Lecture 10: More Production and Costs of the Firm

Outline:

1. The production function revisited

2. Short run production choices

i. Total product (TP)

ii. Average product (AP)

iii. Marginal product (MP)

iv. Law of diminishing returns

3. The cost function

4. Short run costs

i. Total cost (TC), Total variable cost (TVC), Total fixed cost (TFC)

ii. Average total cost (ATC), Average variable cost (AVC), Average fixed cost (AFC)

iii. Marginal cost (MC)

iv. Shape of the cost curves and the production function

5. Shifts of the short run cost curves

1. The Production function revisited

Q=F(L,K,R)

* Simple example: Two inputs L,K and one output Q

2. Short run production choices:

* In the Short Run assume K is the fixed factor and L is the variable factor.

Question: In the short run if the firm wants to increase Q what is its only choice in terms of the inputs?

* For a given amount of the fixed input, how output changes with changes in labor can be looked at in three ways:

Total product (TP)= the total amount Q that is produced with a certain quantity of labor in a given time period

Average product (AP) = the Q that is produced per unit of labor in a given time period

AP = TP/L

Marginal product (MP) = the change in Q resulting in the use of one more unit of L in some time period

MP = Change in TP/ change in L

TP, MP, and AP curves graphically.

Note:

i. Initially when the firm uses more labor the AP rises, then it reaches a maximum and falls. The point at which the AP begins to fall is called the point of diminishing average productivity.

ii. Initially when the firm uses more labor the MP rises, then it reaches a maximum and falls. The point at which the MP begins to fall is called the point of diminishing marginal productivity.

Question: Why do MP and AP eventually decline?

The Law of Diminishing Returns:

If increasing amounts of a variable factor are added to a fixed factor, the variable factor has less and less of the fixed factor to work with and beyond some point the extra units of the variable factor add less and less to total output.

Example

3. The Cost Function

* Maximizing profits implies minimizing costs

* Firms are interested in the lowest cost method of producing a given level of output.

Definition:

The cost function shows the firm's minimum cost of producing each level of output.

C = f (w, r, Q)

where C is total cost

w is the price of a unit of Labor

r is the price of a unit of Capital

Q is the total output

4. Short run costs:

* The firm's cost of producing a given level of output Q will depend on how much of the inputs they hire and the prices of those inputs.

Total cost (TC) = total cost of producing a given level of output Q

Total Variable cost (TVC) = total cost of hiring the variable factor to produce a given level of output Q

Total Fixed cost (TFC) = total cost of hiring the fixed factor

TC = TVC + TFC</P>

TC, TVC, TFC curves graphically

Average costs:

ATC = cost of producing one unit of output

AVC= the variable cost of producing one unit of output

AFC= the fixed cost of producing one unit of output

Marginal Cost (MC) = the increase in TC from producing an extra unit of output

MC = change in TC/ change in Q

MC, ATC, AVC curves graphically

Question: How does the law of diminishing returns affect the shape of the cost curves?

5. Shifts of the cost curves:

* Increase in costs - curves shift up

* Decrease in costs - curves shift down