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The Production Function II

 1. Costs - short run


 measures

 relationship - production & costs


 2. Costs - long run
 scale expansion path
 long run costs

 3.Returns to scale & economies of


scale
1. Costs - short run

 Fixed & variable costs


 fixed= unavoidable
 variable = avoidable

 Costs rise as output increases


 e.g.As L, TPP   TC 
 given PK and PL

 inverse relationship MP & MC, AC & AP


Measures of cost

 Totalcosts: TC = TFC + TVC


 Average costs: ATC = TC \ TPP
 orTC \ Q
 ATC = AFC + AVC

 Marginal costs: MC =TC \ TPP


 ‘…the extra cost of producing one more
unit.’
 Shape - Figures
Output TFC
Total
TVC TC
costs for firm X
100 (Q) (£) (£) (£) TC

0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20
TFC

0
0 1 2 3 4 5 6 7 8
fig
Total costs for firm X
100 TC

TVC

80

Diminishing marginal returns


set in here
60

40

20
TFC

0
0 1 2 3 4 5 6 7 8
fig
Average and marginal costs
MC
Costs (£)

Outputfig(Q)
Average and marginal costs
MC
AC

AVC
Costs (£)

x
AFC

Outputfig(Q)
Average and marginal physical product
Diminishing returns
b set in here
Output

MPP

Quantity of thefigvariable factor


fig
Average and marginal physical product
b

c
Output

APP

MPP

Quantity of thefigvariable factor


fig
2. Costs - long run
K & L are variable
 Profit maximisation requires cost
minimisation
 Choice of technique: if

 MPK \ PK > MPL \ PL

 20 \ £2 > 32 \ £8

 10 > 4
Cost minimisation

 i.e.last pound spent on K adds 10


units
 Therefore
 spend 1 extra pound on K, TPP rises by 10
 spend 2.50 less on L, TPP falls by 10

 output is unchanged, but costs fall 1.50

 Cost minimisation
 MPK \ PK = MPL \ PL
 tangency of isocost & isoquant
Scale expansion path & long run
costs
 Vary K & L  TPP rises (no. of factories)

 See Figure - scale expansion path

 Long run average costs


 Returns to scale
 Scale economies
Deriving an LRAC curve from an isoquant map
Units of capital (K)

At an output of 100
LRAC = TC1 / 100

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

700

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

Expansion path

700

600
500
400
300
100 200
TC TC TC TC TC TC TC
O
1 2 3 4 5 6 7
fig
fig
Units of labour (L)
A typical long-run average cost curve

LRAC
Costs

O Output
fig
A typical long-run average cost curve

Economies Constant Diseconomies LRAC


of scale costs of scale
Costs

O Output
fig
Returns to scale
 (i) Increasing returns
 LRAC

a % increase in inputs leads to a larger %


increase in output
 economies of scale

 (ii) Constant returns


 LRAC constant
 a given % increase in inputs leads to the
same % increase in output
Returns to scale
 (iii) Decreasing returns
 LRAC

a % increase in inputs leads to a smaller %


increase in output
 diseconomies of scale

 Economies of scale
 plant level economies
 multi-plant economies

 Diseconomies of scale
Conclusion
 Cost minimisation - long run
 Profit = Revenue - Cost

 Profit maximisation - level?


 Market structure:
– Perfect competition
– Monopolistic competition
– Oligopoly
– Monopoly

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