Lecture 11 Students Version

Difficulty level:
Moderate
LECTURE 11
Production 60 mins
Costs in the Short run and Long run 60 mins
Group presentations 60 mins
1
SMU Classification: Restricted
Where are we?
Preference
Best
affordable
choice
Budget
COR2100 2
The Big Picture

Demand
• Preference
• Budget constraint
Market
Equilibrium
Supply?
COR2100 3
Firm’s decisions
• 1. What industry to enter?
• 2. How to produce at minimum cost: (How much labor and capital to use)
• 3. How much to produce? (Maximize Profit)
• How do firms make these decisions?
COR2100 4
Theory of the Firm Road Map
• Lecture 11
• Basic concepts
• How to produce at minimum cost
• Lecture 12
• How much to produce
COR2100 5
Part 1
Production
6
What is production?
• Firms turn inputs into outputs
• What are the factors of production (inputs)?
COR2100 7
Decision Time Frames
• The Short Run (Some of the inputs cannot be changed)

• The capital and land are fixed
• Other resources (labor, raw materials, and energy) can be changed
• The Long Run (All of the inputs can be changed)
COR2100 8
Variable and Fixed factor of production
• Variable factor of production (can be changed in the short-run)

• Changes if output changes
• Fixed factor of production (cannot be changed in the short-run)

• Stays the same, regardless of output
• 2 factors of production: Labor and Capital
COR2100 9
Short run production
• To increase output in the short run, a firm must increase the quantity of labor
• Three concepts describe the relationship between output and labor

• Total product
• Marginal product
• Average product
COR2100 10
Three concepts of production
• Total product: The total output produced
• Marginal product: The change in total product that results from a one-unit
increase in labor
• Average product: Total product divided by the quantity of labor

• Average productivity
COR2100 11
Discussion Question: E&S Cheeseman

Number of Workers Total Product (output per day) Average Product Marginal Product
0 0 - -
1 100 100 100
2 207 103.5 107
3 321 107 114
4 444 111 123
5 558 111.6 114
6 664 110.6 106
7 762 108.9 98
8 854 106.75 92
9 939 104.33 85
ECON 001 12
Product Curves
• How the firm’s total product, marginal product, and average product change as
the firm varies the quantity of labor
COR2100 13
Total Product Curve for E&S Cheeseman
Unattainable
Attainable
COR2100 14
Marginal Product Curve for E&S Cheeseman
•Almost all production processes have:

 Increasing marginal product initially+Diminishing marginal product eventually
Marginal Product
123
114 114
107 106
100 98
92
85
80
73
69
64
59
55
51 48
1 2 3 4 5 6 7 8 9 10
Number of workers
11 12 13 14 15 16 17
COR2100 15
Increasing and Decreasing Marginal Product
• Produce more output in a fixed production facility by increasing the

number of workers sharing the facility
COR2100 16
Increasing and Decreasing Marginal Product
• Increasing marginal product: Specialization
• Diminishing marginal product: Each additional worker has less access to capital
and less space to work in
• Law of diminishing returns

• As a firm uses more of a variable input with a given quantity of fixed inputs,
the marginal product of the variable input eventually diminishes
COR2100 17
Discussion Question: Average and Marginal

Product
• Each student gets 95 marks for the midterm: The average mark is________ .
• We have a new comer and his mark is higher than 95

• What is the new average mark, higher or lower than 95?
• What if the new student’s mark is lower than 95?
COR2100 18
Average and Marginal Product Curves

140
Marginal Product > Average Product MP

120
114
123
114
111.6
111 110.666666666667
Maximum Average Product
108.857142857143
107 107 106 106.75
Average Product increases 103.5 104.333333333333

101.9
AP
100 100 99.2727272727269
98 96.75
94.2307692307692
92 91.7142857142857
89.2666666666667
86.875
85 84.5882352941177
80 80
Marginal Product < Average Product,

73
69
64
Average Product decreases 60 59
55
51
48
40
Marginal Product = Average Product,

Average Product is at its maximum
20
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Marginal Product Average Product

Part 2
Costs in the Short run and Long run
20
Where are we going?
• Concepts of Costs
• Cost in the Short Run
• Cost in the Long Run

Opportunity Cost
• Opportunity cost is what is given up when taking an action or making a choice

• The firm can use its capital in two ways, A and B
• If the firm chooses A, the opportunity cost is the payoff the firm could have
earned had it chosen B
Sunk Cost
• Cost that has already been paid, or must be paid, regardless of any future action
• Results from past decisions and cannot be avoided
• No future decisions can change sunk costs
• Sunk costs are irrelevant when making decision
• To determine sunk cost

