Chapter 9 Production & Cost in the Short Run

Our focus has been on the fact that firms

attempt to maximize profits. However, so far we have only focused on the revenue side of profits and have ignored costs. Increased globalization of markets has forced firms to focus more on productivity and control of costs in order to compete in the international market place.
9.1

Short Run versus Long Run

In the short run at least one input is fixed in

quantity and cannot be changed. In the long run all inputs are variable. Thus, even plant size can be changed (capital decisions). Short run costs will depend on short run production theory and long run costs on long run production theory.
9.2

Production Functions
A production function is a

relationship(table, graph, or equation) showing the maximum output that can be produced from any specified set of inputs, given the state of technology. Our production function to allow for graphical efficiency is of the following form: Q = f(L,K)
9.3

Technical Efficiency versus Economic Efficiency

Technical efficiency is achieved when output is

maximized for any combination of inputs. Thus, any point on the production function is technically efficient. Economic efficiency is achieved when a given level of output is generated at least cost. Note a process may be technically efficient and not economically efficient. Example building airfields in SE Asia during WWII (price of inputs becomes important n economic efficiency).
9.4

Some Definitions
Inputs can be Fixed level of usage cannot be changed
Land Capital

Variable level of usage can be changed

Labor services Raw materials

9.5

Short Run(SR) Production Function

In SR, recall that time period is such that at

least one input is fixed in amount. Thus, the SR production function can be written as

Q f ( L, K ) f ( L )
K-bar implies a fixed amount of capital.

9.6

Production in the Short Run

Use simplest of cases where output, Q, is

a function of a single input, L, Labor. Total Product is same as output or Q. Average Product = AP = Q/L Marginal Product = MP = Change in Q/Change in L

9.7

#7, page 349

A Production Function

Units of 1 Labor 1 50
2 3 4 5 110 150 170 160

Units of capital
2 3 4

120
260 360 430 480

160
360 510 630 710

180
390 560 690 790

Long run let both K and L vary Short run fix K and let L vary
9.8

#7, page 349

A Short Run Production Function

Units of Labor 1
2 3 4 5

Units of capital
1 2 3 4

50
110 150 170 160

120
260 360 430 480

160
360 510 630 710

180
390 560 690 790

Short run fix K at L=2 and let L vary

9.9

#7, page 349

A Short Run Production Function: K=2 Number of Total Average Marginal Workers Product Product product (Q) (MP) (L) (AP) 1 120 120 120 2 3 260 360 130 120 140 100

4
5

430
480

107.5
96

70
50
9.10

Law of Diminishing Marginal Product

This is one of the strictest laws in

economics. It states that as the number of units of the variable input increases, holding constant all other inputs, a point is eventually reached where marginal product will decline.

9.11

Graph of Total, Average, and Marginal Products

See Figure 9.1, page 326. What happens to curves if the fixed input, K, is

increased? Important points

TP curve must eventually increase at a diminishing rate(law of diminishing marginal productivity). This occurs where slope of TP, which is MP, starts to decline MP intersects AP at maximum AP. When AP is rising AP > MP. When AP is falling, MP < AP MP = 0 where TP is max

9.12

Economic Costs
Opportunity cost is the value of what firm

owners give up to use a resource. It is the sum of explicit(money flows) costs as well as implicit costs(no money flows)
Explicit costs an out-of-pocket monetary payment for the use of a resource. Implicit costs the foregone return the firms owners could have received had they used their own resources in their (next best) alternative use.
9.13

Normal Profit
Normal Profit is nothing more than implicit

cost of using owner supplied resources.

Capital(best alternative use?)
Lease or rental value Sell and invest proceeds(current market value and not purchase price is relevant)

Owners time

9.14

Short Run Costs

In SR some inputs are fixed. Thus, these

resources must be compensated irrespective of output and lead to some costs being fixed(independent of output). We refer to these as fixed costs, TFC. Payments for variable inputs are called variable costs, TVC, and these depend on output. Total Cost = TVC + TFC
9.15

Other SR Cost Concepts

Average Fixed Cost = AFC = TFC/Q

Average Variable Cost = AVC = TVC/Q

Average Total Cost = ATC = TC/Q

ATC = AVC+AFC
SR Marginal Cost = SMC = (change in TC

or TVC)/change in Q
TVC TC SMC Q Q
9.16

Relationships among Average and Marginals

ATC, AVC, and SMC all have U-shape

with respect to output AFC continuously declines spreading the overhead SMC is above(below) ATC when ATC is increasing(decreasing). Same for AVC and SMC relationship. SMC intersects AVC and ATC at their minimum points respectively.
9.17

SR Cost and SR Production the Linkage

Recall SR production function is Q = f(L)

since K is assumed fixed. Thus, TVC = w * L and TFC = r * K where w = price of labor(wage rate) r = price of capital So TC = wL + rK

9.18

AVC versus AP
Recall AVC = TVC/Q and TVC = wL, so AVC = wL/Q or AVC = w/(Q/L) = w/APL Note the significance of this. AVC is related to

the wage rate, which for the firm is assumed to be fixed(price-taker) and the average product of labor(APL). AP curves initially increase as the quantity of labor increases, reach a max , and then decline. Thus, AVC will do the opposite decrease, reach a minimum, and then increase.

9.19

MC versus MP
TVC w L w SMC Q L MPL MPL
Note MC is the wage rate, which is assumed

fixed) divided by the marginal product of labor. Thus, as MP rises(falls), MC falls(rises). Also the max of MP is the minimum for MC See Figure 9.7

9.20