© The McGraw-Hill Companies, 2005 Chapter 7 Costs and supply David Begg, Stanley Fischer and...
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Transcript of © The McGraw-Hill Companies, 2005 Chapter 7 Costs and supply David Begg, Stanley Fischer and...
©The McGraw-Hill Companies, 2005
Chapter 7Costs and supply
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005
PowerPoint presentation by Alex Tackie and Damian Ward
3©The McGraw-Hill Companies, 2005
The production function
• The amount of output produced depends upon the inputs used in the production process
• A factor of production (“input”) is any good or service used to produce output
• The production function specifies the maximum output which can be produced given inputs
4©The McGraw-Hill Companies, 2005
Short run vs. long run• The short run is the period in which a firm can
make only partial adjustment of inputs• e.g. the firm may be able to vary the amount of
labour, but cannot change capital.
• The long run is the period in which a firm can adjust all inputs to changed conditions.
• The long run total cost curve describes the minimum cost of producing each output level when the firm is free to vary all input levels.
5©The McGraw-Hill Companies, 2005
Average costThe average cost of production is total cost divided by the level of output.
Long-run average cost (LAC) is often assumed to be U-shaped:
LAC
Ave
rage
cos
t
Output
6©The McGraw-Hill Companies, 2005
Economies of scaleEconomies of scale – or increasing returns to scale – occur when long-run average costs decline as output rises:
LAC
Ave
rage
cos
t
Output
7©The McGraw-Hill Companies, 2005
Decreasing returns to scale
occur when long-run average costs rise as output rises:
LAC
Ave
rage
cos
t
Output
8©The McGraw-Hill Companies, 2005
Constant returns to scale
occur when long-run average costs are constant as output rises:
LACAve
rag
e co
st
Output
9©The McGraw-Hill Companies, 2005
The firm’s long-run output decision
• The decision:– If the price is at or
above LAC1 the firm produces Q1
– If the price is below LAC1 the firm goes out of business
• NB: LMC always passes through the minimum point of LAC.
AC1
£
Output(goods per week)
MR
LAC
LMC
Q1
LMC = MR
10©The McGraw-Hill Companies, 2005
Figure 7.5: The firm’s long-run output decision
11©The McGraw-Hill Companies, 2005
The short run
• Fixed factor of production– a factor whose input level cannot be varied
• Fixed costs– costs that do not vary with output levels
• Variable costs– costs that do vary with output levels
• STC = SFC + SVC
12©The McGraw-Hill Companies, 2005
The marginal product of labour
• The marginal product of labour is the increase in output obtained by adding 1 unit of the variable factor but holding constant the inputs of all other factors.
• Labour is often assumed to be the variable factor – with capital fixed.
13©The McGraw-Hill Companies, 2005
Figure 7.6: The productivity of labour and diminishing
marginal returns
14©The McGraw-Hill Companies, 2005
The law of diminishing returns
• Holding all factors constant except one, the law of diminishing returns says that:
• beyond some value of the variable input• further increases in the variable input
lead to steadily decreasing marginal product of that input.• e.g. trying to increase labour input without
also increasing capital will bring diminishing returns.
15©The McGraw-Hill Companies, 2005
The firm’s short-run output decision
• Firm sets output at Q1, where SMC=MR
• subject to checking the average condition:– if price is above
SATC1 firm produces Q1 at a profit
– if price is between SATC1 and SAVC1 firm produces Q1 at a loss
– if price is below SAVC1 firm produces zero output.
SAVC1
£
Output
MR
SAVC
SMC
Q1
SATC
SATC1
SMC = MR
16©The McGraw-Hill Companies, 2005
Figure 7.8: The firm’s short-run output decision
17©The McGraw-Hill Companies, 2005
The long-run average cost curve LAC
Output
Ave
rage
cos
t
SATC1
Each plant sizeis designed fora given outputlevel
SATC2
SATC3
SATC4
So there is a sequence of SATCcurves, eachcorresponding toa different optimal output level.
LAC
In the long-run, plant size itself is variable, and the long-run average cost curve LAC is found to be the ‘envelope’ of the SATCs
18©The McGraw-Hill Companies, 2005
The firm’s output decisions – a summary
Marginal condition
Check whether to produce
Short-run decision Long-run decision
Choose the output level at which MR = SMC Choose the output level at which MR = LMC
Produce this output unless price lower than SAVC. If it is, produce zero Produce this output unless price is lower than LAC. If it is, produce zero.