Q • Average total cost (ATC) = TC/Q • Note: average = total/quantity • Since fixed cost stays the same, as you produce more, AFC will fall. • Since TVC reflects diminishing returns, AVC must as well. • Draw!

11. Short-run Costs • Marginal cost = ∆ TC / ∆ Q • Note: marginal = ∆ total / ∆ quantity • MC is decreasing when AVC and ATC are decreasing and increasing when they are increasing; it crosses them at their minimums. • Draw!

12. Short-run Costs and Production • MC is at its minimum when MP is at its maximum. • Draw!

13. Long-run Production • Long run (LR): a period of time long enough to change all resources, including plant capacity and the entrance/exit of new firms. • Economies of scale: mass production, ATC is declining because of resource specialization. • Diseconomies of scale: inefficiency, increasing ATC because of difficulty of control (firm is too large to manage) • Constant returns to scale: ATC is steady. • Minimum efficient scale: lowest level of output where a firm can minimize LR ATC. • Draw!