Part 5 The Theory of Production and Cost

1. Part 5The Theory of Production and Cost • Production normally organized in Firms • A Firm hires inputs, organizes production, and sells goods or services • A firm is a governance structure that can range from simple to highly complex (sole owner to large multi-nation corporation) • Firms allocate resources and coordinate economic activities internally using commands and incentive systems

2. Why Firms? • Why is all economic activity not coordinated through markets? • Firms exist because they offer cost advantages over market transactions - Transactions costs - Monitoring - Economies of scale or scope - Economies of team production

3. Why Markets? • Why is all economic activity not coordinated through organized firms (or just one giant firm)? • Principal-agent and incentive problems • Problems of information and management provide limits to firm size

4. The Firm’s Goals • The goal of the owners of the firm is to maximize the return on their capital investment—to maximize profit • Profit is revenue less cost-- defined as opportunity cost • Explicit and implicit costs • Normal profit and economic profit

5. The Firm’s Constraints • Available technology • Prices of inputs • Fixed capital in the short run • Degree of competition in the output market • Given these constraints the firm needs to choose the method of production and output level that will maximize profit • Maximizing profit implies minimizing the cost of production

6. Output and Cost: Short Run • In the short run the firm has a plant of given size • The firm can add or subtract labour and other inputs to vary output, but cannot alter the size of the plant • The fixed plant size affects how output will change with changes in the inputs that can be varied

7. The Short Run Production Function • Total product curve Output TP Inflection point TP increasing at a decreasing rate L’ Labour TP= Total output as labour (and other variable inputs) are added to a plant of fixed size

8. Short Run Production Functions • Other possible shapes Output TP Labour Output TP Labour

9. Average and Marginal Product Curves TP TP AP max & AP = MP MP max L Point of diminishing marginal returns AP MP Point of diminishing average returns AP MP L L’ L”

10. Diminishing Returns • When there is a fixed factor must eventually run into diminishing marginal returns • The constraint of the fixed factor eventually makes it more and more difficult (costly) to obtain additional output from the plant of fixed size • Law of Diminishing Returns • Is our world a world of diminishing returns?

11. Short Run Cost • Our production function showed output as a function of the quantity of variable input (labour) with a given quantity of a fixed input (capital). • We need to convert this into a cost function showing cost as a function of output • To do this we assume that the prices of inputs are given

12. Short Run Total Costs • Total cost is total variable cost plus total fixed cost • The total variable cost of a given level of output is the quantity of labour it takes to produce that output (with the fixed level of capital) times the price of labour • The total fixed cost is the quantity of the fixed input times the price of that input • Total fixed cost does not vary with output

13. TP and TVC Q TP Q’ L L’ $ TVC = L x Wage TVC’ (L’ x W) Q Q’

14. Total Cost Curves TC $ TVC TFC Q Diminishing returns due to the fixed factor Means that TVC and TC must eventually Rise at an increasing rate

15. Marginal and Average Costs • Average total cost is total cost divided by output • Average variable cost is total variable cost divided by output • Average fixed cost is total fixed cost divided by output • ATC = AVC + AFC • Marginal cost is the additional cost of an additional unit of output • MC = ΔTC/ΔQ

16. Marginal and Average Cost Curves $ Min ATC MC ATC AVC Min AVC AFC Q ATC = AVC + AFC

17. Marginal and Average Product and Cost Curves • As a firm expands output along its production function the output at which average product is at its greatest will be where AVC is at a minimum • The output level at which MP is at a maximum will the output level where MC is at a minimum • As MP and AP eventually decline due to diminishing returns, so MC and AVC will eventually rise.

18. Shifts in Cost Curves • New Technology • Costs of inputs • Fixed inputs • Variable inputs • Scale of plant (long run)

19. Long Run Cost • Changes to the scale of the plant • Each plant size has a TC curve • Larger plant increases fixed cost but delays onset of diminishing returns • Each plant size has a short run ATC curve • Long run average cost curve is the lower boundary of all short run ATC curves • Long run and the least possible cost of production

20. Long Run Cost $ TC1 TC2 Q1 Q

21. Long Run Cost $ ATC1 ATC2 LAC Q Q1 Constant returns to scale

22. Long Run Average Cost Generalized case: increasing followed by decreasing returns to scale $ ATC3 ATC1 ATC5 ATC2 ATC4 LRATC Q* Q Q’ Least cost plant size to produce Q’ is ATC2 Q* is the lowest possible average cost, but whether this is the firm’s profit maximizing output will depend on market structure.

23. Economies of Scale • Economies of scale due to specialization of labour and capital • Diseconomies of scale due to problems of information and management • Constant returns to scale • Minimum efficient scale