1. Foundation of Economic Analysis 3250:600
Instructor: Richard W. Stratton
Meets: Thursday 5:20 – 7:50 pm
CAS 134

2. The University of Akron
Administration
This Week’s Assignments
Farnham Chapter 5 (SR costs),
Chapter 6 (LR costs)
Homework 4 – due next week
Next Week’s Assignments
Farnham Chapter 7 (Perfect competition)
Homework 5 - attempt
11/19/2018
The University of Akron
Decision Tree

3. Introduction Short Run Production Short Run Costs Discussion
Decision Tree
Long Run Costs
Introduction
Short Run Production
Short Run Costs
Discussion

4. Introduction – net benefit
Why are we interested in cost functions?
Decisions depend on net benefits of alternative courses of action
What are the relevant costs?
Opportunity costs
Marginal costs
11/19/2018
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Decision Tree

5. Introduction – net benefit
Net benefit is the additional benefit received from an activity
Accounting profit
Total revenue – explicit costs
Economic profit
Total revenue – (explicit + implicit costs)
Group activity distinguishing between accounting and economic profit
11/19/2018
The University of Akron
Decision Tree

6. Introduction – net benefit
Benefits determined by
Revenue function
Market structure – demand facing firm
Our topic for next 2 weeks
Costs determined by
Production function
Input prices
To which we now turn
11/19/2018
The University of Akron
Decision Tree

7. The University of Akron
Introduction
Definition of production function
Short run versus long run
Fixed inputs
Variable inputs
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Decision Tree

8. Introduction - definition
Production function is the relationship of how resources (inputs) can be converted to outputs
Labor (L)
Capital (K)
Land (R)
Entrepreneurship (En)
Intermediate inputs (M)
Simplify – focus on L and K
11/19/2018
The University of Akron
Decision Tree

9. Introduction - definition
Production is a flow!
Efficiency
Technical efficiency
Economic efficiency
Given enough time all inputs can be changed to affect output
But some take longer than others
11/19/2018
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Decision Tree

10. Introduction - definition
Short run
The amount of at least one input cannot be changed
The amount of at least one input is fixed
Some input amounts can vary
Long run
All input amounts can be changed
All input amounts can vary
11/19/2018
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Decision Tree

11. Introduction - definition
Simplify – focus on L and K
Short run
Assume Capital fixed
Assume Labor can vary
Long run
Assume Labor and Capital can vary
11/19/2018
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Decision Tree

12. Introduction – Lasting Ideas
Costs derived from production
Cost are a function of input prices
Cost are a function of input productivity
Input substitution is important
Sunk costs are irrelevant
11/19/2018
The University of Akron
Decision Tree

13. Introduction Short Run Production Short Run Costs Discussion
Decision Tree
Long Run Costs
Introduction
Short Run Production
Short Run Costs
Discussion

14. The University of Akron
Short Run Production
Short run production function
Law of variable proportions
Diminishing returns
Total product
Average product
Marginal product
11/19/2018
The University of Akron
Decision Tree

15. The University of Akron
Short Run Production
Proposition:
As the amount of labor increases, capital fixed, output will at some point increase at a decreasing rate
Output may actually decline
Groups – is there a way to quickly test this proposition?
11/19/2018
The University of Akron
Decision Tree

16. The University of Akron
Short Run Production
Suggestion
Paper airplane production in a men’s room stall
Diminishing returns
Law of variable proportions
11/19/2018
The University of Akron
Decision Tree

17. The University of Akron
Short Run Production
Important measures
Total product – total production per unit of time [TP or Q]
Average product – production per unit of variable input
TP / L or Q / L
Marginal product – additional production from one addition unit of variable input
Change TP / Change L or DQ / DL
11/19/2018
The University of Akron
Decision Tree

18. Short Run Production (algebra)
Total Product
Average Product – TP/L
Marginal Product – DTP/DL
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19. Short Run Production (table)
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20. Short Run Production (graph)
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21. Short Run Production (graph)
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22. Short Run Production (graph)
TP maximum
Diminishing Returns
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The University of Akron

23. Introduction Short Run Production Short Run Costs Discussion
Decision Tree
Long Run Costs
Introduction
Short Run Production
Short Run Costs
Discussion

24. The University of Akron
Short Run Costs
Opportunity Cost (explicit, implicit)
Net benefit
Accounting and economic profit
SR Total Costs
Fixed
Variable
Total
SR Average Costs
Marginal Cost
11/19/2018
The University of Akron
Decision Tree

25. The University of Akron
Opportunity Cost
As we have seen the real cost of an activity is the most valued activity sacrificed!
Opportunity Cost
Explicit costs
Implicit costs
11/19/2018
The University of Akron
Decision Tree

26. The University of Akron
Short Run Total Costs
If we know how much of each input is required for production
Production function
And the cost per unit of inputs
Input costs
K = $50/unit
L = $100/unit
We can calculate SR Total Costs
11/19/2018
The University of Akron
Decision Tree

27. The University of Akron
Short Run Total Cost
Total Cost
TC = FC + VC
FC = $50 * 10 = $500
VC = $100 * L
Fixed costs constant
Variable costs
Increase at decreasing rate
Increase at increasing rate
11/19/2018
The University of Akron

28. The University of Akron
Short Run Average Cost
Average Total Cost
ATC = AFC + AVC
AFC = TFC / Q
AVC = TVC / Q
AFC always declining
AVC U shaped
Decline, reach minimum, increase
ATC U shaped
11/19/2018
The University of Akron

29. Short Run Marginal Cost
Change in TC per unit change in Q
Change in VC per unit change in Q
DTC / DQ = DVC / DQ
MC U shaped
Decline, reach minimum, increase
11/19/2018
The University of Akron

30. Short Run Costs (table)
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31. Short Run Total Cost (graph)
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32. Short Run Costs (graph)
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33. Short Run Costs (stylized)$ MC
ATC
AVC
AFC Q Q1 Q2
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34. Short Run Costs (stylized)
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35. Short Run Costs (stylized)
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The University of Akron

36. Introduction Short Run Production Short Run Costs Discussion
Decision Tree
Long Run Costs
Introduction
Short Run Production
Short Run Costs
Discussion

37. Discussion - Short Run Cost
Constant MC
MP constant
DTC / DQ = DVC / DQ constant
TC and VC are straight lines
Impact on AVC?
AVC constant and equal to MC
Impact on ATC?
ATC always declining
11/19/2018
The University of Akron

38. Discussion - Short Run Cost
Decreasing MC
MP increasing
DTC / DQ = DVC / DQ decreasing
Additional units cost less than current units
If current unit profitable, wouldn’t more units also be profitable?
Depends on revenue!
AVC always declining
ATC always declining
11/19/2018
The University of Akron

39. Introduction Short Run Production Short Run Costs Discussion
Decision Tree
Long Run Costs
Introduction
Short Run Production
Short Run Costs
Discussion