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describes how firms make cost-minimizing production decisions and how a firm's result cost varies with its output
* assumes that firm is always using cost-minimizing combination of inputs |
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1. production technology - how inputs (labor, capital and raw materials) are transformed into outputs
2. cost constraints - prices of labor, capital and other inputs
3. input choices -- how much of each input to use in producing its output (e.g. if firm operates in country with low wages, may decide to use more labor and less capital and technology) |
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indicates highest output that a firm can produce for every specified combination of inputs
q = F(K,L)
[L= Labor, K = Capital, q = production]
* applied to a given technology (i.e. understanding that production methods can change)
* describes what is technically feasible when the firm operates efficiently |
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| inputs and outputs are flows |
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| *meaning that... unless otherwise indicated, talking about amount of labor and capital used each year and output produced each year |
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period of time in which quantities of one or more production factors CANNOT be changed
(for example, amount of capital is a fixed input.)
(over a month or two, a firm is unlikely to be able to substitute very much capital for labor) |
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| production factor that cannot be varied (at least one input will be fixed during the short run |
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amount of time needed to make all production inputs variable
i.e.... over time, one can change variables such as capital and labor
*changes from one industry to the next. lemonade stand = 3 days. auto plant = 10 years |
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in short run, firms vary the intensity with which they utilize a given plant and machinery.
in the long run, a firm will vary the size of the plant itself. |
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output per unit of a particular input
e.g. average product of labor = output/labor input = q/L |
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additional output produced as an input is increased by one unit
(usually talking about small changes) |
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| marginal product of labor |
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| change in output/change in labor input = change q/ change L |
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| when capital is fixed but labor is variable... |
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| only way for firms to increase output is by increasing labor input |
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| when MP (marginal product) > AP (average product) |
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| slope of total product curve (with fixed capital) |
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| change q/change L (or... MPL) |
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| law of diminishing marginal returns (to labor w/ fixed capital) |
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as the use of an input increases in equal increments (with other inputs fixed), a point will eventually be reached at which the resulting additions to output decrease)
*dont confuse diminishing marginal returns with *negative* returns -- the law describes a *declining* marginal product, but not necessarily a negative one.
i.e. product usually just increases more slowly and less per worker. |
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| slope when total output is maximized |
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| effect of technological improvement |
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labor productivity (output per unit of labor) can increase technology improves
* delays diminishing returns? |
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| average product of labor for an entire industry (or for the economy as a whole) |
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Curve showing all possible combinations of inputs that yield the same output
q1 = {L1, K1}
*downward sloping and convex
(two-variable inputs) |
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graph combining a number of isoquants, used to describe a production function
(firms grow as q increases) |
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| marginal rate of technical substitution (MRTS) |
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Definition
ability of firm to replace one input (capital) with another (labor) while maintaining same level of output
i.e. amount by which the quantity of one input can be reduced when one extra unit of another input is used, so that output remains constant
MRTS = - changeK/changeL (for a fixed level of Q) |
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| measures MRTS (- changeK/changeL) at any point |
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MRTS falls as we move down along an isoquant
- tells us that productivity for any one input is limited. production usually needs a mix of both inputs (cant rely fully on labor or capital) |
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| rate at which output increases as inputs are increased proportionately |
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| increasing returns to scale |
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| situation in which output more than doubles when all inputs are doubled |
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| constant returns to scale |
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| situation in which output doubles when all inputs are doubled |
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| decreasing returns to scale |
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| situation in which output less than doubles when al inputs are doubled |
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| actual expenses plus depreciation charges for capital equipment. |
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cost to a firm of utilizing economic resources in production, including opportunity cost
*"economic" tells us to distinguish between costs that a firm can control and those it cannot. |
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cost associated with opportunities that are forgone when a firm's resources are not put to their best alternative use
(e.g. guy quitting his job to start a new company)
(e.g. a company not renting out the building it owns) |
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expenditure that has been made and cannot be recovered
e.g. equipment that can only be used for its original purpose and cannot be converted for alternative use
- or... r&d and marketing costs
**the book assumes that firms treat any sunk cost *of capital* as a fixed cost spread out over time |
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| should sunk costs influence a firm's decisions? |
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| no it should not, even though they are more obvious then opportunity costs. |
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| should opportunity costs influence a firm's decisions? |
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| yes they should, even if they are hidden. |
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- an investment
e.g. a firm considering buying specialized equipment. the firm must decide whether the purchase is economical -- i.e. whether it will generate revenues that can justify its cost. |
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| total economic cost of production, consisting of fixed and variable costs |
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cost that does not vary with the level of output -- it must be paid even if there is no output -- and that can be eliminated only by shutting down.
eg: rent
*over a very short time horizon, most costs are fixed, due to contracts and labor inflexibility |
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a cost that varies as output varies
eg: wages, salaries, raw materials used |
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| doesnt necessarily mean going out of business -- can involve downsizing by shuttering certain stores/factories |
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| policy of treating a one-time expenditure as an annual cost spread out over some number of years |
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- shutting down still wont make the annual cost go away (so its not *really* fixed)
- still... simplifies economic analysis by, say, making it easier to understand the tradeoff that a firm faces in its use of labor versus capital. |
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Term
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Definition
the increase in cost resulting from the production of one extra unit of output
- also sometimes called incremental cost
MC = changeVC/changeQ
or...
