ECON 310 Handout #6

Chapter 6: Production and Costs

May 24
Question: uppose you need to do!n"oad #usic $ro# the internet% &ou can either spend
#ore ti#e do!n"oadin' or you can 'et a $aster connection% (hich !i"" you do)
*ns!er: +t depends% +$ you need the #usic $or to#orro!, you !i"" ha-e to spend #ore
ti#e toni'ht% +$ you need it in a $e! !ee.s, you !i"" consider the $aster connection% /he
distinction co#es in 0et!een the short run and the "on' run% +n the "on' run, you ha-e
#ore options%
1usinesses $ace si#i"ar decisions% E23 suppose you o!n a dress#a.in' $actory and you
need to ra#p up hour"y output% &ou can do this 0y ha-in' #ore !or.ers or 0y in-estin'
in ne! #achines% +n the short run, you can 'et #ore !or.ers, 0ecause it ta.es a "on' ti#e
to 'et the #achines ordered, de"i-ered and insta""ed% &our costs depend on t!o thin's:
ho! #any dresses do you #a.e and ho! do you #a.e the#)
Production and Costs in the Short Run (SR)
Production in the SR
+n the short run, the $ir# has "i#ited options% (e assu#e that in the short run, the on"y
thin' a $ir# chan'e is the nu#0er o$ !or.ers it e#p"oys%
/he tota", #ar'ina" and a-era'e products o$ "a0or
/ota" Product 4/P3: the 5uantity o$ output produced 0y the $ir# in a 'i-en a#ount o$
ti#e% /ota" product depends on the 5uantity o$ "a0or the $ir# hires%
hort6run production $unction 47P83: /he $unction that associates to each 5uantity o$
"a0or its tota" product% /he 7P8 s"opes up!ard 0ecause each additiona" !or.er
contri0utes so#ethin' to the production process%
Mar'ina" Product o$ 9a0or 4MP93: /he increase in tota" product due to hirin' one
additiona" !or.er 4assu#in' that capita" is he"d $i:ed3%
*-era'e Product o$ 9a0or 4*P93: /ota" product di-ided 0y the nu#0er o$ !or.ers
*P9 ; /P<9
7e"atin' /P to MP9: the #ar'ina" product o$ "a0or is the s"ope o$ tota" product%
Nu#erica" E:ercise:
8i"" in the 0"an.s in the ta0"e 0e"o!:
Quantity o$ 9a0or /ota" Product 4/P3 Mar'ina" Product o$
9a0or 4MP93
*-era'e Product o$
9a0or 4*P93
1 !or.er = dresses = dresses per !or.er = dresses per !or.er
2 12 > 6
3 21 ? >
4 2@ > >
= 33 = 6%6
6 36 3 6
> 3> 1 =%3
(hat can !e see a0out the shapes o$ the cur-es)
*P9: (e #i'ht thin. that i$ it ta.es = 0a.ers to produce =00 cupca.es, then 6 0a.ers
!ou"d produce 600 cupca.es% 1ut, this #ay not a"!ays 0e the case% /he si:th 0a.er cou"d
#a.e the 0a.ers either #ore or "ess producti-e% E23 His presence #i'ht #a.e it easier
$or the 0a.ers to specia"iAe there0y increasin' e$$iciency in !hich case 6 0a.ers !ou"d
0a.e #ore than 600 cupca.es% *"ternati-e"y, he #ay 'et in the !ay o$ the other = 0a.ers
"eadin' to a situation !here 6 0a.ers #a.e "ess than 600 cupca.es% o, the shape o$ the
*P9 is B6s
MP9: 8or si#i"ar reasons, the #ar'ina" product cur-e a"so is B6shaped% /he second 0a.er
contri0uted #ore than the 1
st
, the third #ore than the second, 0ut the $ourth #ay
contri0ute "ess than the third% /hat is, e-entua""y, there are too #any coo.s in the .itchenC
