1 Short Run Production Example Here we use an example to illustrate some additional concepts.

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Presentation transcript:

1 Short Run Production Example Here we use an example to illustrate some additional concepts.

2 Example of production in the short run u Imagine the room you are in is a cookie factory - like at a shopping mall. u The fixed input is the production facility and it includes refrigerators, bowls, mixers, ovens, tables and other stuff. The variable input will be labor. We will observe output levels at various levels of labor used.

3 Numerical example

4 Example continued This is just an example where we have added labor to a fixed amount of capital. Total output in this example will be measured in dozens of cookies per hour.

5 MP or marginal product u MP is the additional output from adding the additional worker. u As more of the variable input is used with a fixed input, the marginal product first increases, reaches a maximum, then diminishes and even becomes negative.

6 MP - continued u MP is a max. at 2 units of labor and begins to diminish with the 3rd unit of labor. u As more labor is added there is less and less tools - capital - to use, so additional workers can not add as much output as previous workers.

7 AP or average product u At an output level AP = (total output)/(amount of labor used). u AP mimics MP - analogy of heights of people in a room. What happens to the average height of people in the room when the next guy in is 7 feet tall?

8 Short Run cost u We will continue with our example of production, but now we will make some assumptions about prices of inputs and then think about how production costs change as the level of output changes. u There are two types of cost in the short run; fixed and variable.

9 Total Fixed Cost (TFC) u Fixed costs do not vary with changes in output since more or less of the fixed input can not be used in the short run. u Remember we have assumed the fixed input is capital. u Fixed cost will be incurred in the short run whether output is 0 or 1,000,000 or any amount.

10 Total Variable Cost (TVC) u Variable costs are those costs that vary with the level of output. u Examples of variable costs are labor, electricity, materials and so on.

11 Definitions u Total Cost (TC) = TFC + TVC u AFC = TFC/Q which means AFC times Q = TFC. u AVC = TVC/Q or AVC times Q = TVC. u ATC = TC/Q or ATC times Q = TC. u Marginal cost (MC) = (change in TC)/(change in output).

12 Example continued u Recall our cookie factory example. u Let’s say production in our example will occur for one hour and the fixed cost is $40 during that hour. u Let’s say every laborer gets total compensation of $10 per hour.

13 Example continued u To conserve space I have made up labels for column headings: u (1) = units of labor, (2) = units of capital, (3) = TP or total output or Q, (4) = MP or marginal product, (5) = TFC, (6) = TVC, (7) = TC (8) = MC, (9) = AFC, (10) = AVC, (11) = ATC or just AC.

14 Example continued

15 MC an MP relationship u As more labor is added, output changes, and so do total cost and total variable values. u When MP is rising, MC is falling. u When MP is a max., MC is a min. u When MP is diminishing, MC is increasing.

16 MC and MP relationship MP -column 4 MC L -column 1 Q -column column 8 MC curve MP curve