L11 SR production and costs

Review of Short-Run Production and Costs

Overview

This lecture focuses on understanding producer theory, specifically the short-run production and costs associated with it. The key objective is to analyze how firms make decisions regarding production output and related expenses, setting the stage for broader economic principles regarding supply and demand in prior topics.

Aims of Topic 3

• Contextual Learning: Building on foundational concepts about markets established in previous topics, this topic delves deeper into the operational decisions of firms.

• Key Questions Addressed: 1. How much output should a firm produce? 2. How much profit does a firm make? 3. When should firms consider shutting down operations? To answer these questions, firms must analyze their costs and revenue streams effectively.

Short-Run Versus Long-Run Production

• Short-Run Characteristics: In the short-run, only one factor of production typically varies, while the others remain fixed. Commonly, labor is the variable factor because adjustments can be made more readily than they can for capital.

• Long-Run Characteristics: All factors of production can be adjusted in the long run. The concept of diminishing returns becomes particularly relevant when considering short-run production, highlighting that increasing a single variable input will eventually yield lower increases in output.

Lecture Outline

1. Relationship Between Production and Costs: Understanding how output levels influence production costs.

2. Short-Run Production Functions: Detailed analysis of production functions and their measures.

3. Cost Measures and Curves: Examination of fixed, variable, average, and marginal costs.

Revenue and Profit Calculation

• Profit Equation: Profit is defined as total revenue minus total costs (π = TR - TC). For instance, if a firm sells 100 units at a price of £5, total revenue calculated will yield £500.

• Revenue Formula: Total Revenue (TR) can be expressed as TR = price x quantity sold.

Opportunity Costs in Firm Decision-Making

• Understanding Costs: It is vital for firms to incorporate opportunity costs, which represent the value of the next best alternative foregone, in their financial analysis.

• Explicit vs Implicit Costs:

  • Explicit Costs require cash outflows, such as wages to employees.

  • Implicit Costs do not involve cash flow directly but represent lost income, such as what an owner might earn from alternative employment.

Short-Run Production Functions

• Defining Production Functions: A production function explains how total output can change based on varying input levels of labor (L) and fixed capital (K).

• Productivity Measures:

  • Total Physical Product of Labor (TPPL): Total output from labor.

  • Average Physical Product of Labor (APPL): APPL = TPPL/L; reflects output capacity per labor unit.

  • Marginal Physical Product of Labor (MPPL): MPPL = ∆TPPL/∆L; indicates additional output generated from employing one more unit of labor.

Practical Examples

• Assembly Line Example: In an iPhone assembly line, while labor can be increased, the number of assembly machines remains constant in the short-run, limiting production capacity.

• Small Farm Example: A wheat farm employs workers and tractors; in the short-run, tractors cannot be adjusted, requiring optimal labor input to maximize yield.

Law of Diminishing Returns

• Concept Explanation: As more of the variable input (like labor) is utilized while other inputs (like tractors) remain fixed, the additions to output will eventually decrease after a certain point. This concept underlies much of the economic reasoning behind production efficiency.

Total Cost Structure

• Total Costs Breakdown: Total costs (TC) are the sum of total fixed costs (TFC) and total variable costs (TVC).

• Fixed Costs: Do not change with output levels and are a constant expense incurred regardless of production activity.

• Variable Costs: Change in response to the output produced, increasing as production scales up.

Average and Marginal Costs

• Average Total Cost (ATC): Calculated by dividing total costs by the output (TC/Q). Understanding ATC is crucial for firms as they assess their pricing strategies.

• Marginal Cost (MC): Reflects the cost incurred by producing one additional unit of output (∆TC/∆Q). The relationship between MC and output levels helps firms understand pricing and outputs at different production scales.

Summary of Takeaways

1. Recognize the underlying reasons for diminishing returns in the short-run.

2. Understand definitions and relations among total, average, and marginal physical products of labor.

3. Ability to graph and explain the shapes of average and marginal cost curves, demonstrating the links between production levels and associated costs.

By grasping these key principles, students can better understand how firms adapt their production processes and manage costs effectively in response to market conditions.