1. Learning Objectives
Explain general concepts of production and cost analysis
Examine the structure of short-run production based on the relation among total, average, and marginal products
Examine the structure of short-run costs using graphs of the total cost curves, average cost curves, and the short-run marginal cost curve
Relate short-run costs to the production function using the relations between (i) average variable cost and average product, and (ii) short-run marginal cost and marginal product

2. What’s the Firm’s Objective?
Maximize Profit
Why Do Firm’s Exist?
Coase (1937) Nature of Firm followed by Oliver Williamson.
Going to the Market has transactions costs.
Hire workers, negotiate prices and enforce contracts. A firm is essentially a device for creating long-term contracts when short-term contracts are too bothersome. Short-cut the market, so why don’t firms get bigger?
. The proper balance between hierarchies and markets is constantly recalibrated by the forces of competition: entrepreneurs may choose to lower transaction costs by forming firms but giant firms eventually become sluggish and uncompetitive. Mr Coase's theory continues to explain some of the most puzzling problems in modern business. Take the rise of vast and highly diversified business groups in the emerging world, such as India's Tata group and Turkey's Koc Holding. Many Western observers dismiss these as relics of a primitive form of capitalism. But they make perfect sense when you consider the transaction costs of going to the market. Where trust in established institutions is scarce, it makes sense for companies to stretch their brands over many industries. And where capital and labour markets are inefficient, it makes equal sense for companies to allocate their own capital and train their own loyalists.
But Mr Coase's narrow focus on transaction costs nevertheless provides only a partial explanation of the power of firms. The rise of the neo-Coasian school of economists has led to a fierce backlash among management theorists who champion the “resource-based theory” of the firm. They argue that activities are conducted within firms not only because markets fail, but also because firms succeed: they can marshal a wide range of resources—particularly nebulous ones such as “corporate culture” and “collective knowledge”—that markets cannot access. Companies can organise production and create knowledge in unique ways. They can also make long-term bets on innovations that will redefine markets rather than merely satisfy demand. Mr Coase's theory of “market failure” needs to be complemented by a theory of “organisational advantages”.

3. Basic Concepts of Production Theory
Production function
A schedule showing the maximum amount of output that can be produced from any specified set of inputs, given existing technology
Variable proportions production
Production in which a given level of output can be produced with more than one combination of inputs
Fixed proportions production
Production in which one, and only one, ratio of inputs can be used to produce a good

4. Basic Concepts of Production Theory
To maximize profit a firm must produce as efficiently as possible.
Technical efficiency
Achieved when maximum amount of output is produced with a given combination of inputs and technology
Economic efficiency
Achieved when firm is producing a given output at the lowest possible total cost
To maximize profit a firm must produce as efficiently as possible.
A firm engages in efficient production (achieves technological efficiency) if it cannot produce its current level of output with fewer inputs, given existing knowledge about technology and the organization of production.

5. Basic Concepts of Production Theory
Inputs are considered variable or fixed depending on how readily their usage can be changed
Variable input
An input for which the level of usage may be varied to increase or decrease output
Fixed input
An input for which the level of usage cannot be changed and which must be paid even if no output is produced
Quasi-fixed input
A “lumpy” or indivisible input for which a fixed amount must be used for any positive level of output
None is purchased when output is zero

6. Basic Concepts of Production Theory
Short run
Current time span during which at least one input is a fixed input
Long run
Time period far enough in the future to allow all fixed inputs to become variable inputs
Planning horizon
Set of all possible short-run situations the firm can face in the future

7. Sunk Costs
Sunk cost
Payment for an input that, once made, cannot be recovered should the firm no longer wish to employ that input
Irrelevant for all future time periods; not part of the economic cost of production in future time periods
Should be ignored for decision making purposes
Fixed costs are sunk costs

8. Avoidable Costs Avoidable costs
Input costs the firm can recover or avoid paying should it no longer wish to employ that input
Matter in decision making and should not be ignored
Variable costs and quasi-fixed costs are avoidable costs

9. Opportunity Costs
Meredith’s firm sends her to a conference for managers and has paid her registration fee. Included in the registration fee is free admission to a class on how to price derivative securities such as options. She is considering attending, but her most attractive alternative opportunity is to attend a talk by Warren Buffett about his investment strategies, which is scheduled at the same time. Although she would be willing to pay $100 to hear his talk, the cost of a ticket is only $40. Given that there are no other costs involved in attending either event, what is Meredith’s opportunity cost of attending the derivatives talk?
To calculate her opportunity cost, determine the benefit that Meredith would forgo by attending the derivatives class.
Because she incurs no additional fee to attend the derivatives talk, Meredith’s opportunity cost is the foregone benefit of hearing the Buffett speech. Because she values hearing the Buffett speech at $100, but only has to pay $40, her net benefit from hearing that talk is $60 (= $100 – $40). Thus, her opportunity cost of attending the derivatives talk is $60.

