SURVEY OF ECONOMIC ANALYSIS

1
SURVEY OF ECONOMIC ANALYSIS

• LECTURE 12

2
MAIN POINT DEFINING THE SHORT-RUN COST
RELATIONSHIPS
3

• THINKING LIKE AN ECONOMIST
• COOPERATION AND COORDINATION
• IN PRODUCTION
• LAW OF DIMINISHING RETURNS
• LAW OF RETURNS TO SCALE

4
MAIN CONCEPTS

• PRODUCTION FUNCTION
• AVERAGE PRODUCT
• MARGINAL PRODUCT
• COST FUNCTIONS
• TOTAL COST
• AVERAGE COST
• MARGINAL COST

5

• AVERAGE VARIABLE COST
• AVERAGE FIXED COST
• OPPORTUNITY COST---- AGAIN
• SUNK COST
• SHORT-RUN
• LONG-RUN
• ECONOMIES OF SCALE
• ECONOMIES OF SCOPE

6
Law of Diminishing Returns
7

• The law of diminishing marginal returns states
  that as additional units of variable input are
  combined with a fixed amount of other resources
  and a given state of technology, the amount of
  additional output produced will start to declined
  beyond some point.
• The returned additional output that result
  from using more and more of the variable input
  will ultimately diminish.

8
PRODUCTION FUNCTION
9

• THE PRODUCTION FUNCTION IS THE RELATIONSHIP
  BETWEEN THE MAXIMUM OUTPUT A FIRM CAN PRODUCE --
  GIVEN THE STATE OF TECHNOLOGY-- AND THE VARIABLE
  INPUT(S).
• MARGINAL PRODUCT IS THE SLOPE OF THE PRODUCTION
  FUNCTION.
• AVERAGE PRODUCT IS THE TOTAL PRODUCT DIVIDED BY
  THE AMOUNT OF THE VARIABLE INPUT.

10

• .

TOTAL PRODUCT OR OUTPUT
OUTPUT
VARIABLE INPUT
11

• .

TOTAL PRODUCT OR OUTPUT
OUTPUT
VARIABLE INPUT
12

• .

TOTAL PRODUCT OR OUTPUT
OUTPUT
AVERAGE PRODUCT SLOPE OF LINE FROM THE ORIGIN
VARIABLE INPUT
13
TOTAL PRODUCT OR OUTPUT
OUTPUT
Q
VARIABLE INPUT
L
14

• .

TOTAL PRODUCT OR OUTPUT
OUTPUT
VARIABLE INPUT
15

• .

TOTAL PRODUCT OR OUTPUT
OUTPUT
MARGINAL PRODUCT SLOPE OF FUNCTION
VARIABLE INPUT
16
TOTAL PRODUCT OR OUTPUT
OUTPUT
D Q
D L
VARIABLE INPUT
17
TABULAR VIEW OF THE PRODUCTION FUNCTION
18
PRODUCTION FUNCTION
NO. OF HOURS WORKED
TOTAL OUTPUT
95,000 120,000 140,000 155,000 165,000 170,000 17
0,000
5000 6000 7000 8000 9000 10000 11000
19
PRODUCTION FUNCTION
NO. OF HOURS WORKED
TOTAL OUTPUT
D L
95,000 120,000 140,000 155,000 165,000 170,000 17
0,000
5000 6000 7000 8000 9000 10000 11000
----- 1000 1000 1000 1000 1000 1000
20
PRODUCTION FUNCTION
NO. OF HOURS WORKED
TOTAL OUTPUT
D L
D Q
----- 1000 1000 1000 1000 1000 1000
95,000 120,000 140,000 155,000 165,000 170,000 17
0,000
------- 25,000 20,000 15,000 10,000 5,000 --
0 --
5000 6000 7000 8000 9000 10000 11000
21
PRODUCTION FUNCTION
NO. OF HOURS WORKED
MARGINAL PRODUCT PER 1000 HR.
TOTAL OUTPUT
D L
D Q
----- 1000 1000 1000 1000 1000 1000
95,000 120,000 140,000 155,000 165,000 170,000 17
0,000
------- 25,000 20,000 15,000 10,000 5,000 --
0 --
------ 25,000 20,000 15,000 10,000 5,000 -- 0
--
5000 6000 7000 8000 9000 10000 11000
22
PRODUCTION FUNCTION
NO. OF HOURS WORKED
MARGINAL PRODUCT PER 1000 HR.
PER HR. DQ/DL
TOTAL OUTPUT
D L
D Q
----- 1000 1000 1000 1000 1000 1000
95,000 120,000 140,000 155,000 165,000 170,000 17
0,000
------- 25,000 20,000 15,000 10,000 5,000 --
0 --
------ 25,000 20,000 15,000 10,000 5,000 -- 0
--
5000 6000 7000 8000 9000 10000 11000
----- 25 20 15 10 5 0
23
FIRMS COST

