Production and Cost: In-Depth Notes

PRODUCTION FUNCTION

  • A firm is an organization that produces goods or services for sale.
  • Production: The process of turning inputs into outputs.
  • Production function: The relationship between the quantity of inputs used and the quantity of output produced.
  • Fixed input: An input with a fixed quantity for a time period.
  • Variable input: An input whose quantity can be changed at any time.

INPUTS AND OUTPUT

  • Long run: Period where all inputs can be varied.
  • Short run: Period where at least one input is fixed.
  • Total product curve: Shows how output quantity relates to the quantity of variable input for a given fixed input quantity.

PRODUCTION FUNCTION AND TOTAL PRODUCT CURVE

  • The curve slopes upward with more output as more workers are employed.
  • It flattens because the marginal product of labor declines with more workers.

MARGINAL PRODUCT OF LABOR (MPL)

  • MPL: Additional output produced by one additional unit of labor (MPL = rac{ riangle Q}{ riangle L}).
  • MPL equals the slope of the total product curve.
  • MPL declines with increased employment, flattening the total product curve.

DIMINISHING RETURNS TO AN INPUT

  • Diminishing returns: Increased quantity of an input, holding others fixed, reduces the marginal product of that input.

TOTAL PRODUCT, MARGINAL PRODUCT, AND FIXED INPUT

  • More land (a fixed input) increases productivity of each worker, shifting the total product curve up.
  • MPL increases with a larger farm.

MARGINAL COST

  • Marginal cost (MC): Change in total cost (TC) from producing one additional unit (MC = rac{ riangle TC}{ riangle Q}).

EXAMPLE OF MARGINAL COST

  • Fixed cost for Selena's Gourmet Salsas is $108, variable cost changes with output.
  • Example costs at different levels of output are provided in the table.

AVERAGE COST

  • Average total cost (ATC): Total cost per unit of output (ATC = rac{TC}{Q}).
  • Average fixed cost (AFC): Fixed cost per unit of output (AFC = rac{FC}{Q}).
  • Average variable cost (AVC): Variable cost per unit of output (AVC = rac{VC}{Q}).

AVERAGE TOTAL COST CURVE

  • ATC curve has two opposing effects with output changing:
    • Spreading effect: Lower average fixed cost with larger output.
    • Diminishing returns effect: Higher average variable cost with larger output.
  • The ATC curve has a U-shape due to these effects.

MARGINAL AND AVERAGE COST CURVES

  • Marginal cost slopes upward due to diminishing returns; average variable cost also slopes upwards but flatter; average fixed cost slopes downward due to spreading effect.
  • The marginal cost curve intersects the ATC curve at its minimum point.

MINIMUM AVERAGE TOTAL COST

  • Minimum-cost output is where ATC is lowest.
  • Principles about marginal and average cost curves:
    • At minimum-cost output, ATC equals MC.
    • At output below minimum-cost, MC < ATC, ATC is falling.
    • At output above minimum-cost, MC > ATC, ATC is rising.

RETURNS TO SCALE

  • Increasing returns to scale: Long-run average total cost (LRATC) declines with increased output (economies of scale).
  • Decreasing returns to scale: LRATC increases with output (diseconomies of scale).
  • Constant returns to scale: LRATC remains the same as output increases.

ECONOMIES OF SCALE

  • Firms may achieve economies of scale through larger output, better technology, and team production advantages.
  • Diseconomies of scale arise from organizational challenges and increased complexity.
  • Industries may adapt through franchising to maintain flexibility alongside some economies of scale.