MC = changeTC/changeQ
(this is because fixed cost does not change as the firm's level of output changes) |
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| total cost divided by its level of output |
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fixed cost divided by level of output (FC/q)
- declines as the rate of output increases, since fixed costs are constant. |
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| Average Variable Cost (AVC) |
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| variable cost divided by level of output |
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| determinants of short-run costs |
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| diminishing marginal returns to labor occur when... |
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| the marginal product of labor is decreasing (ch. 6) |
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| if labor is only input... |
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Definition
to produce more output, firm must hire more labor. then... if the marginal product of labor decreases as the amount of labor hired is increased (due to diminishing returns), successively greater expenditures must be made the produce output at the higher rate. As a result, variable and total costs increase as the rate of output is increased.
on the other hand... if the marginal product of labor decreases only slightly as the amount of labor is increased, costs will not rise so quickly when the rate of output is increased. |
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Term
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Definition
check these
Marginal Costs = ∆Variable Costs/∆Q = wages(∆ Labor)/∆ Q
therefore...
MC = wages/Marginal Product of labor (MPL)
*don't forget: MPL = ∆ in output/∆ in labor input = ∆ q/ ∆ L |
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| diminishing marginal returns |
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Definition
means that the marginal product of labor (MPl) declines as the quantity of labor employed increases.
- as a result, when there are diminishing marginal returns, marginal cost will increase as output increases. |
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| the shape of the total cost curve (TC) |
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| determined by vertically adding the fixed cost curve to the variable cost curve. (distance between TC and VC is constant) |
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| whenever the marginal cost curve lies below average cost curve... |
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| ... average cost curve falls. |
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| whenever the marginal cost curve is above the average cost curve... |
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Definition
| ... average cost curve rises. |
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| the vertical distance between the ATC curve and the AVC curve... |
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Definition
decrease as output increases, because ATC is the sum of AVC and AFC and the AFC curve declines everywhere.
* MC = AVC at its minimum point and ATC at its minimum point |
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Definition
| annual cost of owning and using a capital asset, equal to economic depreciation +(interest rate)(value of capital) |
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graph showing all possible combinations that can be purchased for a given total cost.
... K=C/r - (w/r)L
slope: ∆K/∆L = -(w/r) |
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Term
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Definition
cost per year of renting one unit of capital
*in a competitive capital market, the rental rate should be equal to the user cost, r
i.e... capital that is purchased can be treated as though it were rented at a rental rate equal to the user cost of capital
** book assumes that firm rents all of its capital at a rental rate, or "price" r, just as it hires labor at a wage rate, or "price" w |
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| when a firm minimizes the cost of producing a particular output... |
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Definition
MPl/MPk = w/r
or...
MPl/w = MPk/r
MPl/w is the additional output that results from spending an additional dollar for labor |
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Term
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Definition
curve passing through points of tangency between a firm's isocost lines and its isoquants
- describes the combinations of labor and capital that the firm will choose to minimize costs at each output level
* as long as the use of both labor and capital increases with output, the curve will be upward sloping |
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| long-run average cost curve (LAC) |
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Definition
curve relating to average cost of production to output when all inputs, including capital, are variable
- U-shaped |
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| short-run average cost curve (SAC) |
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Definition
curve relating to the average cost of production to output when level of capital is fixed
- U-shaped |
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| long-run marginal cost curve (LMC) |
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| curve showing the change in long-run total costs as output is increase incrementally by 1 unit. |
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| ... at where the LAC curve achieves its minimum. |
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situation in which output can be doubled for less than a doubling of cost
- marginal cost will be less than average cost (both are falling)
- often measured in terms of cost-output elasticity:
Ec = (∆C/C)/(∆q/q) = MC/AC |
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Definition
situation in which a doubling of output requires more than a doubling of cost
- marginal cost will be higher than average cost (both are rising) |
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| increasing returns to scale |
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Definition
output more than doubles when the quantities of all inputs are doubled
(compare this to diseconomies of scale...) |
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| product transformation curve |
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Definition
| shows the various combinations of two different outputs (products) that can be produced with a given set of inputs |
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| situation in which joint output of a single firm is greater than the output that could be achieved by two different firms when each produces a single product |
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| situation in which joint output of a single firm is less than could be achieved by separate firms when each produces a single product |
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| degree of economies of scope |
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Definition
| percentage of cost savings resulting when two or more products are produced jointly rather than individually. |
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graph relating amount of inputs needed by a firm to produce each unit of output to its cumulative output
(don't know if need to know this... more in book) |
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| cost-output elasticity (Ec) |
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Definition
the percentage change in the cost of production resulting from a 1-percent increase in output.
*often used to measure economies of scale
Ec = (∆C/C)/(∆q/q)
or...
Ec = (∆C/∆q)/(C/q) = MC/AC |
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| when there are economies of scale... |
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Definition
(i.e. when costs increase less than proportionately with output)
- marginal cost is less than average cost (both are declining)
- Cost-output elasticity (Ec) is less than 1 |
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