• POSTULATE OF RATIONALITY IN THIS CASE IS PROFIT
  MAXIMIZATION
• FIRMS DECISIONS
• WHAT TO PRODUCE
• WHAT QUANTITIES TO PRODUCE
• HOW TO PRODUCE INPUT COMBINATIONS
• ARE BASED ON PROFIT MAXIMIZATION

24
FIRMS COST

• POSTULATE OF RATIONALITY IN THIS CASE IS PROFIT
  MAXIMIZATION
• FIRMS DECISIONS
• WHAT TO PRODUCE
• WHAT QUANTITIES TO PRODUCE
• HOW TO PRODUCE INPUT COMBINATIONS
• ARE BASED ON PROFIT MAXIMIZATION

25
FIRMS COST

• POSTULATE OF RATIONALITY IN THIS CASE IS PROFIT
  MAXIMIZATION
• FIRMS DECISIONS
• WHAT TO PRODUCE
• WHAT QUANTITIES TO PRODUCE
• HOW TO PRODUCE INPUT COMBINATIONS
• ARE BASED ON PROFIT MAXIMIZATION

26
PROFIT CALCULATION
27
Assume zero fixed cost in this example
PROFIT TOTAL REVENUE - TOTAL COSTS
P Q
W L
28
PROFIT CALCULATION
PROFIT TOTAL REVENUE - TOTAL COSTS
P Q
W L
OUTPUT
LABOR
29
P and W are determined in the goods and labor
markets
Under the assumption of price taker behavior
in both markets
PROFIT TOTAL REVENUE - TOTAL COSTS
P Q
W L
OUTPUT
LABOR
30
PROFIT TOTAL REVENUE - TOTAL COSTS
P Q
W L
OUTPUT
SUBJECT TO THE LAW OF DIMINISHING RETURNS
LABOR
31
PROFIT TOTAL REVENUE - TOTAL COSTS
P Q
W L
OUTPUT
SUBJECT TO THE LAW OF DIMINISHING RETURNS
LABOR
32
FORMS OF PRODUCTION FUNCTIONS

• INCREASING RETURNS

• .

OUTPUT
LABOR
33
OTHER FORMS OR RANGES OF PRODUCTION FUNCTIONS

• INCREASING RETURNS

• CONSTANT RETURNS

OUTPUT
OUTPUT
LABOR
LABOR
34
COST CURVES
35

• SHORT-RUN COSTS AT LEAST ONE FIXED INPUT-- AN
  INPUT WHICH IS NOT A FUNCTION OF OUTPUT--
  OPERATING PERIOD.
• LONG-RUN COSTS ALL COSTS ARE VARIABLE --
  PLANNING PERIOD.

36
EXAMPLE SHORT-RUN COST
37
SHORT-RUN COST FUNCTIONS
38
TVC 15
Q
L
TC
MC
AVC
ATC
95,000 120,000 140,000 155,000 165,000 170,000
5000 6000 7000 8000 9000 10000
39
TVC 15
Q
L
TC
MC
AVC
ATC
95,000 120,000 140,000 155,000 165,000 170,000
5000 6000 7000 8000 9000 10000
COST CONCEPTS
40
TVC 15
Q
L
TC
MC
AVC
ATC
95,000 120,000 140,000 155,000 165,000 170,000
5000 6000 7000 8000 9000 10000
75,000 90,000 105,000 120,000 135,000 150,000

