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Lecture

short run cost.doc

14 Pages
98 Views
Fall 2012

Department
Management
Course Code
MGMT 650
Professor
Sebastien Breau

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Principles of Economics: Short-run Cost
We first examine the cost of firms in the period when capital is fixed to understand the
importance of marginal cost in the determination of profit maximizing output. We do this by
deriving cost functions from production functions.
SHORT-RUN PRODUCTION AND COST FUNCTIONS
Production Function
Definition: The set of all maximum possible outputs from a given input or inputs that provide a
technologically feasible way to produce a commodity or service.
Q = f(Xo, X1, X2, X3, X4, … XN) where Xi represents the inputs into production
We simplify this by dividing the inputs into Capital (K) and Labour (L) to get
Q = f(L, K)
Firm
Definition: A business organization producing goods and services from resource inputs
‘Business’ implies the assumption of profit maximization
The firm connects costs and output as the smallest unit of production.
Industry
Definition: All the firms that produce a given good or service
Short-run
Definition: The period in which one factor (input) is fixed
Long-run
Definition: The period in which all factors are variable
Variable Inputs
Definition: Inputs that vary in quantity with each additional unit of output
- 1 -
Principles of Economics: Short-run Cost
Variable inputs include Labour, Fuel, and Raw Materials but we use Labour (L) to represent
them all
Fixed Inputs
Definition: Inputs that do not vary in quantity with an additional unit of output
Fixed inputs include equipment and machinery, buildings, and land but we use Capital (K)
to represent them all
SHORT-RUN PRODUCTION FUNCTIONS
Total Product of Labour (TPL)
Definition: The total output produced from each total labour output given fixed capital
TPL = q = f(LK)
(Q = output of the industry and q = output of a firm so that Q = nq where n = #firms in the
industry)
Average Product of Labour (APL or simply AP since we will assume that capital is fixed)
Definition: Average output of each labour unit given fixed capital
APL = q/L
Marginal Product of Labour (MPL or simply MP)
Definition: The change in output due to a change in labour given fixed capital
MPL = q/L [(q1 – q0)/(L1 – L0) for discrete changes]
(or = dq/dL for infinitesimal changes in Labour)
NOTE: The Marginal Product of Labour is often expressed as the change in output due to an
additional ‘unit’ of labour.
- 2 -
Principles of Economics: Short-run Cost
Law of Eventually Diminishing Returns
Definition: Marginal Product eventually decreases with increases in labour since the efficiency
of additional labour eventually falls due to fixed capital
e.g. The following table shows the Total Product, Average Product, and Marginal Products for
units (days) of labour at cotton cloth manufacturer with a spinning, weaving, and dyeing
machine.
The equation q = - L3 + 12L2 describes the total product of labour.
Labour Units Total Product
(TP)
Average Product
(AP)
Marginal
Product
MP = Ln+1 - Ln
Marginal Product
MP = dTP/dL
1 11 11 11 21
2 40 20 29 36
3 81 27 41 45
4 128 32 47 48
5 175 35 47 45
6 216 36 41 36
7 245 35 29 21
8 256 32 11 0
9 243 27 -13 -27
Marginal Product initially rises because additional workers can use the fixed capital more
efficiently but eventually marginal product declines because the fixed capital limits the
productivity of the workers. Marginal Product declines to below 0 when an additional worker
results in a fall in Total Product, not just a decline in Marginal Product.
Notice that Total Product shows us that output increases up to 8 workers and then decreases
but does not show us the rate at which Total Product increases or decreases. Marginal Product is
more informative since positive (negative) Marginal product tells us not only whether Total
Product increases (decreases) but also the change in Total Product.
- 3 -

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Description
Principles of Economics Shortrun CostWe first examine the cost of firms in the period when capital is fixed to understand the importance of marginal cost in the determination of profit maximizing outputWe do this by deriving cost functions from production functions SHORTRUN PRODUCTION AND COST FUNCTIONSProduction Function Definition The set of all maximum possible outputs from a given input or inputs that provide a technologically feasible way to produce a commodity or serviceQfXo X X X XXwhere Xirepresents the inputs into production1234NWe simplify this by dividing the inputs into Capital K and Labour L to getQfL KFirmDefinition A business organization producing goods and services from resource inputsBusiness implies the assumption of profit maximization The firm connects costs and output as the smallest unit of productionIndustryDefinition All the firms that produce a given good or serviceShortrunDefinition The period in which one factor input is fixedLongrunDefinition The period in which all factors are variableVariable InputsDefinition Inputs that vary in quantity with each additional unit of output 1 Principles of Economics Shortrun Cost Variable inputs include Labour Fuel and Raw Materials but we use Labour L to represent them allFixed InputsDefinition Inputs that do not vary in quantity with an additional unit of outputFixed inputs include equipment and machinery buildings and land but we use Capital K to represent them allSHORTRUN PRODUCTION FUNCTIONSTotal Product of Labour TPLDefinition The total output produced from each total labour output given fixed capital TPqfLK LQoutput of the industry and qoutput of a firm so that Qnq where nfirms in the industryAverage Product of Labour AP or simply AP since we will assume that capital is fixed LDefinition Average output of each labour unit given fixed capitalAPqLLMarginal Product of Labour MP or simply MPLDefinition The change in output due to a change in labour given fixed capitalMPDqDL qqLL for discrete changes L1010ordqdL for infinitesimal changes in LabourNOTE The Marginal Product of Labour is often expressed as the change in output due to an additional unit of labour 2
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