• Ask “What costs do not vary across alternatives?”
Example: Developing a New Drug
• Last year, Acme Pharmaceutical Company spent $10 million developing a new
drug to treat acne. However, just before launching production, management
discovered that the new drug didn’t cure acne but was only be effective in
treating a rare underarm fungus and the annual sales revenue would be just
$30,000. Should they still sell it?
Revenue Development Other costs
cost
Sell $30,000 10 million $10,000
Not sell 0 10 million 0
Sunk Cost Fallacy: Driving in Singapore
• Do people drive more when they paid more for their cars?
• Sunk costs associated with buying a car in Singapore

• COE (Certificate of Entitlement)
• ARF (Additional Registration Fee)
• An increase in purchasing price (due to an increase in COE or ARF) by one

standard deviation leads to an increase in driving by 9.48 km per month
• Source: Ho, Png, and Reza (2014), “Sunk Cost Fallacy in Driving the World’s Costliest Cars”
Where are we?
• Production
• How firms turn labor and capital into output
• How much does it cost to produce a certain amount of output ?

Short Run Total Cost
• Total cost is the cost of all the factors of production
• In the short run (capital is fixed at K0 )
TC  wL  rK 0
w per unit r per unit

Variable Cost and Fixed Cost
• Variable cost (TVC)=Costs of variable inputs

• Change with output
• When output is 0, variable cost is ____0_____
• Fixed cost (TFC)=Costs of fix inputs

• Remain constant as output changes
• In the short run, TC=wL+rK0

• Total Fixed cost=____0____
Fixed Cost and Sunk Cost
• You rent a plant for production: Monthly rent is $10,000

• You want to temporarily shut down the plant: Q=0
• Non-sunk fixed cost

• You can sublet the plant to another firm at $10,000 per month
• Sunk fixed cost

• You cannot sublet
Simplifying Assumption: All Fixed Costs are

Sunk
• TC=TVC+TFC
• If FC is non-sunk, then
• TC(0)=_______
• If FC is sunk, then
• TC(0)=__________
• For simplicity, assume all fixed costs are sunk

Example: E&S Cheeseman
• One machine in the short run
• Price of labor=w=$72 per day
• Price of machine=r=$200 per day

Discussion
Output
Question:
Capital Labor
Production
TFC
Cost
TVC TC
0 1 0 200 0 200
100 1 1 200 72 272
207 1 2 200 144 344
321 1 3 200 216 416
444 1 4 200 288 488
558 1 5 200 360 560
664 1 6 200 432 632
762 1 7 200 504 704
854 1 8 200 576 776
939 1 9 200 648 848
TC(Q) =TVC(Q)+TFC
Total fixed cost is the same

848
776
at each output level 704
648
632
576
560
Total variable cost increases

504
488
432
416
as output increases 344

360
288
272
216
Total cost also increases as 200 200 200
144
200 200 200 200 200 200 200
output increases 72
0
0 100 207 321 444 558 664 762 854 939
TFC TVC TC
More Concepts of Costs
• Average fixed cost (AFC) =TFC/Q
• Average variable cost (AVC)=TVC/Q
• Average total cost (ATC)=TC/Q

• TC =TVC+TFC----------ATC =AVC+AFC
• Marginal cost: The increase in total cost that results from a one-unit increase in
total product
COR2100 34
Discussion Question:
Output Capital Labor TFC TVC TC
Production
ATC AVC
Cost
AFC MC=Change in
TC/change in output
0 1 0 200 0 200 --- --- --- ---
100 1 1 200 72 272
2.72 0.72 2 100
207 1 2 200 144 344
1.66 0.69 0.97 107
321 1 3 200 216 416
1.30 0.68 0.62
444 1 4 200 288 488
1.10 0.65 0.45
558 1 5 200 360 560
1 0.64 0.36
664 1 6 200 432 632
0.95 0.65 0.30
762 1 7 200 504 704 0.92 0.66 0.26
854 1 8 200 576 776 0.91 0.68 0.23
939 1 9 200 648 848 0.90 0.69 0.21
Short-Run Cost
MC<AVC, AVC is falling
MC >AVC, AVC is rising
MC = AVC (Minimum AVC)

Discussion Question: Shifts in the Short Run Cost

Curves
• Product and cost curves depend on technology and prices of puts
• Improvement in Technology=More productive

