Introduction to Supply and Theory of Production

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2. Chapter Introduction Section 1: What is Supply? Section 2: The Theory of Production Section 3: Cost, Revenue, and Profit Maximization Visual Summary Chapter Menu

3. In order to earn some extra money, you are considering opening a lawn or babysitting service. Brainstorm the resources you would need. What specific services would you offer? What prices would you charge? What information do you need to determine answers to these and other questions? Read Chapter 5 to find out about the factors that influence how businesses make production decisions. Chapter Intro 1

4. Section Preview In this section, you will learn that the higher the price of a product, the more of it a producer will offer for sale. Section 1-Preview

5. Content Vocabulary • supply • Law of Supply • supply schedule • supply curve • market supply curve • quantity supplied • change in quantity supplied • change in supply • subsidy • supply elasticity Academic Vocabulary • various • interaction Section 1-Key Terms

6. An Introduction to Supply Supply is the amount of a product that would be offered for sale at all possible prices in the market. The Law of Supply states that suppliers will normally offer more for sale at high prices and less at lower prices. An individual supply curve illustrates how the quantity that a producer will make varies depending on the price that will prevail in the market. A market supply curve illustrates the quantities and prices that all producers will offer in the market for any given product or service. Economists analyze supply by listing quantities and prices in a supply schedule (table). When the supply data is graphed, it forms a supply curve with an upward slope.

7. An Introduction to Supply (cont.) • Normal supply curves have a positive slope—prices go up; quantity supplied goes up. Individual and Market Supply Curves Section 1

8. An Introduction to Supply (cont.) • The quantity supplied is the amount producers bring to market at any given price. • A change in price leads to a change in quantity supplied. • Although the producer has the freedom to adjust production up or down, the interaction of supply and demand usually determines the final price of a product. Section 1

9. Change in Supply (cont.) • A change in supply occurs for several reasons. • Cost of resources • Productivity • Technology • Taxes A Change in Supply Section 1

10. Change in Supply (cont.) Subsidy -payment that a government gives to a business to help the business. If a firm receives a subsidy, the extra money helps it increase its supply of product. • Farm, oil, ethanol, housing, insurance, bailouts (banks, housing, auto) (cash4clunkers) • Expectations • Government regulations • Number of sellers Section 1

11. Elasticity of Supply The response to a change in price varies for different products. Section 1

12. Elasticity of Supply (cont.) • Supply, like demand, has elasticity. • Supply elasticity measures how the quantity supplied responds to a change in price. Elasticity of Supply Section 1

13. Elasticity of Supply (cont.) • Supply elasticity has three forms: • Elastic • Inelastic • Unit elastic Elasticity of Supply Section 1

14. Elasticity of Supply (cont.) • Supply elasticity is based solely on production considerations. • A firm’s ability to adjust to new prices quickly is likely to be elastic. • A firm that takes longer to react to a change in prices is likely to be inelastic. Elasticity of Supply Section 1

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16. Section Preview In this section, you will learn how a change in the variable input called “labor” results in changes in output. Section 2-Preview

17. Content Vocabulary • production function • short run • long run • total product • marginal product • stages of production • diminishing returns Academic Vocabulary • hypothetical • contributes Section 2-Key Terms

18. The theory of production explains how the factors of production (land, capital, labor, and entrepreneurship) are related to the amount of goods and services that are produced. The theory of production is generally based on the short run, which is a short production period. The time is so short that only one variable input—labor—changes. (A variable input is a kind of input that can be changed, such as labor, supply of materials, and amount of money that can be spent on new machinery.) In contrast, the long run is a production period that is long enough to adjust the amounts of all resources, including capital goods.

19. The Law of Variable Proportions states that in the short run, the amount of a product that is produced will change if one kind of input changes while the other kinds of input stay the same. A farmer, for example, uses the law to find out how a crop yield will be affected if different amounts of fertilizer are added, but the farm machinery and the size of the field stay the same. Economists do not like to change more than one factor at a time because then it becomes difficult to study the effect of a single variable on total output.

20. The relationship between changes in output and changes in a single input is called a production function. For example, a production function may show that one worker produces seven units of output, two workers produce 20 units, and so on. The only thing that changes is the number of workers. Other kinds of input, including raw materials, stay the same. Raw materials are the materials used in production, such as wood, cotton, iron, and rubber.