100,000 115,000 130,000 145,000 160,000 175,000
---- . 60 .75 1.00 1.50 3.00
.79 .75 .75 .77 .82 .88
1.05 .96 .93 .94 .97 1.03
41
TVC 15
Q
L
TC
MC
AVC
ATC
95,000 120,000 140,000 155,000 165,000 170,000
5000 6000 7000 8000 9000 10000
75,000 90,000 105,000 120,000 135,000 150,000

100,000 115,000 130,000 145,000 160,000 175,000
---- . 60 .75 1.00 1.50 3.00
.79 .75 .75 .77 .82 .88
1.05 .96 .93 .94 .97 1.03
TVC L W 5000 15 75,000
42
TVC 15
Q
L
TC
TFC
95,000 120,000 140,000 155,000 165,000 170,000
5000 6000 7000 8000 9000 10000
75,000 90,000 105,000 120,000 135,000 150,000

100,000 115,000 130,000 145,000 160,000 175,000
25,000
TC TVC TFC
43
TVC 15
Q
L
TC
TFC
95,000 120,000 140,000 155,000 165,000 170,000
5000 6000 7000 8000 9000 10000
75,000 90,000 105,000 120,000 135,000 150,000

100,000 115,000 130,000 145,000 160,000 175,000
25,000
25,000 25,000 25,000 25,000 25,000

TC TVC TFC
44
DTC/DQ
TVC 15
Q
TC
MC
15,000 25,000
---- . 60 .75 1.00 1.50 3.00
95,000 120,000 140,000 155,000 165,000 170,000
75,000 90,000 105,000 120,000 135,000 150,000

100,000 115,000 130,000 145,000 160,000 175,000
DTC 15,000
DQ 25,000
45
DTC/DQ
TVC 15
Q
TC
MC
15,000 25,000
---- . 60 .75 1.00 1.50 3.00
95,000 120,000 140,000 155,000 165,000 170,000
75,000 90,000 105,000 120,000 135,000 150,000

100,000 115,000 130,000 145,000 160,000 175,000
DTC 15,000
DQ 25,000
MC WAGE PER HOUR / MARGINAL
PRODUCT PER HOUR 15 / 25 .60 MP DQ
/DL 25,000 / 1000 25
46
TVC / Q
TVC 15
Q
L
AVC
95,000 120,000 140,000 155,000 165,000 170,000
5000 6000 7000 8000 9000 10000
75,000 90,000 105,000 120,000 135,000 150,000

.79 .75 .75 .77 .82 .88
75,000 / 95,000
90,000 / 120,000
47
TVC / Q
TVC 15
Q
L
AVC
95,000 120,000 140,000 155,000 165,000 170,000
5000 6000 7000 8000 9000 10000
75,000 90,000 105,000 120,000 135,000 150,000

.79 .75 .75 .77 .82 .88
75,000 / 95,000
90,000 / 120,000
AVC WAGE PER HOUR / AVERAGE
PRODUCT PER HOUR 15 / 19 .79 AP
Q / L 95,000 / 5000 19
48
TC/Q
TVC 15
Q
L
TC
ATC
95,000 120,000 140,000 155,000 165,000 170,000
5000 6000 7000 8000 9000 10000
75,000 90,000 105,000 120,000 135,000 150,000

100,000 115,000 130,000 145,000 160,000 175,000
1.05 .96 .93 .94 .97 1.03
100,000 / 95,000 115,000 / 120000
49
TVC 15
Q
L
TC
MC
AVC
ATC
95,000 120,000 140,000 155,000 165,000 170,000
5000 6000 7000 8000 9000 10000
75,000 90,000 105,000 120,000 135,000 150,000

100,000 115,000 130,000 145,000 160,000 175,000
---- . 60 .75 1.00 1.50 3.00
.79 .75 .75 .77 .82 .88
1.05 .96 .93 .94 .97 1.03
50
COSTS AND THE LAW OF DIMINISHING RETURNS
51
Remember W is constant to the price-taker firm
OUTPUT
MP
AP
INPUT
MC W / MP
AVC W / AP
COSTS
OUTPUT
52
COSTS AND THE LAW OF DIMINISHING RETURNS
OUTPUT
MP
AP
INPUT
AVC
MC
COSTS
OUTPUT
53
COSTS AND THE LAW OF DIMINISHING RETURNS
OUTPUT
MP
AP
INPUT
AVC
MC
COSTS
OUTPUT
54
COSTS AND THE LAW OF DIMINISHING RETURNS
OUTPUT

