Chapter 6' Production and Cost

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Chapter 6. Production and Cost
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Cost structure and production decisions (Example
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• PC industry
• Most of costs are variable costs, because the
  costs of components are proportional to the
  number of computers produced.
• Key strategy to maximize profit
• think of ways to reduce costs by bargaining for
  better prices for components.

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Cost structure and production decisions (Example
2)

• Computer software industry
• Most of costs are sunk, because the money to
  develop a new application system cannot be
  recovered.
• Variable costs are almost zero.
• Key strategy to maximize profit
• recoup its investment by selling as many copies
  of the program as possible.

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Factors of production

• Fixed factor of production (or say Capital, K)
• A firm cannot change the quantity of capital it
  employs (in short term).
• Example the number of factories or computers
• Variable factor of production (or say Labor, L)
• A firm can change the quantity of labor it
  employs.
• Example the number of workers and work hours

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Production and Factors of production

• Input-output table (an example)
• The output function Q F(K,L)

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(No Transcript)
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Short-run versus long-run

• Short-run a period of time over which some
  factors of production are fixed
• In this course, we assume capital to be fixed and
  labor to be variable in the short run.
• Long-run a period of time over which all
  factors of production can be variable.
• Both capital and labor are variable in the long
  run.

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Production problems

• Short-run choices
• Given the number of factories, how many workers
  should be employed to support the production
  line?
• Operation decisions
• Long-run choices
• How many new factories will the firm plan to
  invest?
• How many workers will the firm plan to
  recruit/layoff?
• Planning decisions

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Short-run production problems

• Assume that we have three machines (K3) that can
  be used for coming three years

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Measure the short-run productivity

• Given K3
• Total product (TP) QF(L)
• Average product of labor APL Q/L
• Marginal product of labor MPL?Q/ ?L

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Point of diminishing marginal returns
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Stages of production

• Workers do not always make each other productive
  -- Crowded or limited facilities
• Two stages
• The first stage of production Production with
  relatively few workers, so that each additional
  workers increases the productivity of his
  colleagues. Thus, APL is non-decreasing and
  MPL?APL.
• The second stage of production Production with
  enough workers so that each additional workers
  decreases the productivity of his colleagues.
  Thus, APL is decreasing and MPLltAPL.

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Costs

• Fixed cost cost of renting a fixed factor of
  production (capital K)
• FC PkK
• Variable cost cost of hiring a variable factor
  of production (labor L)
• VC PLL
• Total cost (TC)
• TC FC VC PkK PLL

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Cost Measures

• Average cost AC TC/Q
• Average variable cost AVC VC/Q
• PLL/Q PL/(Q/L) PL/ APL
• AVC PL/ APL

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Marginal cost

• The information about MC is often missing.
• We can recover MC from the wage rate PL and MPL
• Importation relation between cost and
  productivity.
• Intuition
• If MPL 5, then 5 additional units of output
  can be generated by an additional worker
• That is, 1/5 additional worker can produce an
  additional unit of output. Or denote 1/MPL 1/5.
  
• In this case, the marginal cost equals the hiring
  cost of the 1/5 additional workers.
• If the wage rate is 20, MCPL (1/MPL)
  20(1/5)4.

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Example

• Assume that PL 15, FC 50

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• The AC and AVC curves are U-shaped.
• When MC is below AC, AC is falling
• When MC is above AC, AC is rising.
• Thus, MC must cross AC at the bottom of AC.

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The shutdown decision

• remaining in operation or shutting down?
• The profit to be earned from operating TR-TC
• The profit to earned from shutting down -FC
• The firm stays in operation if
• TR-TCgt -FC
• That is,
• PgtAVC
• Firms would stay in business only if the market
  price is enough to cover the average variable
  cost.