Production and Cost Analysis
4.1 Production Function
1. Definition: The production function shows the relationship between the quantities of
inputs (e.g., labor, capital) used in production and the maximum quantity of output
that can be produced with those inputs. It is usually expressed as Q = f(L, K), where
Q is output, L is labor, and K is capital.
2. Short - run vs. Long - run Production:
1. Short - run: At least one input is fixed (usually capital), and other inputs
(usually labor) are variable. Firms can only increase output by increasing the
variable input.
2. Long - run: All inputs are variable. Firms can adjust both labor and capital to
change output levels, and they can also enter or exit the industry.
4.2 Law of Diminishing Marginal Returns
3. Definition: In the short run, as more units of a variable input (e.g., labor) are added
to a fixed input (e.g., capital), the marginal product of the variable input will eventually
decrease. Marginal product (MP) is the additional output produced by adding one
more unit of the variable input.
4. Example: A bakery with a fixed number of ovens (capital) hires more workers (labor).
Initially, each additional worker increases output significantly (increasing marginal
returns). However, after a certain number of workers, the ovens become
overcrowded, and each additional worker adds less to output (diminishing marginal
returns). Eventually, adding more workers may even reduce total output (negative
marginal returns).
4.3 Costs of Production
5. Short - run Costs:
1. Fixed Costs (FC): Costs that do not vary with the level of output. Examples
include rent, insurance, and the cost of capital equipment. FC remains the
same whether the firm produces 0 units or 1000 units of output.
2. Variable Costs (VC): Costs that vary with the level of output. Examples
include the cost of labor, raw materials, and energy. VC increases as output
increases and decreases as output decreases.
3. Total Cost (TC): The sum of fixed costs and variable costs. TC = FC + VC.
4. Average Fixed Cost (AFC): Fixed cost per unit of output. AFC = FC / Q. AFC
decreases as output increases because FC is spread over more units of
output (this is called "spreading the overhead").
5. Average Variable Cost (AVC): Variable cost per unit of output. AVC = VC /
Q. AVC first decreases due to increasing marginal returns and then increases
due to diminishing marginal returns, resulting in a U - shaped curve.
6. Average Total Cost (ATC): Total cost per unit of output. ATC = TC / Q =
AFC + AVC. ATC also has a U - shaped curve because AFC is always
decreasing and AVC first decreases then increases. The minimum point of
the ATC curve is where the firm achieves "minimum efficient scale".
7. Marginal Cost (MC): The additional cost of producing one more unit of
output. MC = ΔTC / ΔQ = ΔVC / ΔQ (since ΔFC = 0 in the short run). MC
intersects both AVC and ATC at their minimum points. This is because when
MC is less than AVC (or ATC), AVC (or ATC) is decreasing; when MC is
greater than AVC (or ATC), AVC (or ATC) is increasing.
6. Long - run Costs:
1. In the long run, there are no fixed costs, only variable costs. The long - run
average total cost (LRATC) curve shows the lowest average total cost at
which a firm can produce each level of output in the long run, using the
optimal combination of labor and capital.
2. Economies of Scale: As a firm increases its scale of production, the LRATC
decreases. This can occur due to specialization of labor and capital, bulk
purchasing of inputs, and the use of more efficient technology. For example, a
large car manufacturer can produce cars at a lower average cost than a small
car manufacturer.
3. Constant Returns to Scale: When a firm increases its scale of production,
the LRATC remains constant. This means that the firm's average cost does
not change with the level of output.
4. Diseconomies of Scale: As a firm continues to increase its scale of
production beyond a certain point, the LRATC increases. This can be due to
problems with coordination and communication in large organizations,
increased bureaucracy, and higher input costs (e.g., having to pay higher
wages to attract skilled workers in a tight labor market).