• Product curves? Cost curves?
• An increase in r
• TFC? TC ? MC? TVC?
• An increase in w
• TFC? TC ? MC? TVC?
COR2100 37
Long run cost
• All inputs are variable and all costs are variable
COR2100 38
E&S sweaters: From short run to Long run
• 4 different plants: 1, 2, 3, or 4 knitting machines
• For each plant, short run U-shaped ATC curve
• Compare the ATC for each output at different plants
COR2100 39
Long-Run Cost
ATC1 is the ATC curve for a plant with 1 knitting machine

Long-Run Cost
ATC2 is the ATC curve for a plant with 2 knitting machines

Long-Run Cost

Long-Run Cost

Discussion Question: 13 sweaters
• How many knitting machines?
COR2100 44
Long-Run Cost
13 sweaters cost $7.69 each on ATC1
Long-Run Cost

Long-Run Cost

Long-Run Cost

Long-Run Cost
The least-cost way of producing 13 sweaters: 2 knitting machines

Long-Run Cost
• The long-run average cost curve is made up from the lowest ATC for
each output level (both capital and labor are varied)
• Which plant has the lowest cost for producing each output level?
COR2100 50
Long-Run Cost
Long-Run Average Cost Curve in Real

World
Factories come in many sizes ATC
Each with its own SRATC curve LRATC
Q
Why Self-Checkout Counters?
COR2100 53
Key Ideas for Lecture 11
• The seller’s problem has three parts: production, costs, and revenues
• Almost all production processes have increasing marginal returns initially
and diminishing marginal returns eventually
• When marginal product exceeds average product, average product
increases. While when marginal product is below average product,
average product decreases
• In short run, we distinguish between variable cost and fixed cost
• The long-run average cost curve is the relationship between the lowest
attainable average total cost and output when both the plant and labor
are varied
COR2100 54
In-Class Quiz 2
• 2.5 hours lecture+30 mins in-class quiz (20 MCQ)
• Coverage
• Lecture 10 – Lecture 11
• Bring
• Laptop (lockdown browser+camera)
• Non-programmable calculator
COR2100 55
Public holidays and rescheduling (G6,G7)
• Thursday, 4 Nov
• Deepavali
• Lectures are rescheduled to Saturday, 6 November
COR2100 56

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Difficulty level:

Costs in the Short run and Long run 60 mins

Group presentations 60 mins

Where are we?

The Big Picture

• 1. What industry to enter?

• 3. How much to produce? (Maximize Profit)

• How do firms make these decisions?

Theory of the Firm Road Map

• Firms turn inputs into outputs

• What are the factors of production (inputs)?

Decision Time Frames

• The Short Run (Some of the inputs cannot be changed)

• The Long Run (All of the inputs can be changed)

Variable and Fixed factor of production

• Variable factor of production (can be changed in the short-run)

• Fixed factor of production (cannot be changed in the short-run)

• 2 factors of production: Labor and Capital

Short run production

• Three concepts describe the relationship between output and labor

Three concepts of production

• Total product: The total output produced

• Average product: Total product divided by the quantity of labor

Discussion Question: E&S Cheeseman

Total Product Curve for E&S Cheeseman

Marginal Product Curve for E&S Cheeseman

•Almost all production processes have:

Increasing and Decreasing Marginal Product

• Produce more output in a fixed production facility by increasing the

Increasing and Decreasing Marginal Product

• Increasing marginal product: Specialization

• Law of diminishing returns

Discussion Question: Average and Marginal

• We have a new comer and his mark is higher than 95

• What if the new student’s mark is lower than 95?

Average and Marginal Product Curves

Marginal Product > Average Product MP

Average Product increases 103.5 104.333333333333

Marginal Product < Average Product,

Marginal Product = Average Product,

Marginal Product Average Product

Where are we going?

• Cost in the Short Run

• Cost in the Long Run

• Opportunity cost is what is given up when taking an action or making a choice

• Sunk costs are irrelevant when making decision

• To determine sunk cost

Example: Developing a New Drug

Sunk Cost Fallacy: Driving in Singapore

• Sunk costs associated with buying a car in Singapore

• An increase in purchasing price (due to an increase in COE or ARF) by one

Where are we?

• How much does it cost to produce a certain amount of output ?

Short Run Total Cost

• Total cost is the cost of all the factors of production

• In the short run (capital is fixed at K0 )

w per unit r per unit

Variable Cost and Fixed Cost

• Variable cost (TVC)=Costs of variable inputs

• Fixed cost (TFC)=Costs of fix inputs

• In the short run, TC=wL+rK0

Fixed Cost and Sunk Cost

• You rent a plant for production: Monthly rent is $10,000