Today n n Production and cost in the

Today n n Production and cost in the Short Run Print out slides #31 & #32 full-sized for easier work.

How Costs Vary with Output

Recall: Short-Run & Long-Run n n Short run: When an economic agent can adjust somewhat (but not completely) to an event. Long run: When an agent has fully adjusted to an event.

SR & LR for a Firm n n Short run: Period of time during which some important input or inputs is fixed or limited in quantity. The firm can stop producing but can’t close down. Long run: Period of time needed so that all inputs are variable in quantity. Everything can be adjusted. The firm could close down, liquidating resources.

Example: Pizza Parlor n n n Pizza parlor sees increased demand & decides to sell 20% more pizzas. SR: cannot increase the size of the building, # of ovens. May hire more workers per shift, use more ingredients, or expand the hours of business. LR: add ovens, floor space, kitchen space. May take several months to a year.

A Note on SR & LR n n These are not set periods of time: their length will depend on the type of firm or industry. We can think of them as response times.

“Production in the SR” n . . . refers to how the firm is able to vary its level of output while some input (or inputs) is fixed in quantity.

Pizza Parlor n In the short run, assume the following is fixed: n n n restaurant size # of ovens # of tables workspace Variable inputs in short run n n labor ingredients (will not focus on these)

Adding more labor to fixed inputs n # Workers 0 1 2 3 4 5 Total Product 0 10 22 32 38 36 What can you notice about the relation between workers and total product?

Definition of Marginal Product n Marginal Product of Labor (MPL) = TP/ L.

Add MP to the Table n L TP 0 1 2 3 4 5 0 10 22 32 38 36 MP n/a 10 12 10 6 -2

Graphing Marginal Product n L MP 0 n/a 1 10 2 12 3 10 4 6 5 -2 MP 10 8 6 4 2 -2 MP 1 2 3 4 5 L

The Pattern of MP n In this example, MP increases at first. n n n MP then decreases. n n n Represents increased division of labor. Can separate cooking from serving functions. Represents the effects of crowding. More people trying to use limited space, equipment. MP negative: extreme crowding.

Law of Diminishing Marginal Returns n Holding some important inputs (or inputs) constant and increasing the use of another input by equal increments will eventually result in a decreasing marginal product.

Notes on the Law of Diminishing Marginal Returns n n n A physical law (doesn’t involve prices). Allows for increasing MP at initial levels of output. Applies to SR situations only (why? )

What the LDMR implies for costs n n n Beyond some point, adding additional labor leads to a falling Marginal Product. This implies that beyond that same point, it will cost more and more to produce an extra unit of output. Let’s make this idea more formal.

Definitions of TC, TFC, TVC n n Total cost (TC): the economic cost of producing a given level of output. Total Fixed Cost (TFC): Costs which do not vary with changes in output, given a particular short run situation. (Overhead) Total Variable Cost (TVC): Costs which do vary as output changes. TC = TFC + TVC

Ex: Producing Cheese in the Short Run n Fixed factors in the SR: n n n Size of factory Machinery Manager n n Fixed Costs (in $1, 000) n n Rent on factory-$6 Rent on machinery-$2 Manager salary-$2 TFC = $10 Variable factors in the SR: n Labor Raw materials such as milk, rennet. Variable Costs n n n Wages of production workers Cost of raw materials. TVC depends on Q

Ex: TVC, TFC, TC Q 0 1 2 3 4 5 6 TVC 0 3 5 8 12 17 23 TFC 10 10 TC 10 13 15 18 22 27 33 n n n Why is TFC equal to 10 for every Q? Where does TC come from? Note: Q is the same thing as TP.

Definitions of ATC, AVC, AFC n n n Average Total Cost: TC/Q, where Q = quantity of goods produced. Average Variable Cost: TVC/Q Average Fixed Cost: TFC/Q

Table: AVC, ATC Q 0 1 2 3 4 5 6 TVC 0 3 5 8 12 17 23 AVC TC n/a 3. 0 2. 5 2. 7 3. 0 3. 4 3. 8 ATC 10 n/a 13 13. 0 15 7. 5 18 6. 0 22 5. 5 27 5. 4 33 5. 5 n Do you see where the values in the AVC and ATC columns come from?

Graph of AVC, ATC n n ATC and AVC both are Ushaped. AVC lies everywhere below ATC. Why? $/Q 14 12 10 8 6 4 2 ATC AVC 2 4 6 Q

Notes on ATC and AVC n n n How can you see AFC on this graph? Why do ATC and AVC grow closer together as Q rises? The minimum of AVC occurs at a lower level of output than for ATC. Why?

Marginal Cost n n n Marginal Cost (MC): The change in total cost associated with increasing output by one unit. MC = TC Q What are marginal fixed costs equal to? Is MC the same thing as MVC?

Table: MC Q 0 1 2 3 4 5 6 TVC 0 3 5 8 12 17 23 MC AVC TC n/a 3 2 3 4 5 6 n/a 3. 0 2. 5 2. 7 3. 0 3. 4 3. 8 ATC 10 n/a 13 13. 0 15 7. 5 18 6. 0 22 5. 5 27 5. 4 33 5. 5 n Do you see where the values in the MC column come from?

Graph of MC n Graph MC halfway between the old & new Q for greater accuracy. $/Q 14 12 10 8 6 4 2 MC ATC AVC 2 4 6 Q

Notes on MC must eventually rise due to the Law of Diminishing Marginal Returns. n n If each successive laborer has a lower MP, then the MC of producing one more unit is rising. MC cuts ATC and AVC and their lowest points. Why?

The Relation between Marginal and Average n n n When marginal cost is below average cost, average cost will be falling. When marginal cost is above average cost, average cost will be rising. This relationship between “marginal” and “average” applies to all variables.

Coming Up n n n Shift in SR cost curves Production and cost in the Long Run Group Work n Table & Graph of firm’s costs.

Cost Curves of the Firm n n Fill in the blanks in the table. Use your class notes to understand the abbreviations. Use the number of decimal places already shown in each column. Use your answers to graph ATC, AVC, and MC onto the graph.

Table of Firm Costs in the SR Q TVC MC AVC 0 0 undef 1 3 3 3. 00 2 4 3 7 4 5 16 6 22 7 29 8 3 2. 33 4 2. 75 TFC TC ATC 3 undef 3 6 3 7 3 3. 50 3. 33 14 3. 50 3 19 3. 80 3. 67 3 25 4. 17 7 4. 14 3 8 4. 63 5 4. 57 40 9 46 9 5. 11 3 49 10 56 10 5. 60 3 59 5. 00

Graph of Firm Costs in the SR

Questions n n MC cut AVC between ___1/2 and ___1/2 units. While your graph may be slightly off, what do we know must be happening to AVC at the point where MC cuts it? MC cut ATC between ___1/2 and ___1/2 units. While your graph may be slightly off, what do we know must be happening to AVC at the point where MC cuts it?

More Questions n n How should we interpret the vertical distance between ATC and AVC on the graph? Why does this distance shrink as quantity increases?