1. Chapter 8 Production & Cost in the Short Run
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2. 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

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
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

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. 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

10. 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)

11. 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

12. 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

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

14. 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

15. 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

16. Total Cost Curves (Figure 8.3)

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

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

19. 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

20. Average & Marginal Cost Curves (Figure 8.4)

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

22. 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

23. 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

24. 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

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

26. 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

27. 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

28. 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

29. 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