Foundation of Economic Analysis 3250:600

1. Foundation of Economic Analysis3250:600 Instructor: Richard W. Stratton Meets: Thursday 5:20 – 7:50 pm CAS 134

2. 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 The University of Akron Decision Tree

3. 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 The University of Akron 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 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 The University of Akron Decision Tree

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

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

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

15. 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? The University of Akron Decision Tree

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

17. 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 The University of Akron Decision Tree

18. Short Run Production (algebra) • Total Product • Average Product – TP/L • Marginal Product – DTP/DL The University of Akron

19. Short Run Production (table) The University of Akron

20. Short Run Production (graph) The University of Akron

21. Short Run Production (graph) The University of Akron

22. Short Run Production (graph) TP maximum Diminishing Returns The University of Akron

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

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

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

26. 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 The University of Akron Decision Tree

27. 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 The University of Akron

28. 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 • Decline, reach minimum, increase The University of Akron

29. Short Run Marginal Cost • 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 The University of Akron

30. Short Run Costs (table) The University of Akron

31. Short Run Total Cost (graph) The University of Akron

32. Short Run Costs (graph) The University of Akron

33. Short Run Costs (stylized) $ MC ATC AVC AFC Q Q1 Q2 The University of Akron

34. Short Run Costs (stylized) The University of Akron

35. Short Run Costs (stylized) The University of Akron

36. 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 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 The University of Akron

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