Chapter 8 Production and Costs

1. Chapter 8Production and Costs

2. Marginal Physical Product (MPP) • What is the variable input? • What is the variable cost?

3. So… • As more labor (VARIABLE INPUT) are added to land (FIXED INPUT) the variable inputs would yield smaller and smaller additions to output

4. Marginal Physical Product

5. Crowding Problem • The point at which MPP declines • Shows the law of diminishing returns

6. Average Physical Productivity • Output divided by Inputs (usually labor) • Good for comparing firms or countries.

7. So find that… • MC and MPP are related • What is the relationship?

8. In –class exercise 10 Does MPP show Diminishing Returns???

9. Law of Diminishing Marginal Returns

10. Marginal Cost

11. 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)

12. MPP determines shape of MC • MPP must have a declining part because of diminishing returns • Can also define MC as:

13. In-class exercise 11 How do we calculate these costs?? Give two ways to get to the cost…

14. 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

15. From Average-Marginal Rule can infer… • MC intersects the AVC and ATC curves at their MINIMUM POINTS • Cannot infer anything about AFC

16. Average and Marginal Cost Curves

17. Average and Marginal Cost Curves

18. 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

19. Average and Marginal Cost Curves

20. Tying Products to Costs A CLOSER LOOK MPP Variable Input When MC is below ATC, AVC MC Production in the short run: at least one fixed input When MC is above ATC, AVC MPP Variable Input MC

21. 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

22. 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

23. 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

24. Long-Run Average Total Cost Curve (LRATC)

25. 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

26. Shape of LRATC • U-shaped • Decreasing, Flat, then Increasing • Important when finding optimal long run output level

27. Long-Run Average Total Cost Curve (LRATC)

28. 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

29. 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

30. 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)

31. Long-Run Average Total Cost Curve (LRATC)

32. 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

33. 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

34. Review • Economies of Scale • LRATC falling • Constant Returns to Scale • LRATC flat • Diseconomies of Scale • LRATC rising

35. 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

36. Why does diseconomies of scale exist? • Communication problems • Shirking • Management problems

37. 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

38. Long-Run Average Total Cost Curve (LRATC)

39. Minimum Efficient Scale for Six Industries

40. 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)

41. 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

42. 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??

43. Homework • Chapter 8 • Questions: 3, 5, 10, and 11 • Working with numbers and graphs • Questions 3, 6, and 7

44. In-class exercise 12 Do we understand Chapter 8??