Chapter 6 Production and Cost ECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western

Production Business firm – an organization Production Technology Owned and operated by private individuals Specializes in production Production Process of combining inputs to make goods and services Technology Method of combining inputs to produce goods or services

The Production Function Indicates the maximum amount of output a firm can produce over some period of time from each combination of inputs Figure 1 The Firm’s Production Function Different Combinations of Inputs Different Quantities of Output Production Function

Short-Run versus Long-Run Decisions A time horizon long enough for a firm to vary all of its inputs Variable inputs - can be adjusted up or down as the quantity of output changes Short run A time period during which at least one of the firm’s inputs is fixed Fixed inputs - cannot be adjusted as output changes in the short run

Production in the Short-Run Total product Maximum quantity of output that can be produced from a given combination of inputs Marginal product of labor: MPL=ΔQ/ΔL Additional output produced when one more worker is hired

Total and Marginal Product Figure 2 Total and Marginal Product Units of Output Number of Workers 6 2 3 4 5 1 196 Total Product 184 160 DQ from hiring fourth worker = 30 130 DQ from hiring third worker = 40 90 DQ from hiring second worker = 60 30 DQ from hiring first worker = 30 increasing marginal returns diminishing marginal returns

Marginal Returns To Labor Increasing marginal returns to labor MPL increases as more labor is hired Diminishing marginal returns to labor MPL decreases as more labor is hired Law of Diminishing Marginal Returns As more and more of any input is added to a fixed amount of other inputs, its marginal product will eventually decline

Thinking About Costs Total cost Sunk cost The opportunity cost of the owners - everything they must give up in order to produce that amount of output Sunk cost A cost that has been paid or must be paid, regardless of any future action being considered Should not be considered when making decisions

Explicit vs. Implicit Costs Explicit cost Money actually paid out for the use of inputs Implicit cost The cost of inputs for which there is no direct money payment

Costs in the Short Run Fixed costs Variable costs Costs of a firm’s fixed inputs Remain constant as output changes Variable costs Costs of a firm’s variable inputs Change with output

Total Costs in the Short Run Total fixed cost (TFC) The cost of all inputs that are fixed in the short run Total variable cost (TVC) The cost of all variable inputs used in production Total cost (TC=TFC+TVC) The costs of all inputs—fixed and variable

Total Cost Curves Figure 3 The Firm’s Total Cost Curves Dollars 135 Dollars 135 195 255 315 375 $435 30 90 130 160 Units of Output 184 TC TVC TFC TFC

Average Costs Average fixed cost (AFC=TFC/Q) Total fixed cost divided by the quantity of output produced Average variable cost (AVC=TVC/Q) Cost of the variable inputs per unit of output Average total cost (ATC=TC/Q) Total cost per unit of output

Marginal Cost Marginal Cost (MC) MC curve is U-shaped Increase in total cost from producing one more unit or output MC curve is U-shaped When MPL rises, MC falls When MPL falls, MC rises. MPL rises and then falls, MC will fall and then rise.

Average And Marginal Costs Figure 4 Average And Marginal Costs Units of Output Dollars $4 3 2 1 30 90 130 160 196 MC AFC ATC AVC

Average And Marginal Costs At low levels of output MC - below the AVC and ATC curves AVC and ATC slope downward At higher levels of output MC - above the AVC and ATC curves AVC and ATC slope upward U-shaped curves MC curve will intersect the minimum points of the AVC and ATC curves