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produce?

•How does a firm decide how much of

each input to use in production?

•

possible combination of inputs, i.e.

Q F K , L

where K = capital and L = labour.

function:

QK L ;0 , 1

•

of inputs ⇒ technical efficiency.

Production in the Short Run (SR)

Q F K, L

i.e. there is only one variable input, L.

The amount of K is fixed.

Definitions

•Total Product (TP): total output, Q.

•Marginal Product of L (MPL): additional

by 1 unit (holding K fixed), i.e.

MPL

Q F K , L

L L

e.g.

1 1

QK L 2 2

1

1 12 12 1 K 2

MPL L K

2 2 L

unit of labour input, i.e.

Q

APL

L

1 1

e.g. Q K L 2 2

1 1 1

K L 1

21

K

2 2

APL K L

2 2

L L

K L Q MPL APL

8 0 0 - -

8 1 5 5 5

8 2 18 13 9

8 3 36 18 12

8 4 56 20 14

8 5 75 19 15

8 6 90 15 15

8 7 98 8 14

8 8 104 6 13

8 9 108 4 12

8 10 110 2 11

8 11 110 0 10

8 12 108 -2 9

8 13 104 -4 8

Q

110

90

56

0 L

4 6 11

APL, MPL

20

15

APL

MPL

0 L

4 6 11

NB:

MPL < APL ⇒ APL ↓.

2. MPL > 0 ⇒ Q ↑

MPL < 0 ⇒ Q ↓.

origin to a point on the TP curve gives

APL at that point.

gives the MPL at that point.

other inputs fixed), a point is eventually

reached beyond which the output level

begins to fall.

Production in the LR

Q F K , L

Both K and L can be varied.

combinations of inputs that yield the same

output.

Deriving Isoquants

1 1 Q

QK L 2 2

Q=10

K

Q=5

0 L

K

1 1

K L 10

2 2

1 1

K L 5

2 2

0 L

Returns to Scale

same proportion (e.g. doubles the

amount of K and L). Then,

output increases by proportionally more

(i.e. Q more than doubles).

(b)Constant returns to scale (CRS) ⇒ If

output increases in the same proportion

(i.e. Q doubles too)

(c)Decreasing returns to scale (DRS) ⇒

If output increases by proportionally

less (i.e. Q less than doubles).

⇒ mergers / takeovers

Isoquant Slopes

(MRTS)

= the slope of the isoquant at a given

combination of inputs

K

=

L

= the amount by which K can be

reduced when an extra unit of L is

employed (holding Q constant).

• ↑ L ⇒ MPL (> 0)

⇒ Q ↑ by (∆L) MPL

• ↓ K ⇒ MPK (< 0)

⇒ Q ↓ by (∆K) MPK

they lie on the same isoquant.

∆Q = (∆L) MPL + (∆K) MPK = 0

Rearranging yields:

(∆K) MPK = - (∆L) MPL

K MPL

MRTS

L MPK

Mathematically …

Q

MRTS L

Q

K

Measuring Costs

alternative use of a resource.

e.g.

Say a firm owns a building and so pays

no rent for office space:

⇒ accounting cost = 0

⇒ opportunity cost = amount of rent firm

could have received.

made and cannot be recovered

⇒ does NOT influence firm decisions

⇒ opportunity cost = 0.

Costs in the SR

Definitions

TC FC VC Q

2. Marginal cost (MC) = the extra cost

incurred by producing an additional

unit of output.

TC VC

MC

Q Q

3. Average total cost:

TC FC VC

ATC

Q Q

SR Cost Curves

TC

Cost

VC

FC

0 Q

Cost

MC ATC

AVC

AFC

0 Q

A: min. VC, AVC

MC = AVC

MC = ATC

C: MC = AFC

because we have assumed diminishing

marginal returns to labour.

inputs to produce a given output at

minimum cost.

that can be purchased for a given total

cost, i.e.

C wL rK

where C = total cost, w = wage and

r = rental cost of capital (the interest rate).

rK C wL

C w

K L

r r

•It can do this at points B and A. But A

is cheaper!

•The firm cannot produce Q by

spending only C0 (e.g. at point C).

•At A:

w

MRTS

r

MPL w

MPK r

MPL MPK

w r

output costs the same regardless which

input is used.

An Example Problem

1 1

given by Q K L . Also, w = 8, r = 2.

2 2

wishes to produce 36 units of output?

Also calculate the minimum cost of

producing 36 units of output?

*** Solution ⇒

1 1

36 K L 2 2

C 4L 2K

1

Q 1 1 1

1 K

2

MPL K L

2 2

L 2 2 L

1

Q 1 1

1

1 K 2

MPK LK 2 2

K 2 2 L

MPL K

MRTS

MPK L

w

MRTS

r

K 8

4

L 2

K 4L

the isoquant simultaneously for K and L,

i.e.

1 1

36 K L 2 2

1 1

4L L

2 2

2L

∴ L* 18 K * 72

and hence,

C * 4 18 2 72

72 144

216

Expansion Path

cost combinations of K and L needed to

produce each level of output in the LR.

in the LR must be less than or equal to

the cost of producing Q units in the SR.

Why??

Economies of Scale

in output when input quantities are

varied in proportion.

another is tripled. How can we describe

the change in output that results?

increases proportionally more than an

increase in cost.

cost ⇒ economies-of-scale.

•If doubling output requires more than

twice the cost ⇒ diseconomies-of-scale.

Relating SR & LR Costs

•LMC flatter than SMC. Why?

Summary

4. Measuring costs

5. Costs in the SR

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