10. Inputs in Production (Table 8.1)
Input Type
Payment
Relation to Output
Avoidable or Sunk?
Employed in SR or LR?
Variable
Variable cost
Fixed
Fixed costs
Quasi-fixed
Quasi-fixed costs
Direct
Avoidable
SR & LR
Constant
Sunk
SR only
Constant
Avoidable
If required: SR & LR

11. Short Run Production Q = f (L, K) = f (L)
In the short run, capital is fixed
Only changes in the variable labor input can change the level of output
Short run production function
Q = f (L, K) = f (L)

12. Average & Marginal Products
Average product of labor
AP = Q/L
Marginal product of labor
MP = Q/L
When AP is rising, MP is greater than AP
When AP is falling, MP is less than AP
When AP reaches it maximum, AP = MP
Law of diminishing marginal product
As usage of a variable input increases, a point is reached beyond which its marginal product decreases

13. Total, Average, & Marginal Products of Labor, K = 2 (Table 8.3)
Number of workers (L)
Total product (Q)
Average product (AP=Q/L)
Marginal product (MP=Q/L) 1 52 2
112 3
170 4
220 5
258 6
286 7
304 8
314 9
318 10 -- -- 52 52 56 60
56.7 58 55 50
51.6 38
47.7 28
43.4 18
39.3 10
35.3 4
31.4 -4

14. Total, Average, & Marginal Products K = 2 (Figure 8.1)

15. Short Run Production Costs
Total fixed cost (TFC)
Total amount paid for fixed inputs
Does not vary with output
Total variable cost (TVC)
Total amount paid for variable inputs
Increases as output increases
Total cost (TC)
TC = TFC + TVC

16. Short-Run Total Cost Schedules (Table 8.5)
Output (Q)
Total fixed cost (TFC)
Total variable cost (TVC)
Total Cost (TC=TFC+TVC)
$6,000
100
6,000
200
300
400
500
600 $
$ 6,000
4,000
10,000
6,000
12,000
9,000
15,000
14,000
20,000
22,000
28,000
34,000
40,000

17. Question
For a linear production function q = f(L, K) = 2L + K, what is the short-run production function given that capital is fixed at capital equals to 100? What is the marginal product of labor?
Set = 100. The short-run production function is q = 2L
2. Determine the marginal products of labor by showing how q changes as L is increased by ΔL units.
Δq = (2[L + ΔL] + 100) – (2L + 100) = 2ΔL.
Thus, the marginal product of labor is MPL = Δq/ΔL = 2.

18. Total Cost Curves (Figure 8.3)

19. Average Costs Average fixed cost (AFC) Average variable cost (AVC)
Average total cost (ATC)

20. Short Run Marginal Cost
Short run marginal cost (SMC) measures rate of change in total cost (TC) as output varies

21. Average & Marginal Cost Schedules (Table 8.6)
Output (Q)
Average fixed cost (AFC=TFC/Q)
Average variable cost (AVC=TVC/Q)
Average total cost (ATC=TC/Q= AFC+AVC)
Short-run marginal cost (SMC=TC/Q)
100
200
300
400
500
600 -- -- -- --
$60
$40
$100
$40 30 30 60 20 20 30 50 30 15 35 50 50 12 44 56 80 10
56.7
66.7
120

22. Average & Marginal Cost Curves (Figure 8.4)

23. Short Run Average & Marginal Cost Curves (Figure 8.5)

24. Effects of Taxes on Costs
Taxes applied to a firm shift some or all of the marginal and average cost curves.
For example, suppose that the government collects a specific tax of $10 per unit of output from the firm.

25. Effect of a Specific Tax on Cost Curves
A $10.00 tax shifts both the AC and MC by exactly $10… M C a = b
+ 10
Costs per unit, $ 80 A C a = b
+ 10 M C b A C b
$10
$10 37 27 5 8 10 15 q
, Units per d a y

26. What is the effect of a lump-sum franchise tax on the quantity at which a firm’s after tax average cost curve reaches its minimum? (Assume that the firm’s before-tax average cost curve is U-shaped.)

27. Answer

28. Short Run Cost Curve Relations
AFC decreases continuously as output increases
Equal to vertical distance between ATC & AVC
AVC is U-shaped
Equals SMC at AVC’s minimum
ATC is U-shaped
Equals SMC at ATC’s minimum

29. Short Run Cost Curve Relations
SMC is U-shaped
Intersects AVC & ATC at their minimum points
Lies below AVC & ATC when AVC & ATC are falling
Lies above AVC & ATC when AVC & ATC are rising

30. Relations Between Short-Run Costs & Production
In the case of a single variable input, short-run costs are related to the production function by two relations
Where w is the price of the variable input
TC = wL + rK

31. Short-Run Production & Cost Relations (Figure 8.6)

32. Relations Between Short-Run Costs & Production
When marginal product (average product) is increasing, marginal cost (average cost) is decreasing
When marginal product (average product) is decreasing, marginal cost (average variable cost) is increasing
When marginal product = average product at maximum AP, marginal cost = average variable cost at minimum AVC

33. Summary
Technical efficiency occurs when a firm produces maximum output for a given input combination and technology; economic efficiency is achieved when the firm produces a given output at the lowest total cost
Production inputs can be variable, fixed, or quasi-fixed inputs
Short run refers to the current time span during which one or more inputs are fixed; Long run refers to the period far enough in the future that all fixed inputs become variable inputs
Sunk costs are irrelevant for future decisions and are not part of economic cost of production in future time periods; avoidable costs are payments a firm can recover or avoid, thus they do matter in decisions

34. Summary
The total product curve gives the economically efficient amount of labor for any output level when capital is fixed in the short run
Average product of labor is the total product divided by the number of workers: AP = Q/L
Marginal product of labor is the additional output attributable to using one additional worker with the use of capital fixed: MP = ∆Q/∆L
The law of diminishing marginal product states that as the number of units of the variable input increases, other inputs held constant, a point will be reached beyond which the marginal product of the variable input declines

35. Summary
Short-run total cost, TC, is the sum of total variable cost, TVC, and total fixed cost, TFC: TC = TVC + TFC
Average fixed cost, AFC, is TFC divided by output: AFC = TFC/Q; average variable cost, AVC, is TVC divided by output: AVC = TVC/Q; average total cost (ATC) is TC divided by output: ATC = TC/Q
Short-run marginal cost, SMC, is the change in either TVC or TC per unit change in output Q
The link between product curves and cost curves in the short run when one input is variable is reflected in the relations, AVC = w/AP and SMC = w/MP, where w is the price of the variable input