7. Cost and supply Flashcards
An input (or factor of production) is a good or service used to produce output.
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A production technique is technically efficient if there is no other way to make a
given output using less of one input and no more of the other inputs. The
production function is the set of all technically efficient techniques.
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A fixed factor of production is an input that cannot be varied. A variable factor
can be varied, even in the short run.
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The marginal product of a variable factor is the extra output from an extra unit of
that input, holding constant all other inputs.
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Holding all factors constant except one, the law of diminishing marginal returns
says that, beyond some level of the variable input, further increases in the
variable input lead to a steadily decreasing marginal product of that input.
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Fixed costs do not vary with output.
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Variable costs change as output changes.
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Short-run marginal cost (SMC) is the extra cost of making an extra unit of output
in the short run while some inputs remain fixed.
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Short-run average variable cost (SAVC) = short-run variable cost (SVC)/Quantity of output
Short-run average fixed cost (SAFC) = short-run fixed cost (SFC)/Quantity of output
Short-run average total cost (SATC) = short-run average fixed cost (SAFC) + short-run average variable cost (SAVC)
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Short-run average variable cost (SAVC) equals SVC divided by output, and
short-run average total cost (SATC) equals STC divided by output.
Short-run average fixed cost (SAFC) equals short-run fixed cost (SFC) divided
by output.
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The firm’s short-run output decision is to supply Q1, the output at which MR = SMC, if the price covers short-run average variable cost SAVC1 at that output. If not, the firm supplies zero.
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Technical progress is a new technique allowing a given output to be made with fewer inputs than before.
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Long-run total cost (LTC) is the minimum cost of producing each output level when the firm can adjust all inputs.
Long-run marginal cost (LMC) is the rise in long-run total cost if output rises permanently by one unit.
Long-run average cost (LAC) is the total cost LTC divided by the level of output Q
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Economies of scale (or increasing returns to scale) mean long-run average cost falls as output rises.
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Diseconomies of scale (or decreasing returns to scale) mean long-run average cost rises as output rises.
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A production function displays increasing, constant or decreasing returns to scale if the following definitions hold:
a. Increasing returns to scale (or economies of scale): when all the inputs of production are increased by the same factor and the output produced increases more than proportionally. Constant returns to scale mean long-run average costs are constant as output rises.
b. Constant returns to scale : when all the inputs of production are increased by the same factor and the output produced increases by the same factor.
c. Decreasing returns to scale (or diseconomies of scale): when all the inputs of production are increased by the same factor and the output produced increases less than proportionally.
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Constant returns to scale mean long-run average costs are constant as output rises.
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Minimum efficient scale (MES) is the lowest output at which the LAC curve reaches its minimum.
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Globalization is the increasing integration of national markets that were previously much more segmented from one another strike but by a computer virus.
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Globalization is the increasing integration of national markets that were previously much more segmented from one another.
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This chapter discusses short-run and long-run decisions, based on the corresponding cost curves. In the long run, a firm can fully adjust all its inputs. In the short run, some inputs are fixed. The length of the short run varies from industry to industry.
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The production function shows the maximum output that can be produced using given quantities of inputs. The inputs are machines, raw materials, labor and any other factors of production. The production function summarizes the technical possibilities faced by a firm.
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In the short run, the firm cannot adjust some of its inputs. But it still has to pay for them. It has short-run fixed costs (SFC) of production. The cost of using the
variable factors is short-run variable cost (SVC). Short-run total cost (STC) is equal to SFC plus SVC.
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The total cost curve is derived from the production function, for given wages and rental rates of factors of production.
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Short-run average total cost (SATC) is equal to short-run total cost (STC) divided by output. SATC is equal to short-run average fixed cost (SAFC) plus short-run average variable cost (SAVC). The SATC curve is U-shaped.
The falling part of the U results both from declining SAFC as the fixed costs are spread over more units of output and from declining SAVC at low levels of output. The SATC continues to fall after SAVC begins to increase, but eventually increasing SAVC outweighs declining SAFC and the SATC curve slopes up.
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The short-run marginal cost curve (SMC) reflects the marginal product of the variable factor, holding other factors fixed. Usually we think of labor as variable but capital as fixed in the short run. When very little labor is used, the plant is too big for labor to produce much. Increasing labor input leads to large rises in output and SMC falls. Once machinery is fully manned, extra workers add progressively less to output. SMC begins to rise.
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The SMC curve cuts both the SATC and SAVC curves at their minimum points.
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In the short run, the firm supplies the output at which SMC is equal to MR, provided price is not less than short-run average variable cost. In the short run, the firm is willing to produce at a loss provided it is recovering at least part of its fixed costs.
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The long-run total cost curve is obtained by finding, for each output, the least-cost method of production when all inputs can be varied. If the relative price of using a factor of production rises, the firm substitutes away from that factor in its choice of production techniques.
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Average cost is total cost divided by output. The long-run average cost curve (LAC)is derived from the long-run total cost curve.
LAC is typically U-shaped. As output rises, at first average costs fall because of indivisibilities in production, the benefits of specialization and engineering advantages of large scale. There are increasing returns to scale on the falling part of the U. The rising part of the U reflects diseconomies of scale.
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Much of manufacturing has economies of scale. For some industries, particularly personal services, economies of scale run out at quite low output
levels.
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When marginal cost is below average cost, average cost is falling. When marginal cost is above average cost, average cost is rising. Average and marginal cost are equal only at the lowest point on the average cost curve.
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In the long run, the firm supplies the output at which long-run marginal cost
(LMC) equals MR provided price is not less than the level of long-run average cost at that level of output. If price is less than long-run average cost, the firm goes out of business.
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The LAC curve is always below the SATC curve, except at the point where the two coincide. This implies that a firm is certain to have higher profits in the long run than in the short run if it is currently producing with a plant size that is not best from the viewpoint of the long run.
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Marginal and average cost
MC < AC => AC is: (1)
MC = AC => AC is: (2)
MC > AC => AC is: (3)
- Falling
- Minimum
- Rising
The firm’s output decision in the short run
Marginal condition: (1)
Check whether to produce: (2)
- Choose the output at which MR = SMC
- Produce this output if p > SAVC. Otherwise, produce
zero
There are three reasons for economies of scale.
- invisibilities in the production process
- specialization
- closely related
The firm’s output decision in the long run
- Marginal condition: (1)
- Check whether to produce: (2)
- Choose the output at which MR = LMC
2. Produce this output if p > LAC. Otherwise, produce zero.
An isoquant shows minimum combinations of inputs to make a given output.
Different points on an isoquant reflect different production techniques.
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