21. As more workers are added, production rises. However, after even more workers are added, production does not rise as fast. And if too many workers are added, production can even go down, because the workers get in each other’s way. The two most important measures of output are total product and marginal product. Total product is the total amount of a product that is produced by a business. Marginal product is the extra output produced when one input, such as one more worker or one new machine, is added.

22. The three stages of production are based on changes in marginal product as the number of workers increases. During Stage I, when there are few workers, each new worker hired con- tributes more to the total output than the worker before. In other words, if two workers, can produce 10 units of product, then three workers might be able to produce 20 units. That happens because new workers are needed so that the machinery and other resources can be used well. The increase in productivity during this stage is called increasing returns. (Returns refers to total production.)

23. During Stage II the total production continues to grow with each new worker. However, it grows by smaller and smaller amounts with each new hired worker. Suppose, in the example described above, a fourth worker is hired, and the total output becomes 27 units. While the third worker added 10 units, the fourth only added seven. This occurrence is called diminishing returns. In Stage III, the firm has hired too many workers; they get in one another’s way. At this point, marginal product actually decreases each time a new worker is added. So total factory output decreases.

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25. Section Preview In this section, you will learn how businesses analyze their costs and revenues, which helps them maximize their profits. Section 3-Preview

26. Content Vocabulary • fixed costs • overhead • variable costs • total cost • marginal cost • e-commerce • break-even point • total revenue • marginal revenue • marginal analysis • profit-maximizing quantity of output Academic Vocabulary • conducted • generates Section 3-Key Terms

27. Measures of Cost Businesses analyze fixed, variable, total, and marginal costs to make production decisions. Section 3

28. Measures of Cost • Fixed costsare those that a business has even if it has no output. These include management salaries, rent, taxes, and depreciation on capital goods. • Fixed cost includes such things as interest payments on debts, rents, and taxes. It also includes depreciation, which is a measurement of the decreasing value of capital goods, such as machinery, as they are used over and over again. Total fixed cost is called overhead.

29. Variable costs are those that change when the rate of operation or production changes, including hourly labor, raw materials, freight charges, and electricity. • Total cost is the sum of all fixed costs and all variable costs. Marginal cost is the extra (variable) costs incurred when a business produces one additional unit of a product.

31. Inputs affect production because different input have different costs, and inputs can be combined in different ways. For example, a gas station is likely to have large fixed costs, such as the cost of the lot and taxes. The variable costs are probably small, such as employee wages and the cost of electricity. Because of this, the owner might be able to keep the gas station open 24 hours a day for a fairly low cost. Since the variable costs are small, they may be covered by the profits of the extra sales.

32. An e-commerce business is a business that operates on the Internet. It does not have to pay rent or have a large supply of goods because customers visit the store on the Web and look at “virtual” merchandise. Thus, fixed costs are very low.

33. Total revenue is the number of outputs or products sold, multiplied by the average price for each product. Marginal revenue is the extra revenue gained from the sale of each additional unit of output. You can figure out marginal revenue by dividing the change in total revenue by the marginal product.

34. Economists use marginal analysis, which compares the extra benefits to the extra costs of an action. Marginal analysis helps in finding the break-even point—the total product the business needs to sell in order to cover its costs. It also helps a business figure out the profit-maximizing quantity of output. This is the point at which marginal cost is equal to marginal revenue.

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36. Law of Supply When the price of a product goes up, quantity supplied goes up. When the price goes down, quantity supplied goes down. VS 1

37. Production FunctionThe production functionhelps us find the optimalnumber of variable units(labor) to be used inproduction. As workersare added in Stage I,production increases atan increasing rate. InStage II, productionincreases at a decreasing rate because of diminishing returns. In Stage III, production decreases because more workers cannot make a positive contribution. VS 2

38. Cost and Revenue While businesses have several types of costs, they can find the profit-maximizing quantity of output by comparing marginal cost to their marginal revenue. VS 3

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47. Kenneth I. Chenault (1951– ) • first African American to be CEO of a top-100 company • responsible for continuing American Express’s 155-year-old tradition of “reinvention” during global change Profile

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