The Production Function II u 1 Costs short

The Production Function II u 1. Costs - short run u measures u relationship u 2. - production & costs Costs - long run u scale expansion path u long run costs u 3. Returns to scale & economies of scale

1. Costs - short run u Fixed & variable costs u fixed = unavoidable u variable = avoidable u Costs rise as output increases u e. g. As L , TPP TC u given PK and PL u inverse relationship MP & MC, AC & AP u Measures of cost - Table 1

Measures of cost u Total costs: TC = TFC + TVC u Average costs: ATC = TC TPP u or TC Q u ATC = AFC + AVC u Marginal u ‘…the unit. ’ u Shape costs: MC = TC TPP extra cost of producing one more - Figures 1 to 3

Output TFC (Q) (£) 0 1 2 3 4 5 6 7 12 12 Total costs for firm X TVC TC (£) 0 10 16 21 28 40 60 91 12 22 28 33 40 52 72 103 TC TVC TFC fig

Average and marginal physical product b Output c APP MPP Quantity of the variable factor fig

Average and marginal costs Costs (£) MC x Outputfig(Q)

2. Costs - long run u. K & L are variable u Profit maximisation requires cost minimisation u Choice of technique: if u MPK PK > MPL PL u 20 2 > 32 8 u 10 > 4

Cost minimisation u i. e. last pound spent on K adds 10 units u Therefore u spend 1 extra pound on K, TPP rises by 10 u spend 2. 50 less on L, TPP falls by 10 u output is unchanged, but costs fall 1. 50 u Cost minimisation u MPK PK = MPL PL u tangency of isocost & isoquant

Scale expansion path & long run costs u Vary K & L TPP rises (no. of factories) u See Figure - scale expansion path u Long run average costs u Returns to scale u Scale economies

Units of capital (K) Deriving an LRAC curve from an isoquant map At an output of 100 LRAC = TC 1 / 100 TC O 1 fig Units of labour (L)

Units of capital (K) Deriving an LRAC curve from an isoquant map Expansion path 700 100 200 TC TC 5 6 7 fig Units of labour (L) TC 2 4 TC 1 TC 3 TC TC O 600 500 400 300

A typical long-run average cost curve Costs LRAC O Output fig

Returns to scale u (i) Increasing returns u LRAC ua % increase in inputs leads to a larger % increase in output u economies of scale u (ii) Constant returns u LRAC constant u a given % increase in inputs leads to the same % increase in output

Returns to scale u (iii) Decreasing returns u LRAC ua % increase in inputs leads to a smaller % increase in output u diseconomies of scale u Economies of scale u plant level economies u multi-plant economies u Diseconomies of scale

Conclusion u Cost minimisation - long run u Profit = Revenue - Cost u Profit maximisation - level? u Market structure: – Perfect competition – Monopolistic competition – Oligopoly – Monopoly