Point o$ Di#inishin' 7eturns: /he point a$ter !hich the #ar'ina" product cur-e 0e'ins to
decrease% (here is this point on the 'raph a0o-e)
*ns!er: 90
(hat happens to *P9 !hen MP9E*P9)
*ns!er: *P9 0e'ins to $a""% Happens at point 91
7e"ationship 0et!een MP9 and *P9:
1% (hene-er a !or.erFs MP9 G *P9, *P9 rises
2% (hene-er a !or.erFs MP9 E *P9, *P9 $a""s
3% MP9 ; *P9 ri'ht at the point !here the *P9 turns around
Costs in the 7
7e#e#0er, $ir#s ha-e 0oth $i:ed and -aria0"e costs% +n the short run, !e assu#e the on"y
thin' a $ir# can -ary is "a0or% /hus, in the 7, the on"y -aria0"e cost i$ the cost o$ hirin'
"a0or%
(a'e rate: price o$ hirin' "a0or
Haria0"e Cost Cur-e: re"ated the 5uantity o$ output 4NO/ (O7IE73 to the -aria0"e
cost%
8i:ed Costs: in the 7, !e assu#e a $ir#Fs $i:ed costs are the costs o$ its capita"% Capita"
are the physica" $actors o$ production 4ie% #achines, etc%3
/ota" Costs ; HC J 8C
*-era'e Haria0"e Costs: Haria0"e cost di-ided 0y the 5uantity o$ output%
*HC ; HC<Q
*-era'e /ota" Cost: /ota" cost di-ided 0y the 5uantity o$ output
*/C; /C< Q
(hen "a0or is the on"y -aria0"e $actor, !e can 'et a-era'e -aria0"e cost usin' a di$$erent
$or#u"a% Notice, !hen a $ir# hires 9 !or.ers, then its -aria0"e costs co#e to P" K 9,
!here P"; !a'e rate o$ "a0or% /hus,
*HC ; HC<Q ; 4P"K93<Q ; P"<4Q<93 ; P"<*P9, or *HC ; P"<*P9
7e#inder: Mar'ina" cost: additiona" cost associated !ith the "ast unit o$ an acti-ity% +n
this case, MC; additiona" cost o$ producin' one #ore dress%
Ca"cu"atin' MC:
Ho! can !e 'et the MC o$ #a.in' 21 dresses 4!ith 3 !or.ers3 !hen !e are #issin'
in$or#ation on the 20
th
dress)
*ns!er: (hi"e !e donFt ha-e the cost in$or#ation $or the 20
th
dress, !e do ha-e it $or the
12
th
dress 4!hich is #ade !ith 2 !or.ers3% /he MP9 at a 5uantity o$ 21 dresses, is ?,
0ecause !ith 2 !or.ers !e #a.e 21 dresses and !ith 1 !or.er, !e #ade 12 dresses% +$
the MP9 ; ? dresses% /his is the sa#e thin' as sayin' top #a.e 1 dress, !e need 1<? o$ a
!or.er% *t a !a'e rate o$ L1=, this #eans the MC ; 41<?3 K 1= ; 1%66>
/hus, !e 'et the $or#u"a: MC ; P" <MP9
Nu#erica" E:ercise:
8i"" in the 0"an.s in the ta0"e 0e"o!:
#
!or.ers
/P
4dresses3
MP9
4dress<
!or.er3
*P9
4dress<
!or.ers3
#
dresses
HC
L
/C
L
*HC
L<
dress
*/C
L<
dress
MC
L<
dress
1 = = = = 1= 6= 3 13 3
2 > > 6 12 30 @0 2%= 6%6> 2%14
3 21 ? > 21 4= ?= 2%14 4%=2 1%6>
4 2@ > > 2@ 60 110 2%14 3%?3 2%14
= 33 = 6%6 33 >= 12= 2%2> 3%>? 3
6 36 3 6 36 ?0 140 2%= 3%@? =
> 3> 1 =%3 3> 10= 1== 2%@4 4%1? 1=
(hat do these costs cur-es "oo. "i.e 'raphica""y)
hapes o$ Cost Cur-es:
1% HC is a"!ays increasin', 0ecause #ore output re5uires #ore "a0or and hence
hi'her costs
2% /C cur-e is deter#ined 0y the $or#u"a /C ; 8C J HC, !here 8C is constant%
/here$ore, it has e:act"y the sa#e shape as the HC cur-e%
3% MC cur-e is B6shaped
4% */C and *HC cur-es are a"so u6shaped
=% (hen MCE *HC, *HC is $a""in'
6% (hen MCG *HC, *HC is risin'
>% MC crosses *HC at the 0otto# o$ the *HC MBN