MP
AP
INPUT
AVC
MC
COSTS

OUTPUT
55
COSTS AND THE LAW OF DIMINISHING RETURNS
OUTPUT

MP
AP
INPUT
AVC
MC
COSTS

OUTPUT
56
COSTS AND THE LAW OF DIMINISHING RETURNS
OUTPUT

MP
MC
W MPL
AP
INPUT
AVC
MC
COSTS
AVC W AP

OUTPUT
57
STOP
LONG-RUN COST RELATIONSHIPS
PRODUCTION AND COSTS WITH MANY FACTORS
58
PRODUCTION WITH MANY FACTORS

• ISOQUANTS

UNMECHANIZED PROCESS HIGH L/K RATIO
LABOR
C
MODERATELY MECHANIZED PROCESS
B
HIGHLY AUTOMATED PROCESS
A
CAPITAL
59
PRODUCTION WITH MANY FACTORS

• ISOQUANTS

UNMECHANIZED PROCESS HIGH L/K RATIO
LABOR
C
MODERATELY MECHANIZED PROCESS
B
HIGHLY AUTOMATED PROCESS
A
CAPITAL
60
PRODUCTION WITH MANY FACTORS

• ISOQUANTS

UNMECHANIZED PROCESS HIGH L/K RATIO
LABOR
C
MODERATELY MECHANIZED PROCESS
Y
B
HIGHLY AUTOMATED PROCESS
X
A
CAPITAL
61
MARGINAL RATE OF TECHNICAL SUBSTITUTION

• CONTINUOUS ISOQUANT

L4
DL
L3
L2
DL
L1
Q10,000 UNITS
K4
K3
K2
K1
DK
DK
62
MARGINAL RATE OF TECHNICAL SUBSTITUTION

• CONTINUOUS ISOQUANT

THE SLOPE OF THE ISOQUANT IS CALLED MARGINAL
RATE OF TECHNICAL SUBSTITUTION DL/DK
L4
DL
L3
L2
DL
L1
Q10,000 UNITS
K4
K3
K2
K1
DK
DK
63
COST MINIMIZATION

LABOR
CAPITAL
64
COST MINIMIZATION

LABOR
CAPITAL
65
COST MINIMIZATION

LABOR
CAPITAL
66
COST MINIMIZATION

LABOR
CAPITAL
67
COST MINIMIZATION

LABOR
L
K
0
CAPITAL
68
RISE IN THE PRICE OF LABOR

A
L1
C
B
L2
69
RISE IN THE PRICE OF LABOR

A
L1
C
B
L2
LESS LABOR INTENSIVE PRODUCTION PROCESS
70
DERIVING THE COST CURVES

L
Q
K
71
DERIVING THE COST CURVES

L
1000
A
A
100
1000
100
Q
K
72
DERIVING THE COST CURVES

L
1500
B
1000
A
200
1500
100
200
Q
K
73
DERIVING THE COST CURVES

L
2000
C
1500
B
C
1000
300
A
2000
100
200
300
Q
K
74
DERIVING THE COST CURVES

TCLR
2000
C
1500
B
1000
A
100
200
300
Q
75
DERIVING THE COST CURVES

L
TCLR
C
C2
B
L2
B
A
C1
Q2
A
Q1
C1
C2
K
Q1
Q2
Q
K
76
DERIVING THE COST CURVES

L
C3
TCLR
C
L3
C2
B
L2
B
A
C1
Q2
A
Q1
C1
C2
Q1
Q2
Q
K
K
77
DERIVING THE COST CURVES

L
TCSR
C3
C
TCLR
C3
C
L3
C2
B
L2
B
A
C1
Q2
A
Q1
C1
C2
Q1
Q2
Q
K
K
78
DERIVING THE COST CURVES

TCSR

L
TCSR
C3
C
C3
TCLR
C
L3
C2
B
L2
B
A
C1
Q2
A
Q1
C1
C2
K
Q1
Q2
Q
K
79
DERIVING THE COST CURVES

L
TCLR
C
C2
B
B
A
C1
Q2
A
Q1
C1
C2
K
Q1
Q2
Q
K
80
CLASS EXERCISE

• MINIMUM , AVERAGE
• SCOPE
• FIXED
• PRODUCTION FUNCTION
• RAISE
• PRINCIPLE OF SUBSTITUTION
• SCALE
• DIMINISHING RETURNS
• MARGINAL PRODUCT
• MARGINAL COST

