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Chapter 7 Costs and supply©McGraw-Hill Companies, 2010
©McGraw-Hill Companies, 2010Choosing output Costs Revenues Technology & costs of hiring factors of production Demand curve AR MR TC curves (short & long run) AC (short & long run) CHECK: produce in SR? close down in LR? MC Choose output level ©McGraw-Hill Companies, 2010 2
The production functionThe amount of output produced depends upon the inputs used in the production process. A factor of production (“input”) is any good or service used to produce output The production function specifies the maximum output which can be produced given inputs ©McGraw-Hill Companies, 2010 3
©McGraw-Hill Companies, 2010Short run vs. long run The short run is the period in which a firm can make only partial adjustment of inputs. E.g. the firm may be able to vary the amount of labour, but cannot change capital. The long run is the period in which a firm can adjust all inputs to changed conditions. The long run total cost curve describes the minimum cost of producing each output level when the firm is free to vary all input levels. ©McGraw-Hill Companies, 2010 4
©McGraw-Hill Companies, 2010Average cost The average cost of production is total cost divided by the level of output. Long-run average cost (LAC) is often assumed to be U-shaped: LAC Average cost Output ©McGraw-Hill Companies, 2010 5
©McGraw-Hill Companies, 2010Economies of scale Economies of scale – or increasing returns to scale – occur when long-run average costs decline as output rises: LAC Average cost Output ©McGraw-Hill Companies, 2010 6
Decreasing returns to scaleoccur when long-run average costs rise as output rises: LAC Average cost Output ©McGraw-Hill Companies, 2010 7
Constant returns to scaleoccur when long-run average costs are constant as output rises: LAC Average cost Output ©McGraw-Hill Companies, 2010 8
The firm’s long-run output decisionLAC1 Output (goods per week) MR LAC LMC Q1 LMC = MR The decision: If the price is at or above LAC1 the firm produces Q1 If the price is below LAC1 the firm goes out of business NB: LMC always passes through the minimum point of LAC. ©McGraw-Hill Companies, 2010 9
©McGraw-Hill Companies, 2010The short run Fixed factor of production a factor whose input level cannot be varied Fixed costs costs that do not vary with output levels Variable costs costs that do vary with output levels Short-run total cost (STC) = short-run fixed cost (SFC) + short-run variable cost (SVC) ©McGraw-Hill Companies, 2010 10
The marginal product of labourThe marginal product of labour is the increase in output obtained by adding 1 unit of the variable factor but holding constant the inputs of all other factors. Labour is often assumed to be the variable factor with capital fixed. ©McGraw-Hill Companies, 2010 11
The law of diminishing returnsHolding all factors constant except one, the law of diminishing returns says that: beyond some value of the variable input further increases in the variable input lead to steadily decreasing marginal product of that input. E.g. trying to increase labour input without also increasing capital will bring diminishing returns. ©McGraw-Hill Companies, 2010 12
The firm’s short-run output decisionFirm sets output at Q1, where SMC=MR subject to checking the average condition: if price is above SATC1 firm produces Q1 at a profit if price is between SATC1 and SAVC1 firm produces Q1 at a loss if price is below SAVC1 firm produces zero output. SMC SATC SATC1 SAVC SAVC1 SMC = MR MR Q1 Output ©McGraw-Hill Companies, 2010 13
The long-run average cost curve LACSATC1 Each plant size is designed for a given output level. Output Average cost LAC In the long-run, plant size itself is variable, and the long-run average cost curve LAC is found to be the ‘envelope’ of the SATCs. SATC2 SATC3 SATC4 So there is a sequence of SATC curves, each corresponding to a different plant size. ©McGraw-Hill Companies, 2010 14
The firm’s output decisions – a summaryMarginal Condition Check whether to produce Short run decision Long run Produce this output unless price lower than SAVC, in which case produce zero Choose the output at which MR=SMC Produce this output unless price is lower than LAC, in which case produce zero. Choose the output at which MR=LMC ©McGraw-Hill Companies, 2010 15
©McGraw-Hill Companies, 2010Some maths An example of a short-run total cost function: Where SFC=F and SVC = cQ+ Dq2 and Thus the short-run average fixed cost decreases steadily as Q increases. ©McGraw-Hill Companies, 2010 16
©McGraw-Hill Companies, 2010Some maths (2) Short run average variable cost is: And short run average total cost: ©McGraw-Hill Companies, 2010 17
Choosing output REVENUES COSTS AR Demand curve AC (short & long run)
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