Unit 5. Producer theory: revenues and costs

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1 Unit 5. Producer theory: revenues and costs

2 In accordance with the APT programme objectives of the lecture are to help You to: understand the concept of the short-run production function, describing the relationship between the quantity of inputs and the quantity of output; understand within the context of the production function, average and marginal products as well as the law of diminishing marginal returns; learn the link between productivity and costs; examine the relationships among the short-run costs: total, average and marginal; consider the process of cost minimization; explain the properties of long-run costs; examine economies and diseconomies of scale, as well as returns to scale; make the distinction between accounting and economic profits; establish the profit-maximizing rule, using marginal analysis.

3 Required reading Begg, D., R.Dornbusch, S.Fischer. Economics. 8th edition. McGraw Hill. 25. Chapter 6. Introducing supply decisions. Chapter 7. Costs and supply.

4 uestions to be revised Utility maximization: optimal consumption bundle; Opportunity cost.

5 Revenues Supplies Supplies Rentals Supply Side: a firm in a market economy Product market Factor markets Labour market Wages Capital market Output Producer (firm) Labour Capital Supplies

6 Technology A factor of production is an aggregate input that plays a sufficient role in production of output. Main factors: capital and labor. Other factors: land and entrepreneurship A production function specifies the maximum output that can be produced from any given amount of inputs.

7 Long Run and Short Run The long run is a sufficient period of time for a firm to adjust all its inputs to a change in economic environment. The short run is the period in which the firm can make only partial adjustment of its inputs to a change in economic environment. We typically assume that capital is fixed in the short run. (It takes up to several years to build a new plant.)

8 II stage Production function Marginal and average products Short run products MP L, AP L MP L I stage AP L TP L III stage IV stage L 1 L 2 L 3 L 1 L 2 L 3 L L Average product of a factor (labour) is given by the output related to the quantity of the factor: Marginal product of a variable factor (labour) is a change in output obtained by an increment of the variable factor (labour), holding constant all other factors: The law of diminishing marginal returns: beyond the I st stage of production, continual increments in the variable input lead to the steadily decreasing marginal product.

9 II stage Production function Marginal and average products MP L, AP L I stage III stage L 1 L 2 L 3 Short run products TP L IV stage L Marginal and average product curves intersect at the point of maximum of average product of the variable factor. To prove it take a derivative of average product of labour: At the point of maximum it is zero: MP L AP L L 1 L 2 L 3 L It follows that marginal product is equal to average product at this point:

10 Supply Side: Producer (firm) cares about Costs (depend on technology, what inputs it uses and in what proportions; prices of inputs), and Revenues (depend on demand). A firm s revenue is the amount it earns by selling goods or services. R = P()* Firm seeks to maximize profit: Profit = Revenue - Cost

11 Economic vs. Accounting Costs and Profits Economic costs: Accounting costs and opportunity costs. Accounting costs are the actual payments of a firm. Opportunity cost is the amount lost by not using the resource (labor or capital) in its best alternative use. Economic profit = Revenue economic costs Accounting profit = Revenue accounting costs

12 Short-Run Cost Curves A fixed factor of production is a factor whose level cannot be varied in the short-run. A variable factor can be adjusted, even in the short-run. Fixed costs are costs that do not vary with output level. Variable costs are costs that vary with output level. Short-run total cost = short-run fixed cost + short-run variable cost. STC=SVC+SFC

13 Short-Run Average & Marginal Costs SMC, SAC, AVC, AFC SMC SAC AVC TC AC AFC AVC FC AFC VC AVC AFC

14 SMC, SAC, AVC, AFC Short-Run Average & Marginal Costs SMC SAC AVC AFC 1) AC, AVC, and MC curves are first decreasing and then increasing; 2) AC and AVC are declining whenever MC is below AC and AVC correspondingly, and rising whenever MC is above the average cost curves; 3) MC curve cuts the AC and AVC curves at the minimum points of the average cost curves. dac d TC MC TC MC AC 2 d d dac d MC TC MC TC AC

15 STC, VC, FC Costs in short run. STC VC Variable, fixed and total costs FC SMC, SAC, AVC, AFC 1 2 SMC SAC AVC Average and marginal costs AFC 1 2

16 Short run costs: example 1

17 Short run costs: example 2

18 Average and marginal product curves Production function L TP L Short run product and cost curves L APL tg MPL tg AP L III stage L 2 L 1 β II stage L 2 L 1 I stage STC, VC, FC γ SMC, SAC, AVC, AFC α δ 1 2 η η STC VC FC SMC SAC AVC MP L Variable, fixed and total cost curves AVC tg AC tg MC tg MP L, AP L AVC wl w w AP L d dl w w MC ( wl( )) w d d d MP dl L L Average and marginal costs AFC 1 2 3

19 Short run costs: example 3

20 Cost minimizing output combination K Isocost lines K * E Minimize costs of production of a particular output Isoquant curve L * L

21 Cost minimization: example

22 Cost shifters Costs of inputs, Changes in technology.

23 Long run cost curves LTC LTC Long run total cost curve LMC, LAC 1 2 LMC LAC Average and marginal cost curves 1 2

24 Long-Run & Short-Run Cost Curves TC STC 1 STC 2 STC 3 TC TC AC SAC 1 SAC 2 SAC 3 MC AC SAC i are short-run average total cost curves for different plant sizes MC SMC 1 SMC 2 SMC 3 AC curve shows the minimum average cost to produce a given output when all factors (incl. capital) can be varied

25 Long Run: Technology and Returns to Scale Technology dictates how costs (average) change with the amount of output. Increasing returns to scale: Decreasing returns to scale: Constant returns to scale:

26 LAC LAC LAC Long-Run Average Cost (LAC) &Returns to Scale LAC LAC LAC Increasing returns to scale, or economies of scale LAC curve is downward sloping. Constant returns to scale AC are constant Decreasing returns to scale, or diseconomies of scale LAC curve is upward sloping

27 Diseconomies of Scale Versus Diminishing Marginal Returns Diseconomies of scale ALL factors can be varied. Relationship between output and LAC. Diminishing marginal returns only one factor is varied, others are fixed at particular level. Relationship between changes in quantity of one input and output.

28 Marginal Revenue Marginal Revenue under imperfect competition declines with an increase in output, because it depends on demand. Can sell more output only if the price is lower. MR = extra revenue from selling last unit. To sell an additional unit of output means to loose revenue from the previous units, selling them at lower price.

29 Profit maximization. PR, TR, TC TC TR P, MR, MC PR MC P* MR D 1 *

SHORT-RUN PRODUCTION

TRUE OR FALSE STATEMENTS SHORT-RUN PRODUCTION 1. According to the law of diminishing returns, additional units of the labour input increase the total output at a constantly slower rate. 2. In the short-run