Chapter 5: Supply Decisions

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Chapter 5 Supply Decisions
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• 1. Capacity Constraints The Production
  Function

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Factors of Production

• Factors of production are needed to produce a
  good or service.

• The factors of production are the resource inputs
  used to produce goods and services.
• They are land, labor, capital, entrepreneurship.

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Production Function

• A production function tells us how much output
  can be produced with varying amounts of factor
  inputs.

• Output of one resource depends on amount of other
  resources available to it.

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Production Function
Output Jeans
Labor Input (workers per day)
Capital Input (sewing machines per day)
In the table above, note that you cant sew
jeans without either people or tools (capital).
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Production Function

• Note how you can increase overall production by
  increasing either the labor input (given a
  specific level of capital) . . . or

• . . . you can increase overall production by
  increasing the capital input (given a specific
  level of labor).

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Production Function

• It is possible for firms to change certain
  inputs more readily than others. It is
  possible, in the long run to change land,
  capital, or labor by buying new land, building
  new factories, and hiring more labor. In the
  short run things are a bit different.

• In the short run land and capital are fixed and
  only labor changes may be implemented.
  Decisions are made given a specific level of
  capital for instance we could make decisions
  based on a capital level of 1 sewing machine.

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Production Function
Note only the 1st 4 pts. on
this graph are shown in the table.
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Efficiency

• Need to use inputs efficiently.

• Every point on the production function represents
  the most possible output produced with a given
  number of workers.

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Capacity

• A production function shows how much output that
  can be produced with a given amount of inputs.

• Land and capital constraints place a ceiling on
  potential output.

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Marginal Physical Product

• Marginal Physical Product (MPP)
• The change in total output associated with one
  additional unit of input.

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Law of Diminishing Returns

• The marginal physical product of a variable input
  declines as more of it is employed with a given
  quantity of other (fixed) inputs.

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Why output tends to increase at a
diminishing rate

• MPP may initially increase due to specialization
  of labor.

• As labor is increased, each unit of labor has
  less capital and land to work with and workers
  crowd the facility.
• As a result, MPP begins to decline.

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Short Run vs. Long Run

• Short run

• The period in which the quantity (and quality) of
  some inputs cannot be changed.
• Long run
• A period of time long enough for all inputs to be
  varied (no fixed costs).

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• 2. Costs of Production

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Costs of Production

• A production function tells us how much a firm
  could produce but not how much it will want to
  produce.

• The most desired rate of output is one that
  maximizes total profit.
• Profit is the difference between total revenue
  and total cost.

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Total Cost

• The market value of all resources used to produce
  a good or service.

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Fixed Costs

• Costs of production that do not change with the
  rate of output.

• Examples include the cost of plant or equipment,
  basic phone service, and property taxes.
• Fixed costs cannot be avoided in short run.

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Variable Costs

• Costs of production that change when the rate of
  output is altered,

• Examples include labor or material costs.
• Any short-run change in total costs are a result
  of changes in variable costs.

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Costs of Production
ProductionCosts per day

• Fixed costs are those that do not change with
  the rate of output. Here we will assume that
  fixed costs are 120.

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Total Costs

• Variable costs begin at 0 and increase with
  the rate of output.

800

• Total cost is the combination of fixed and
  variable costs. Total costs rise as output
  increases as additional variable costs must be
  encumbered.

700
600
500


rate of fixed variable total
output costs costs costs

400
85 205
300
125 245
200
150 270
240 360
100
350 470
550 670
75
60
45
30
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633 753
Rate of Outputpair(s) of jeans
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Average Total Cost

• Average Total Cost (ATC)

• Total cost divided by quantity produced in a
  given time period.

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Costs of Production
ProductionCosts per unit

• Average total costs are graphed with a
  slightly different axis. Note that the
  vertical axis is a per unit cost versus total
  cost as before.

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AverageTotal Costs

• The Average total cost curve tends to fall
  initially, then later rise.

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• This gives it the familiar U-shape for which
  you will know it.

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rate of fixed variable total
output costs costs costs

ATC
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85 205
20.50
12
125 245
16.33
150 270
13.50
10
240 360
12.00
350 470
11.75
13.40
550 670
50
40
30
20
10
14.75
633 753
Rate of Outputpair(s) of jeans
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Marginal Cost

• The increase in total cost associated with a
  one-unit increase in production.

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Marginal Cost Curve
ProductionCosts per unit
Marginal Costs

• Here we examine Marginal costs for ice
  sculptures. Recall that the MC is the
  increase in total cost from the unit before.

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• At any level of production the fixed cost is
  10, as is apparent when output is 0.

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• In this market MC initially decreases, then
  rises with output as a consequence of the law
  of diminishing returns.

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18
15
12
3
1 13
9
2
2 15
6
4
3 19
6
4 25
3
9
5 34
14
6 48
5
4
3
2
1
8
6
7
8 98
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Rate of Output s of ice sculptures
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Relationship of MC to ATC

• MC curve intersects ATC curve at its lowest
  point.

• If MC lt ATC, then ATC declines
• If MC gt ATC, then ATC increases

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Basic Cost Curves
ProductionCosts per unit

• If we assemble what we know about the Marginal
  costs and Average costs curve together on the
  same graph we see how they relate to each
  other.

Marginal Costs
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• The MC curve typically rises, sometimes after
  a brief decline, the ATC has a U-shape, and the
  MC curve will always intersect the ATC curve at
  its lowest point.

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AverageTotal Costs
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12
3
13.00
9
2
7.50
6
4
6.33
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6.25
3
6.80
9
8.00
14
5
4
3
2
1
8
6
7
12.25
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Rate of Output s of ice sculptures
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• 3. Economic vs. Accounting Costs

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Accounting Costs

• Explicit expenses

• The direct dollar costs of producing goods or
  services, e.g., any actual out- of-pocket
  expense.

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Economic Costs

• The dollar value of all resources used to produce
  a good or service.

explicit costs
implicit costs

• Implicit costs include
• Factors of production that are not an explicit
  wage or rent.

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• 4. Supply Horizons

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Supply Horizons

• The supply decision has two dimensions.

• A short-run horizon which concerns the production
  decision.
• A long-run horizon which concerns the investment
  decision.

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Production Decision

• The marginal cost curve is a basic determinant of
  short-run production decisions.

• Fixed costs are unavoidable in the short-run and
  are thus ignored when making short-run production
  decisions.

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Investment Decision

• The decision to build, buy or lease plant and
  equipment to enter or exit an industry.

• Because no fixed costs exist in the long-run, all
  costs are variable.

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End of Chapter 5 Lecture