Today

1. Today • Production and cost in the Short Run

2. How Costs Vary with Output

3. Recall: Short-Run & Long-Run • Short run: When an economic agent may adjust somewhat (but not completely) to an event. • Long run: When an agent has fully adjusted to an event.

4. SR & LR for a Firm • Short run: Period of time during which some important input or inputs is fixed or limited in quantity. • Long run: Period of time needed so that all inputs are variable in quantity. Everything can be adjusted. (Includes the possibility of closing the firm.)

5. Example: Pizza Parlor • Pizza parlor sees increased demand & decides to sell 20% more pizzas. • SR: cannot increase the size of the building, # of ovens. May hire more workers per shift, use more ingredients, or expand the hours of business. • LR: add ovens, floor space, kitchen space. May take several months to a year.

6. A Note on SR & LR • These are not set periods of time: their length will depend on the type of firm or industry. • We can think of them as response times.

7. “Production in the SR” • . . . refers to how the firm is able to vary its level of output while some input (or inputs) is fixed in quantity.

8. Pizza Parlor • In the short run, assume the following is fixed: • restaurant size • # of ovens • # of tables • workspace • Variable inputs in short run • labor • ingredients (will not focus on these)

9. Adding more labor to fixed inputs • # Workers Total Product 0 0 1 10 2 22 3 32 4 38 5 36 What can you notice about the relation between workers and total product?

10. TP 40 30 20 10 1 2 3 4 5 Graphing Total Product • L TP 0 0 1 10 2 22 3 32 4 38 5 36 TP L

11. Definition of Marginal Product • Marginal Product of Labor (MPL) = DTP/DL.

12. Add MP to the Table • L TP MP 0 0 n/a 1 10 10 2 22 12 3 32 10 4 38 6 5 36 -2

13. Graphing Marginal Product TP 40 • L MP 0 na 1 10 2 12 3 10 4 6 5 -2 6 30 TP 20 1 10 L 1 2 3 4 5 Marginal product can be seen as the slope of the total product curve.

14. Graphing Marginal Product TP 40 • L MP 0 n/a 1 10 2 12 3 10 4 6 5 -2 6 30 TP 20 1 10 MP L 1 2 3 4 5 10 8 6 4 MP 2 -2 L 1 2 3 4 5

15. The Pattern of MP • In this example, MP increases at first. • Represents increased division of labor. • Can separate cooking from serving functions. • MP then decreases. • Represents the effects of crowding. • More people trying to use limited space, equipment. • MP negative: extreme crowding.

16. Law of Diminishing Marginal Returns • Holding some important inputs (or inputs) constant and increasing the use of another input by equal increments will eventually result in a decreasing marginal product.

17. Notes on the Law of Diminishing Marginal Returns • A physical law (doesn’t involve prices). • Not an economic assumption. • Allows for increasing MP at initial levels of output. • Applies to SR situations only (why?) • Implies the slope of TP must eventually fall.

18. What the LDMR implies for costs • Beyond some point, adding additional labor leads to a falling Marginal Product. • This implies that beyond that same point, it will cost more and more to produce an extra unit of output. • Let’s make this idea more formal.

19. Definitions of TC, TFC, TVC • Total cost (TC): the economic cost of producing a given level of output. • Total Fixed Cost (TFC): Costs which donot vary with changes in output, given a particular short run situation. (Overhead) • Total Variable Cost (TVC): Costs which do vary as output changes. • TC = TFC + TVC

20. Ex: Producing Cheese in the Short Run • Fixed factors in the SR: • Size of factory • Machinery • Variable factors in the SR: • Labor • Raw materials such as milk, rennet. We will ignore these.

21. Why is TFC equal to 10 for every Q? Where does TC come from? Note: Q is the same thing as TP. Ex: TVC, TFC, TC

22. Graph of TVC, TFC, TC • Add total fixed costs vertically on top of TVC to get TC. • TC is positive when Q = 0. $ TC 30 TVC 20 10 TFC TFC Q 2 4 6

23. Definitions of ATC, AVC, AFC • Average Total Cost: TC/Q, where Q = quantity of goods produced. • Average Variable Cost: TVC/Q • Average Fixed Cost: TFC/Q

24. Do you see where the values in the AVC and ATC columns come from? Table: AVC, ATC

25. Graph of AVC, ATC • ATC and AVC both are U-shaped. • AVC lies everywhere below ATC. Why? $/Q 14 12 10 8 6 ATC 4 AVC 2 Q 2 4 6

26. Notes on ATC and AVC • How can you see AFC on this graph? • Why do ATC and AVC grow closer together as Q rises? • The minimum of AVC occurs at a lower level of output than for ATC. Why?

27. Marginal Cost • Marginal Cost (MC): The change in total cost associated with increasing output by one unit. • MC = TC • Q • What are marginal fixed costs equal to? • Is MC the same thing as MVC?

28. Do you see where the values in the MC column come from? Table: MC

29. Graph of MC • Graph MC half-way between the old & new Q for greater accuracy. $/Q 14 12 10 8 MC 6 ATC 4 AVC 2 Q 2 4 6

30. Notes on MC • MC must eventually rise due to the Law of Diminishing Marginal Returns. • If each successive laborer has a lower MP, then the MC of producing one more unit is rising. • MC cuts ATC and AVC and their lowest points. Why?

31. The Relation between Marginal and Average • When marginal cost is below average cost, average cost will be falling. • When marginal cost is above average cost, average cost will be rising. • This relationship between “marginal” and “average” applies to all variables.

32. Coming Up • Shift in SR cost curves • Production and cost in the Long Run

33. Group Work? • Work on cost problem on handout if there is time.