@% Points =66 ho"d $or */C as !e""
?% hapes o$ the cost cur-es are re"ated to the shapes o$ the product cur-es% 8or
e:a#p"e, *HC ; P"<*P9 and MC ; P"<MP9
Bp to point !here 9 ; 91 and Q ; Q1, 413 MP9 G *P9, so *P9 risesO 423 MC E *HC, so
*HC $a""s% +n this re'ion, /P9 is increasin' at an increasin' rate 4MP9 has a positi-e
s"ope3 and /C and HC are increasin' at a decreasin' rate 4MC has a ne'ati-e s"ope3%
*$ter point 91, Q1, 413 MP9 E *P9, so *P9 $a""sO 423 MC G *HC, so *HC rises% +n this
re'ion, /P9 is increasin' at a decreasin' rate 4MP9 has a ne'ati-e s"ope3 and /C and HC
are increasin' at an increasin' rate 4MC has a positi-e s"ope3%
MC cuts throu'h *HC and */C at the 0otto# o$ the B%
Production and Costs in the Long Run
97: in the "on' run, $ir#s can adPust its e#p"oy#ent o$ 0oth "a0or and capita" so as to
achie-e the "east e:pensi-e #ethod o$ producin' a 'i-en 5uantity o$ output%
+so5uants:
/his $i'ure sho!s a"" co#0inations that su$$ice to produce one unit o$ a certain 'ood,
!hich !e !i"" ca"" 2, in a 'i-en period o$ ti#e% Hertica" a:is is I, represents capita" and
the horiAonta" a:is, 9, represents "a0or% +n this 'raph, e-ery 0as.et o$ inputs in the shaded
re'ion su$$ices to produce 'ood 2% Ho!e-er, points that o$$ the 0oundary are said to 0e
techno"o'y ine$$icient%
/echno"o'y ine$$icient: * production process that uses #ore inputs than necessary to
produce a 'i-en output%
Point 1 is techno"o'y ine$$icient%
Bnit iso5uant: /he set o$ a"" technica""y e$$icient !ays to produce one unit o$ output% /he
unit iso5uant is do!n!ard s"opin'%
/he Mar'ina" 7ate o$ /echnica" u0stitution o$ "a0or $or capita" 4M7/9I3: /he a#ount
o$ capita" that can 0e su0stituted $or one unit o$ "a0or, ho"din' output constant%
Mar'ina" Products and the M7/:
uppose "a0or input is reduced 0y one unit and capita" input is increased 0y I units
!here I is Pust enou'h to #aintain the e:istin' "e-e" o$ output% /hen, I ;
M7/9I%
Consider these t!o steps separate"y:
13 (hen one unit o$ "a0or is sacri$iced, output $a""s 0y the MP9% (hen I units o$
capita" are hired, output rises 0y IKMPI, !here MPI; #ar'ina" product o$
capita"%
23 ince output doesnFt chan'e, it #ust #ean that, MP9 ; IKMPI;
M7/9IKMPI% /hus,
M7/9I ; MP9<MPI
Note: this is similar to our conclusion about consumer behavior that MVxy = MUx /
MUy
/he Production 8unction:
uppose the $ir# produces 2 units instead o$ 1, !e can dra! another iso5uant
representin' a"" o$ the techno"o'ica""y e$$icient input co#0inations it can use%
+#portant $acts a0out +so5uants 4si#i"ar to +C3:
1% +so5uants s"ope do!n!ard
2% +so5uants $i"" the p"ane
3% +so5uants ne-er cross
4% +so5uants are con-e:
Production $unction: /he ru"e $or deter#inin' ho! #uch output can 0e produced !ith a
'i-en 0as.et o$ inputs
Choosing a Production Process
+socosts and Cost Mini#iAation:
uppose a $ir# can hire "a0or $or a !a'e rate o$ P9 and can hire capita" at a 'oin' rate o$
PI % uppose a"so that the $ir# spend L10 on inputs% /hen, the $ir# can hire 9 units o$
