1. The Production Function (3/17) A firm’s quantity of output depends on the quantity of inputs Fixed input: quantity fixed for period of time – cannot be varied Variable input: quantity can be varied at any time – depends on the level of output Example – wheat farm Fixed inputs: Variable inputs:

2. Making paper cups What you’ll need 1. Paper 2. Markers (1 red and 1 blue) 3. Workers Which are fixed inputs? Which are variable?

3. We’ll go through 4 rounds of production. Round 1 will start with one worker, Round 2 will have 2 workers, and so on. You MUST follow the directions PERFECTLY – no shortcuts! I must have good, quality products made. This is not a race, so chill out. Each round will take 90 seconds. After each round, note total product and marginal product on your group’s scorecard. For each round, you have to start back at zero product – you can’t count each round as an accumulation.

4. Land: fixed input Labor: variable input Adding each add’l worker adds to total product, and TP increases at a greater and greater rate– increasing returns to labor Adding more workers adds to TP, but TP increases at a decreasing rate – decreasing returns to labor Negative returns: MP of labor is negative – bad!

5. Production Function and TP Curve for George and Martha’s Farm Although the total product curve in the figure slopes upward along its entire length, the slope isn’t constant: as you move up the curve to the right, it flattens out due to changing marginal product of labor. 0 1 2 3 4 5 6 7 8 19 17 15 13 11 9 7 5 0 19 36 51 64 75 84 91 96 Quantity of labor L (worker) Quantity of wheat Q (bushels) MP of labor MPL =  Q/  L (bushels per worker) 786543210 100 80 60 40 20 Quantity of wheat (bushels) Quantity of labor (workers) Total product, TP Adding a 7 th worker leads to an increase in output of only 7 bushels Adding a 2 nd worker leads to an increase in output of only 17 bushels

6. Marginal Product of Labor Curve Marginal product of labor, MPL 786543210 19 17 15 13 11 9 7 5 Marginal product of labor (bushels per worker) Quantity of labor (workers) There are diminishing returns to labor.

7. With more land, each worker can produce more wheat. So an increase in the fixed input shifts the total product curve up from TP 10 to TP 20. This shift also implies that the marginal product of each worker is higher when the farm is larger. As a result, an increase in acreage also shifts the marginal product of labor curve up from MPL 10 to MPL 20. (a) Total Product Curves (b) Marginal Product Curves Marginal product of labor (bushels per worker) Quantity of wheat (bushels) 786543210 30 25 20 15 10 5 786543210 160 140 120 100 80 60 40 20 TP 20 TP 10 MPL 20 MPL 10 Quantity of labor (workers) Total Product, Marginal Product, and the Fixed Input

8. Costs of Production Fixed costs: costs that do not depend on level of output “overhead” costs Examples: Variable costs: costs that depend on level of output Examples: Total cost = fixed costs + variable costs TC = FC + VC

9. Total Cost Curve for George and Martha’s Farm 19365164758491960 $2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 Cost Quantity of wheat (bushels) A B C D E F G Total cost, TC H I A B C D E F G H I Point on graph 0 1 2 3 4 5 6 7 8 $400 400 O 200 400 600 800 1,000 1,200 1,400 1,600 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000 0 19 36 51 64 75 84 91 96 Variable cost (VC) Total cost (TC = FC + VC) $$ Quantity of labor L (worker) Quantity of wheat Q (bushels) Fixed Cost (FC)

10. Marginal cost: change in total cost generated by producing one more unit of output MC = change in total cost/change in quantity of output (or MP) It’s basically like this: If I hire one more worker, how much will each of his/her paper cups produced cost me?

11. Total Cost and Marginal Cost Curves for Selena’s Gourmet Salsas $250 200 150 10 0 50 Cost of case 789106543210 $1,400 1,200 1,000 800 600 400 200 Cost Quantity of salsa (cases) 789106543210 (b) Marginal Cost (a) Total Cost TC MC Quantity of salsa (cases) 8 th case of salsa increases total cost by $180. 2 nd case of salsa increases total cost by $36. Why does marginal cost slope upwards? Diminishing returns to inputs:

12. Average Cost Average total cost, often referred to simply as average cost, is total cost divided by quantity of output produced. ATC = TC/Q = (Total Cost) / (Quantity of Output) A U-shaped average total cost curve falls at low levels of output, then rises at higher levels. Average fixed cost is the fixed cost per unit of output. AFC = FC/Q = (Fixed Cost) / (Quantity of Output) AFC will ALWAYS decrease as output increases!

