Chapter 11 Lecture Presentation - Part I PDF

11 OUTPUT AND COSTS Part I Chapter Outline (A) Decision Time Frames (B) Production in the Short Run (C) Costs in the Short Run (A) Decision Time Frames The firm makes many decisions to achieve its main objective: profit maximization. Some decisions are critical to the survival...

11 OUTPUT AND COSTS Part I Chapter Outline (A) Decision Time Frames (B) Production in the Short Run (C) Costs in the Short Run (A) Decision Time Frames The firm makes many decisions to achieve its main objective: profit maximization. Some decisions are critical to the survival of the firm. Some decisions are irreversible (or very costly to reverse). Other decisions are easily reversed and are less critical to the survival of the firm, but still influence profit. All decisions can be placed in two time frames: 1- The short run 2- The long run (A) Decision Time Frames A sunk cost is a cost incurred by the firm and cannot be changed. If a firm’s plant has no resale value, the amount paid for it is a sunk cost. Sunk costs are irrelevant to a firm’s current decisions. (B) Production in the Short Run To increase output in the short run, a firm must increase the amount of labor employed. Three concepts describe the relationship between output and the quantity of labor employed: 1- Total product (TP) 2- Marginal product (MP) 3- Average product (AP) (B) Production in the Short Run 1- Total product (TP) Is the total output produced in a given period. 2- Marginal product (MP) Is the change in total product that results from a one-unit increase in the quantity of labor employed, with all other inputs remaining the same. ∆𝑇𝑃 𝑀𝑃 = ∆𝐿 3- Average product (AP) Is equal to total product divided by the quantity of labor employed. 𝑇𝑃 𝐴𝑃 = 𝐿 (B) Production in the Short Run Example: In the short as shown in the table to the right: As the quantity of labor employed increases: TP increases firstly at an increasing rate and then at a decreasing rate. MP increases initially, and then decreases. AP firstly increases and then decreases. (B) Production in the Short Run Product Curves 1- Total Product Curve The total product curve shows how total product changes with the quantity of labor employed. The total product curve is like the PPF. It separates attainable output levels from unattainable output levels in the short run. (B) Production in the Short Run The total product curve can be drawn as the sum of MP of a certain level of workers hired, as shown in the graph to the right. The height of each bar measures the MP of labor. For example, when labor increases from 2 to 3, TP increases from 10 to 13, so, the MP of the third worker is 3 units of output. MP is the slope of TP. (B) Production in the Short Run 2- Marginal Product Curve To make a graph of the marginal product of labor, we can stack the bars in the previous graph side by side. The marginal product of labor curve passes through the mid-points of these bars. MP behaves in this way in the short run due to the law of diminishing returns. (B) Production in the Short Run In the short run, almost all production processes have: (a) Increasing marginal returns initially Initially, the MP of a worker exceeds the MP of the previous worker. Such increasing marginal returns arise from increased specialization and division of labor. (b) Diminishing marginal returns eventually Eventually, the MP of a worker is less than the MP of the previous worker. Such diminishing marginal returns arise because each additional worker has less access to capital and less space in which to work. This is illustrated by the law of diminishing returns. (B) Production in the Short Run The law of diminishing returns states that: As a firm uses more of a variable input with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes. Accordingly, the average product curve can be illustrated while focusing on how AP is following MP as represented in the next graph. Think: Why average product is following marginal product? (B) Production in the Short Run 3- Average Product Curve Based on the graph: (a) When MP exceeds AP, AP increases. (b) When MP is below AP, AP decreases. (c) When MP equals AP, AP is at its maximum.