Chapter 7

1. Chapter 7 Production, Inputs, and Cost: Building Blocks for Supply Analysis Of course, that’s only an estimate. The actual cost will be higher. AUTO MECHANIC TO CUSTOMER

2. Figure 1 Historical costs for long-distance telephone transmissions

3. Short-Run vs. Long-Run Costs • Run • Period of time • Short run • Some cost commitments – not ended • Predetermined • Plant size • Most input quantities

4. Short-Run vs. Long-Run Costs • Long run • All cost commitments – ended • Adjustable • Plant size • Inputs

5. Short-Run vs. Long-Run Costs • Fixed cost • Quantity of input • Doesn’t vary with output • Cost of input • Doesn’t vary with output • Variable cost • Varies with output

6. Production, Input Choice, & Cost • Short run • Only one variable input • Total physical product (TPP) • Total amount of output • From a given quantity of input

7. Table 1 Total physical product schedule for Al’s building company

8. Figure 2 Total physical product with different quantities of carpenters used by Al’s firm 40 32 35 30 TPP 25 B A E F G Total Output in Garages per Year D C 20 15 10 0 1 2 3 4 5 6 7 5 Quantity of Carpenters per Year

9. Production, Input Choice, & Cost • Average physical product (APP) • Total physical product (TPP) • Divided by quantity of input (X) • APP=TPP/X • Marginal physical product (MPP) • Increase in total output • From: one-unit increase in input • All other inputs constant

10. Table 2 Al’s product schedules: total, average, and marginal physical product and marginal revenue product

11. Production, Input Choice, & Cost • MPP curve • Rate of change: TPP curve • Equals slope of TPP curve • Increasing marginal returns • MPP – increases • TPP – increases • Increasing rate

12. Production, Input Choice, & Cost • Diminishing marginal returns • MPP – decreases; positive • TPP – increases • Decreasing rate • Negative marginal returns • MPP – negative • TPP – decreases

13. Figure 3 Al’s marginal physical product (MPP) curve 14 Increasing marginal returns Diminishing marginal returns Negative marginal returns 12 10 8 6 4 MPP in Garages per Year 2 0 -2 -4 0 1 2 3 4 5 6 7 Number of Carpenters MPP -6

14. Production, Input Choice, & Cost • “Law” of diminishing marginal returns • Increase • Amount of one input • All other inputs amounts • Constant • Ultimately • Lower marginal returns

15. Production, Input Choice, & Cost • Marginal revenue product (MRP) • Additional money revenue • From increased sales • From one additional unit of input • MRP=MPP ˣ Price of output

16. Production, Input Choice, & Cost • Firm – maximize profits • Total revenue • Minus total cost • Optimal quantity of input • MRP > P of input • Use more input • MRP < P of input • Use less input • MRP = P of input • Optimal quantity of input

17. Multiple Input Decisions • Firm • Choice: different technological options • Given: target production level • Substitute one input for another • Trade-off • Decrease use - one input • Increase use - another input • Combination of inputs - least costly • Depends on relative prices of inputs

18. Multiple Input Decisions • Optimal quantities of inputs • MRP (input X) > MRP (input Y) • Increase spending on input X • MRP (input X) < MRP (input Y) • Increase spending on input Y • MRP (input X) = MRP (input Y) • Optimal combination of inputs • Same MRPs per dollar

19. Multiple Input Decisions • One input - more costly • Relative to competing inputs • Substitution • Use less – more expensive input • Use more – competing inputs

20. Cost and its Dependence on Output • Total cost (TC) • Cost of fixed inputs • Cost of variable inputs • Opportunity costs • Average cost (AC) • Total cost / Quantity produced • Marginal cost (MC) • Increase in total cost • From: one additional unit of output

21. Cost and its Dependence on Output • Total variable cost (TVC) • Cost of variable inputs • Average variable cost (AVC) • Total variable cost / Quantity produced • Marginal variable cost (MVC) • Increase in total variable cost • From: one additional unit of output

22. Table 3 Al’s (variable) cost schedules

23. Cost and its Dependence on Output • TVC curve • Rise steady with output • AVC curve • U-shaped • MVC curve • U-shaped

24. Figure 4 (a) Al’s total variable cost, average variable cost, and marginal variable cost TVC 200 180 160 Total (Variable) Cost 140 120 Total Variable Cost per Year (thousands $) 100 80 60 40 0 2 4 6 Quantity of Garages 20 8 10

25. Figure 4 (b) Al’s total variable cost, average variable cost, and marginal variable cost 30 25 Average (Variable) Cost AVC 20 D Average Variable Cost per Garage (thousands $) C 15 10 0 2 4 6 5 Quantity of Garages 8 10

26. Figure 4 (c) Al’s total variable cost, average variable cost, and marginal variable cost MVC 50 45 40 Marginal (Variable) Cost 35 30 Marginal Variable Cost per Added Garage (thousands $) 25 20 15 10 0 2 4 6 Quantity of Garages 5 8 10

27. Cost and its Dependence on Output • Total fixed cost (TFC) • Doesn’t vary with output • TFC curve – straight horizontal line • Average fixed cost (AFC) • Total fixed cost / quantity produced • AFC curve – decreases with output • Marginal fixed costs (MFC) • Are always = 0

28. Table 4 Al’s fixed costs

29. Figure 5 (a) Fixed costs: total and average TFC 14 12 10 Total Fixed Cost per Year (thousands $) 8 6 4 7 9 1 3 5 0 2 4 6 2 Output 8 10

30. Figure 5 (b) Fixed costs: total and average 14 12 10 Average Fixed Cost per Year (thousands $) 8 TFC 6 4 7 9 1 3 5 0 2 4 6 2 Output 8 10

31. Cost and its Dependence on Output • Total cost • TC = TFC + TVC • Average cost • AC = AFC + AVC • Marginal cost • MC = MFC + MVC = 0 + MVC = MVC

32. Cost and its Dependence on Output • AC curve • U-shaped • Downward-sloping segment • Increasing MPP • Spread fixed costs • Upward-sloping segment • Rise in administrative costs