"a0or and I units o$ capita" on"y i$
P9K 9 J PIKI ; L10
/he co""ection o$ the pairs 49,I3 co#e $ro# the "ine that satis$ies this e5uation and has
the s"ope 6 4P9< PI3%
+socost: /he set o$ a"" 0as.ets o$ inputs that can 0e e#p"oyed at a 'i-en cost
Note, there are di$$erent iso5uants $or each 'i-en "e-e" o$ e:penditure on inputs%
*t !hat point !i"" the $ir# choose its inputs i$ it !ants to produce 2 units o$ 2)
Point *: tota" cost ; L13
Point 1: tota" cost ; L12
Point C: tota" cost ; L11
/hus, he !i"" produce 2 $or "o!est cost !hich is at point C%
7B9E: +n order to #ini#iAe the cost o$ producin' a 'i-en "e-e" o$ output, the $ir#
a"!ays chooses a point o$ tan'ency 0et!een an isocost and the appropriate iso5uant%
Cost Mini#iAation and the E5ui#ar'ina" Princip"e:
uppose the $ir# considers hirin' one "ess unit o$ "a0or and rep"acin' it !ith su$$icient
capita" so that it continues to produce 2 units o$ output% Ho! #uch additiona" capita"
#ust it hire)
*ns!er: M7/ !hich is a"so e5ua" to a0so"ute -a"ue o$ the s"ope o$ the iso5uant
(hat are the #ar'ina" costs and 0ene$its o$ this decision)
1ene$it o$ "osin' one !or.er ; P9
Cost o$ addin' #ore capita": M7/ K PI
E5ui#ar'ina" princip"e says set M1 ; MC, then M7/ ; P9<PI
9e$t side: s"ope o$ iso5uant
7i'ht side: s"ope o$ isocost
7e6e:a#ine Point *: M7/ G P9<PI, this #eans the $ir# can hire one #ore unit o$ "a0or
$or "ess cost than it !i"" sa-e 0y rep"acin' capita", so they #o-e do!n the iso5uant%
Output Ma:i#iAation: !e can a"so "oo. at the $ir#Fs pro0"e# $ro# the standpoint o$
output #a:i#iAation% /hat is, !e can as., $or a 'i-en "e-e" o$ input e:penditure, !hat is
the #a:i#u# "e-e" o$ output !e can produce)
/he E:pansion Path:
/his a"" see#s -ery #uch "i.e the ana"ysis !e Pust did !ith consu#er 0eha-ior !hen !e
$ound the opti#u# point 0et!een an indi-idua"Fs indi$$erence cur-e and her 0ud'et "ine%
/here is one critica" di$$erence here:
* consu#er has a 'i-en inco#e to di-ide a#on' consu#ption 'oods, !hereas a $ir# can
choose its "e-e" o$ e:penditure on inputs% Put di$$erent"y, a consu#er is constrained to
on"y one 0ud'et "ine, !hereas a $ir# has a !ho"e $a#i"y o$ isocosts 4one $or each "e-e" o$
e:penditure3%
* $ir# doesnFt ha-e a 0ud'et constraint% (hereas consu#ers pursue consu#ption, $ir#s
pursue pro$its%
E:pansion path: /he set o$ tan'encies 0et!een iso5uants and isocosts%
/o $i'ure out !here a"on' its e:pansion path the $ir# !i"" operate, !e need to .no!
so#ethin' a0out its #ar'ina" re-enue% (e !i"" return to this in Chapter >%
/he 97 cost cur-es:
/o $i'ure out a $ir#Fs 97 cost cur-e, !e need to .no! so#ethin' a0out its production
$unction 4its iso5uants3 and the input prices%
97 tota" cost 497/C3: /he cost o$ producin' a 'i-en a#ount o$ output !hen the $ir# is
a0"e to operate on its e:pansion path%
97 a-era'e cost 497*C3: 9on'6run cost di-ided 0y 5uantity
97 #ar'ina" cost 497MC3: /hat part o$ "on'6run tota" cost attri0uta0"e to the "ast unit
produced%