13. Average Cost Average variable cost is the variable cost per unit of output. AVC = VC/Q= (Variable Cost) / (Quantity of Output)

14. Average Total Cost Curve Increasing output, therefore, has two opposing effects on average total cost: The spreading effect: the larger the output, the greater the quantity of output over which fixed cost is spread, leading to lower the average fixed cost. The diminishing returns effect: the larger the output, the greater the amount of variable input required to produce additional units leading to higher average variable cost.

15. The minimum-cost output is the quantity of output at which average total cost is lowest— the bottom of the U-shaped average total cost curve.

16. Generic Cost Curves MC ATC AVC Cost of unit Quantity 2. … but diminishing returns set in once the benefits from specialization are exhausted and marginal cost rises. 1. Increasing specialization leads to lower marginal cost…

17. Graph for Marty’s Fro- Yo

18. Graph for generic example

19. Units of Labor Total Product (TP) 00 cups 15 215 330 440 545 640 730 The table above shows how hiring increasing amounts of labor to a fixed amount of capital affects the hourly output of Molly's lemonade stand. Based on this table of production data, which of the following can be said? (A) Diminishing marginal returns begins with the first worker hired. (B) Marginal cost begins to rise at the 6th worker hired. (C) Total product is maximized at the 3rd worker hired. (D) Average product begins to decline with the first worker hired. (E) Diminishing marginal returns begins with the 4th worker hired. Warm-up: March 18, 2016

20. OutputTC 0$20 132 246 362 480 5100 1.Fixed cost: 2.ATC of producing 3 units: 3.AFC of producing 4 units: 4.Variable cost of producing 2 units: 5.Marginal cost of producing the 5 th unit: 6.AVC of producing the 1st unit:

21. OutputTC 0$20 132 246 362 480 5100 1.Which of the following is the firm’s variable cost of producing 3 units? a.$20 b.$42 c. $20.67 d.$6.67 e.$14 2.Which is the firm’s average total cost of producing 2 units? a.$32 b.$10 c.$13 d.$23 e.$14 3.Which of the following is the marginal cost of producing the 4 th unit? a.$18 b.$4.50 c.$9 d.$20 e.$80

22. Short-Run vs. Long-Run Costs Let’s say I want to adjust my fixed inputs – I’m thinking about buying another oven for my bakery. How will this affect my fixed cost? How will this affect my variable cost? (hint: will the new oven affect my level of employment?)

23. Short-Run versus Long-Run Costs In the short run, fixed cost is completely outside the control of a firm. But all inputs are variable in the long run: This means that in the long run fixed cost may also be varied. In the long run, in other words, a firm’s fixed cost becomes a variable it can choose. The firm will choose its fixed cost in the long run based on the level of output it expects to produce.

24. The long-run average total cost curve shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output. The Long-run Average Total Cost Curve

25. Short-Run and Long-Run Average Total Cost Curves B ATC 6 ATC 9 ATC 3 LRATC 35847069 Increasing returns to scaleDecreasing returns to scale Constant returns to scale C XA Y Cost of case Quantity of salsa (cases) Increasing returns (economies of scale): LRATC declines as output increases Decreasing returns (diseconomies of scale): LRATC increases as output increases Constant returns: LRATC is constant as output increases ATC 3 = 1 machine ATC 6 = 2 machines ATC 9 = 3 machines

26. 5. Don owns a small concrete-mixing company. His fixed cost is the cost of the concrete-batching machinery and his mixer trucks. His variable cost is the cost of the sand, gravel, and other inputs for producing concrete; the gas and maintenance for the machinery and trucks; and his workers. He is trying to decide how many mixer trucks to purchase. He has estimated the costs shown in the accompanying table based on estimates of the number of orders his company will receive per week. Quantity of trucks FC20 orders40 orders60 orders 2$6000$2000$5000$12000 3$7000$1800$3800$10800 4$8000$1200$3600$8400 Variable Cost

27. a.For each level of fixed cost, calculate Don’s total cost and average total cost per order for producing 20, 40 and 60 orders per week. (It helps to keep the info in a chart.) b. If Don is producing 20 orders per week, how many trucks should he purchase? Answer the same questions for 40 and 60 orders per week.

28. 6. Consider Don’s concrete-mixing business described in Problem 13. Assume that Don purchased 3 trucks, expecting to produce 40 orders per week. a. Suppose that, in the short run, business declines to 20 orders per week. What is Don’s average total cost per order in the short run? What will his average total cost per order in the short run be if his business booms to 60 orders per week? b. What is Don’s long run average total cost for 20 orders per week? Explain why his short run average total cost of producing 20 orders per week when the number of trucks is fixed at 3 is greater than his long run average total cost of producing 20 orders per week. c. Draw Don’s long run average total cost curve. Draw his short run average total cost curve if he owns three trucks.