Chapter Eight: Production, Inputs, and Cost: Building Blocks for Supply Analysis

Short Run Versus Long Run Costs: What Makes an Input Variable Input choices are precommitted by past decisions The Economic Short Run Versus the Long Run Short Run: Period of time during which some of the firms cost commitments will not have ended Long Run: Period of time long enough for all of the firms commitments to come to an end Little control of plant and equipment capacities in the short run Fixed Costs and Variable Costs Fixed Costs: Cost of an input whose quantity does not rise when output goes up, one that the firm requires to produce any output at all. The total cost of such indivisible inputs does not change when the output changes. Variable: In the long run more costs change The distinction between the short and long run also determines which of the firms costs rise or fall with a change in the amount of output the firm produces Some costs cannot be varied no matter how long the period Fixed Costs. Arise when some types of inputs can be bought only in big batches or when inputs have a large productive capacity. Total, Average, and Marginal Physical Products Single input variable Relationship between the quantity of inputs utilized and the quantity of production Total Physical Product - Total Physical Product (TPP): How much stuff is produced depending on how many inputs are used. Total input from total output Average Physical Product - Average Physical Product (APP): Output per unit of input TPP/Q Marginal Physical Product - Marginal Physical Product (MPP): How much additional output comes from an additional input - Curve that reports the rate at which the TPP curve is changing. Marginal Physical Product and the Law of Diminishing Marginal Returns Diminishing marginal returns are still good because theyre positive Law of Diminishing Marginal Returns: An increase in the amount of input leads to less returns from the inputs The Optimal Quantity of an Input and Diminishing Returns How can the firm select the optimal quantity of an input? Marginal Revenue Product and Input Prices - Marginal Revenue Product (MRP): Additional revenue that the producer earns from the increased sales when it uses an additional unit of input - MRP = MPP x Price of Output - When the MRP exceeds its price, its good to use more the input - Best optimal input choice is when MRP = Price of input Input Quantities and Total, Average, and Marginal Cost Curves How do we derive the firms cost relationships from the input decisions that we have just explained? How much of its product or service should the profit-maximizing firm produce? The most desirable output quantity for the firm depends on the way in which costs change when output varies. Cost curves show how cost changes when output varies. Total cost curve, average cost curve, marginal cost curve How much input it took to make an output, multiply that quantity by its price Total Costs

Opportunity costs The total product curves shows number of input it takes to produce a number of output. Input price shows the total cost (TC) of producing any level of output. The relationship of TC to output is determined by the technological production relationships between inputs and outputs and by input prices Total, Average and Marginal Cost Curves - Average Cost = Total Cost / Quantity Produced - Marginal Cost Increase in total cost for producing another unity - TC rises fairly steadily as output increase - Graphs look like the letter U Total Fixed Cost and Average Cost Curves - AFC = TFC / Q - AFC never becomes 0. Gets smaller as output increases - TC = TFC + TVC - AC = AFC + AVC

The Law of Diminishing Marginal Productivity and The U-Shaped Average Cost Curve The fixed costs are being spread out more at first MPP rises at first, average costs decrease as quantity produced goes up, average cost of output goes down Law of diminishing marginal returns eventually using more corn or input raises costs eventually Increasing administrative cost for bigger firms also drives up average cost. AC curve is typically U-shaped. Down-sloping segment is because of increase MPP of the spread of fixed costs over more outputs. Up-sloping segment is because of decreasing MPP and higher administrative costs. The Average Cost Curve in the Short and Long Run All the cost curves depend on the firms planning horizon. Curves differ in the long and short run because in the long run all input quantities become variable. In the long run a firm will choose a plant size that is more economical for the output level it expects to produce The long run curve consists of all of the lower segments of the short-run AC curves. The long-run average cost curve shows the lowest possible short-run average cost corresponding to each output level. Multiple Input Decisions: The Choice of Optimal Input Combinations Production levels, optimal input quantities, and firms production costs How a firm makes up for decreased availability of one input by increasing another. Substitutability: The Choice of Input Proportions There are many options for inputs Lease cost method Substitute one input for another Firms can choose different technological options to produce a particular volume of output Cut down on one unit = Increase of another substitution. Labor vs. Machinery The least costly combination to produce a level of input depends on the relative prices of the various inputs The Production Function and Substitutability Production Function: Indicates the maximum amount of product that any particular collection if inputs is capable of producing. The total cost of producing any given quantity of output equals the quantities of each of the inputs times the price of the inputs Total cost curve Total cost quantity of output = average cost

Economics of Scale Economics of Scale: Production is said to involve economics of scale, also referred to as increasing returns to scale. If, when all input quantities are doubles, the quantity of output is more than doubled. Does a large firm benefit from substantial economies of scale that allow it to operate more efficiently than smaller firms? Larger firms have cost advantages over smaller ones, so larger is considered better Cars and telecommunications Long-run average cost curve Output more than doubles, cost is spread about more evenly, average cost decreases Production functions with economies of scale lead to long0run average cost curves that decline as output expands The Law of Diminishing Returns and Returns to Scale Returns to a single input. How much does output expand by expanding the quantity of just one input? Returns to scale. How much does output expand by increasing all inputs to the same level? Production functions with economies of scale lead to long run average cost curves that decline as output expands. Single input Law of diminishing returns All inputs Return to scale A production function that displays diminishing returns to a single input may show diminishing, constant, or increasing returns when all input quantities are increased proportionally. Historical Costs Versus Analytical Cost Curves All points on economic cost curves are the same period of time Historical costs Costs from year to year Different points Alternative possibilities Analytical cost curves can help determine whether an industry provides economies of large scale production Cost Minimization in Theory and Practice Input up, decrease in additional output MRP = Marginal PP x Output Price The amount of an input is optimal when MRP = Price (input) Downsizing teams, everybody cares about the end product, trying to control costs The Law of Diminishing Marginal Returns sets in. Not making enough garages to cover costs.