chapter 7 costs and supply ©mcgraw-hill education, 2014
TRANSCRIPT
CHAPTER 7 Costs and supply
©McGraw-Hill Education, 2014
The complete theory of supply (1)
• Short-run and long-run cost curves and output decisions need to be carefully distinguished when we study the determinants of supply.
• The profit-maximizing firm will choose the lowest cost way of producing any given level output, given the technology available and factor input costs.
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The complete theory of supply (2)
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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.
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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.
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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
• Short-run total cost (STC) = short-run fixed cost (SFC) + short-run variable cost (SVC)
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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.
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The law of diminishing marginal returns
• Holding all factors constant except one, the law of diminishing marginal returns implies that beyond some value of the variable input further increases in the variable input lead to steadily decreasing marginal product of that input.
• For example, trying to increase labour input without also increasing capital will bring diminishing marginal returns.
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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
Q1
SATC1
SMC = MR
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Costs in the long run: Average cost
The 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:
Avera
ge c
ost
Output©McGraw-Hill Education, 2014
Costs in the long run: Economies of scale
Economies of scale – or increasing returns to scale – occur when long-run average costs decline as output rises:
Avera
ge c
ost
Output
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Costs in the long run: Decreasing returns to scale
Decreasing returns to scale occur when long-run average costs rise as output rises:
Avera
ge c
ost
Output
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Costs in the long run: Constant returns to scale
Constant returns to scale occur when long-run average costs are constant as output rises:
Avera
ge c
ost
Output
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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.
£
Output(goods per week)
MR
LMC = MR
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The long-run average cost curve (LAC)
Output
Ave
rage
cos
t
SATC1
Each plant sizeis designed fora given output level.
SATC2
SATC3
SATC4
So there is a sequence of SATC curves, each corresponding toa different plant size.
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.
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The firm’s output decisions – a summary
Marginal condition
Check whether to produce
Short-run decision
Choose the output at which MR=SMC
Produce this output unless price lower than SAVC, in which case produce zero
Long-run decision
Choose the output at which MR=LMC
Produce this output unless price is lower than LAC, in which case produce zero.
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Some maths
• An example of a short-run total cost function:
• Where SFC=F and SVC = cQ+ Dq2
• and
• Thus the short-run average fixed cost decreases steadily as Q increases.
2dQcQFSTC
dQc
dQ
dSTCSMC 2
Q
F
Q
SFCSAFC
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Some maths (2)
• Short run average variable cost is:
• And short run average total cost:
dQc
Q
SVCSAVC
dQc
Q
F
Q
STCSATC
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Concluding comments (1)• In the long run, a firm can fully adjust all its
inputs. • In the short run, some inputs are fixed.• The production function shows the maximum
output that can be produced using given quantities of inputs.
• The total cost curve is derived from the production function, for given wages and rental rates of factors of production.
• The short-run marginal cost curve (SMC) reflects the marginal product of the variable factor, holding other factors fixed.
• The SMC curve cuts both the SATC and SAVC curves at their minimum points.©McGraw-Hill Education, 2014
Concluding comments (2)• 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.
• Average cost is total cost divided by output.• LAC is typically U-shaped.• Much of manufacturing has economies of
scale.• When marginal cost is below average cost,
average cost is falling.• 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.
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