81

• THE RELATIONSHIP BETWEEN THE INPUTS USED IN
  PRODUCTION AND THE LEVEL OF OUTPUT IS CALLED THE
  ----------------- .
• THE RELATIONSHIP BETWEEN THE INPUTS USED IN
  PRODUCTION AND THE LEVEL OF OUTPUT IS CALLED THE
  PRODUCTION FUNCTION.
• THE INCREASE IN OUTPUT THAT RESULTS FROM USING
  ONE MORE UNIT OF AN INPUT IS THE ----------------
  .

82

• THE INCREASE IN OUTPUT THAT RESULTS FROM USING
  ONE MORE UNIT OF AN INPUT IS THE MARGINAL
  PRODUCT.
• THE PRINCIPLE OF ----------------- SAYS THAT AS
  MORE AND MORE OF ONE INPUT IS ADDED , WHILE OTHER
  INPUTS REMAIN UNCHANGED , THE MARGINAL PRODUCT OF
  THE ADDED INPUT DIMINISHES .

83

• THE PRINCIPLE OF DIMINISHING RETURNS SAYS THAT AS
  MORE AND MORE OF ONE INPUT IS ADDED , WHILE OTHER
  INPUTS REMAIN UNCHANGED , THE MARGINAL PRODUCT OF
  THE ADDED INPUT DIMINISHES.
• COSTS THAT DO NOT DEPEND UPON OUTPUT ARE CALLED
  ------------- OR OVERHEAD COSTS.
• COSTS THAT DO NOT DEPEND UPON OUTPUT ARE CALLED
  FIXED OR OVERHEAD COSTS.

84

• THE ---------- IS THE EXTRA COST OF PRODUCING ONE
  MORE UNIT OF PRODUCTION.
• THE MARGINAL COST IS THE EXTRA COST OF PRODUCING
  ONE MORE UNIT OF PRODUCTION.
• THE MARGINAL COST INTERSECTS THE AVERAGE COST
  CURVE AT THE ------------ OF THE -----------
  COST CURVE.

85

• THE MARGINAL COST INTERSECTS THE AVERAGE COST
  CURVE AT THE MINIMUM OF THE AVERAGE COST CURVE.
• IF MARGINAL COSTS ARE ABOVE THE AVERAGE COSTS
  ,THEN PRODUCING AN ADDITIONAL UNIT WILL
  ------------ THE AVERAGE .
• IF MARGINAL COSTS ARE ABOVE THE AVERAGE COSTS
  ,THEN PRODUCING AN ADDITIONAL UNIT WILL RAISE
  THE AVERAGE .

86

• AN INCREASE IN THE PRICE OF ONE INPUT WILL LEAD A
  FIRM TO SUBSTITUTE OTHER INPUTS. THIS IS A
  STATEMENT OF THE ------------ OF ------------- .
• AN INCREASE IN THE PRICE OF ONE INPUT WILL LEAD A
  FIRM TO SUBSTITUTE OTHER INPUTS. THIS IS A
  STATEMENT OF THE PRINCIPLE OF SUBSTITUTION .

87

• IF THE AVERAGE COST IS LOWER WHEN THE FIRM
  PRODUCES A LARGER QUANTITY , THEN THERE ARE
  ECONOMIES OF --------------- .
• IF THE AVERAGE COST IS LOWER WHEN THE FIRM
  PRODUCES A LARGER QUANTITY , THEN THERE ARE
  ECONOMIES OF SCALE.

88

• IF IT IS LESS EXPENSIVE TO PRODUCE A VARIETY OF
  GOODS TOGETHER THAN TO PRODUCE EACH GOODS
  SEPARATELY , THEN THERE ARE ECONOMIES OF
  ---------- .
• IF IT IS LESS EXPENSIVE TO PRODUCE A VARIETY OF
  GOODS TOGETHER THAN TO PRODUCE EACH GOODS
  SEPARATELY , THEN THERE ARE ECONOMIES OF SCOPE .