Slides 4:

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Rose-Hulman Institute of Technology Department of
Humanities Social Sciences / K. Christ SL 151,
Principles of Economics
Slides 4 Supply Theory -- Production Cost
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Thinking about supply in a market economy
Suppliers
Demanders
Producing Sector
Consuming Sector
Goal Maximize well-being (satisfaction
or utility) Constraints Income Prices
Goal Maximize profit Constraints Prices of
inputs Prices of outputs
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Thinking about supply in a market economy
(pq) (lw) (kr)
Theory of Market Structure Revenue Behavior
Theory of Production Cost Cost Behavior

• Two conjectures
• Price taking behavior
• Price making behavior

• Key concepts
• Short run vs. long run
• Diminishing marginal returns
• Economies of scale

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Thinking about supply in a market economy
Theory of Market Structure Revenue Behavior
Price taking behavior
Price making behavior
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Theory of Production Cost

• Key concepts
• Short run vs. long run
• Diminishing marginal returns
• Economies of scale

Short Run A production time frame in which some
of the factors of production (inputs) are
variable and some are fixed. Long Run A
production time frame in which all of the factors
of production are variable.
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The stylized view of production functions
long run and short run
Capital Input, K
Total Output, Q
Long-run Production with 2 variable inputs (K,
L)
Labor Input, L
Total Output, Q
Short-run Production with 1 fixed input (K
) 1 variable input (L)
Labor Input, L (with K fixed)
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The stylized view of production functions
short run
Inflection Point
Diminishing Marginal Returns
Increasing Marginal Returns
Negative Marginal Returns
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Short-run production -- detailed look
Intensive Margin
Extensive Margin
Q
Inflection Point
Stage II
Stage I
Stage III
L
L
Diminishing Marginal Returns
Increasing Marginal Returns
Negative Marginal Returns
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The Law of Diminishing Marginal Returns
As additional units of a variable factor are
added to a fixed factor, at some point the
additional output attributable to each unit of
the variable factor decreases. Diminishing
marginal returns apply only to the
short-run. Mathematically,
and
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Diminishing marginal returns and marginal costs
Number of Workers
Total Product
Total Cost
Marginal Cost
Marginal Cost
Marginal Product
0 1 2 3 4 5 6 7 8 9 10
0 4 10 17 23 28 31 32 32 30 25
4 6 7 6 5 3 1 0 -2 -5
0 10 20 30 40 50 60 70 80 90 100
10 10 10 10 10 10 10 10 10 10
2.50 1.67 1.43 1.67 2.00 3.33 10.00
Per worker Per unit of output
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Short-run production and cost
Stage II Production
Diminishing Marginal Returns
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Short-run cost curves and their shapes
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Diminishing marginal returns and marginal costs
Number of Workers
Total Product
Total Cost
Marginal Cost
Marginal Cost
Marginal Product
0 1 2 3 4 5 6 7 8 9 10
0 4 10 17 23 28 31 32 32 30 25
4 6 7 6 5 3 1 0 -2 -5
0 10 20 30 40 50 60 70 80 90 100
10 10 10 10 10 10 10 10 10 10
2.50 1.67 1.43 1.67 2.00 3.33 10.00
Per worker Per unit of output
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Long run production returns to scale
Given an equal magnitude change in all
inputs If we say the
production process exhibits Constant Returns to
Scale (CRTS) If long-run average costs do not
change as the scale of the production operation
increases, we say there are no economies of
scale. This concept applies only to
the long-run.
F
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Long run production returns to scale
Given an equal magnitude change in all
inputs If we say the
production process exhibits Increasing Returns
to Scale (IRTS) Economies of scale is a closely
related concept that describes a production
process in which long-run average costs decline
as the scale of the production operation
increases. These concepts apply only
to the long-run.
F
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Long run production returns to scale
Given an equal magnitude change in all
inputs If we say the
production process exhibits Decreasing Returns
to Scale (DRTS) Diseconomies of scale is a
closely related concept that describes a
production process in which long-run average
costs increase as the scale of the production
operation increases. These concepts
apply only to the long-run.
F
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Long-Run Costs and Economies of Scale
Costs
Economies of Scale
Q
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Long-Run Costs and Economies of Scale
Costs
Constant Returns to Scale (No Economies Of
Scale)
Q
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Long-Run Costs and Economies of Scale
Costs
Economies of Scale
Diseconomies of Scale
Constant Returns to Scale
Q
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Factors affecting a firms cost behavior
Cost Function
Technology (Production Function)
Factor Costs
Diminishing Returns Economies of
Scale Economies of Scope (for
)
q q q
Purchasing Power Market Power of suppliers
q q