Krugman/Wells Economics 6e Ch 11 PDF

WHAT YOU WILL LEARN IN THIS CHAPTER 11 What is the firm’s production function? Why is production often subje...

WHAT YOU WILL LEARN IN THIS CHAPTER 11 What is the firm’s production function? Why is production often subject to diminishing returns to inputs? What types of costs does a firm face, and how does the firm generate its marginal and average cost curves? Why do the firm’s costs differ in the short run and in the long run? Behind the Supply Curve: What is increasing returns to scale, and what advantage does it give? Inputs and Costs Revised by Vitaly Terekhov Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers THE PRODUCTION FUNCTION INPUTS AND OUTPUT A firm is an organization that produces goods or services for sale. The long run is the period in which all inputs can be varied. Production is the process of turning inputs into outputs. The short run is the period in which at least one input is fixed. A production function is the relationship between the quantity The total product curve shows how the quantity of output of inputs a firm uses and the quantity of output it produces. depends on the quantity of the variable input for a given quantity A fixed input is an input whose quantity is fixed for a period of of the fixed input. time and cannot be varied. A variable input is an input whose quantity the firm can vary at any time. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  PRODUCTION FUNCTION AND TOTAL PRODUCT PRODUCTION FUNCTION AND TOTAL PRODUCT CURVE (1 of 2) CURVE (2 of 2) Figure 11-1 The marginal product of an input is the additional quantity of output that is produced by using one more unit of that input. Marginal product of labor (MPL) is the change in output resulting from a one-unit increase in the amount of labor input (ΔQ/ΔL) MPL equals the slope of the total product curve. In Figure 11-1, MPL declines as more workers are hired. As employment increases, the total product curve gets flatter. Figure 11-2 shows how MPL depends on the number of workers: The curve slopes upward because more wheat is produced as more workers are employed. It becomes flatter because the marginal product of labor declines as more workers are employed. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers DIMINISHING RETURNS TO AN INPUT LEARN BY DOING: PRACTICE QUESTION 1 Diminishing returns to an input: an increase in the quantity of that input, holding the levels of all other inputs fixed, reduces that input’s marginal product. If one worker makes 14 baskets, two workers make 34 baskets, three workers make 45 baskets, and four workers make 50 baskets, which worker yielded the highest marginal product? a) the first worker b) the second worker c) the third worker d) the fourth worker Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  LEARN BY DOING: PRACTICE QUESTION 1 (Answer) LEARN BY DOING: PRACTICE QUESTION 2 If one worker makes 14 baskets, Marginal product is the slope of the: two workers make 34 baskets, three workers make 45 baskets, and a) marginal cost curve. four workers make 50 baskets, which worker yielded the highest marginal product? b) total product curve. a) the first worker c) long-run average total cost curve. b) the second worker (correct answer) c) the third worker d) total cost curve. d) the fourth worker Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers LEARN BY DOING: PRACTICE QUESTION 2 (Answer) TOTAL PRODUCT, MARGINAL PRODUCT, AND FIXED INPUT Figure 11-3 Marginal product is the slope of the: a) marginal cost curve. b) total product curve. (correct answer) c) long-run average total cost curve. d) total cost curve. With more land (fixed input) each worker can produce more. This shifts the total product curve up. So the MPL of each worker is higher when the farm is larger; the MPL curve shifts up, too. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  PITFALLS: WHAT’S A UNIT? LEARN BY DOING: DISCUSSION QUESTION 1 Thomas Malthus (1766–1834) predicted that as population grew, the The MPL is defined as the increase in the quantity of output when you economy’s diminishing ability to produce food from a given set of increase the quantity of that input by one unit. resources would necessarily lead to insufficient food. However, What do we mean by a unit of labor? Is it an additional hour of labor, population continues to grow, and so does food production. an additional week, or a person-year? What aspect of food production did Malthus fail to anticipate? The answer is that it doesn’t matter, as long as you are consistent. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers FROM THE PRODUCTION FUNCTION TO COST CURVES LEARN BY DOING: PRACTICE QUESTION 3 A fixed cost is a cost that does not depend on the quantity You own a deli. Which of the following is most likely a fixed input at your deli? of output produced. It is the cost of the fixed input. a) the dining room A variable cost is a cost that depends on the quantity of b) the bread used to make sandwiches output produced. It is the cost of the variable input. c) the tomato base used to make soups d) the employees Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  LEARN BY DOING: PRACTICE QUESTION 3 (Answer) TOTAL COST CURVE The total cost of producing a given quantity of output is the sum of the fixed cost and the variable cost of producing that quantity of output. You own a deli. Which of the following is most likely a fixed input TC = FC + VC at your deli? The total cost curve shows how total cost depends on the quantity of a) the dining room (correct answer) output. b) the bread used to make sandwiches The total cost curve becomes steeper as more output is produced, a result of diminishing returns. c) the tomato base used to make soups d) the employees With diminishing returns, additional units of output require more and more labor; therefore the cost increases. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers MARGINAL COST TOTAL COST CURVE The marginal cost is the change in total cost generated by one additional unit of output. Figure 11-4: MC = ΔTC/ΔQ The curve gets where Δ = change, TC = total cost, and Q = quantity of output steeper as output increases due to diminishing returns to labor. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  MARGINAL COST EXAMPLE MARGINAL COST GRAPHS TABLE 11-1 Costs at Selena’s Gourmet Salsas Figure 11-6 Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers WHY IS THE MARGINAL COST CURVE UPWARD SLOPING? AVERAGE COST Because there are diminishing returns to inputs in this Average total cost (often referred to simply as average cost) = total cost example. As output increases, the marginal product of the per unit of output produced. variable input declines. ATC = TC/Q This implies that more and more of the variable input must be used to produce each additional unit of output as the amount Average fixed cost = fixed cost per unit of output produced. of output already produced rises. AFC = FC/Q And since each unit of the variable input must be paid for, the Average variable cost = variable cost per unit of output produced. cost per additional unit of output also rises. AVC = VC/Q Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  LEARN BY DOING: PRACTICE QUESTION 4 LEARN BY DOING: PRACTICE QUESTION 4 (Answer) You produce widgets. Currently you produce 4 widgets at a total cost You produce widgets. Currently you produce 4 widgets at a total cost of $40. of $40. Suppose you could produce one more widget (the fifth) at a marginal Suppose you could produce one more widget (the fifth) at a marginal cost of $5. If you do produce that fifth widget, what will your cost of $5. If you do produce that fifth widget, what will your average total cost be? Has your average total cost increased or average total cost be? Has your average total cost increased or decreased? decreased? a) Your average total cost has decreased to $11. a) Your average total cost has decreased to $11. b) Your average total cost has decreased to $9. b) Your average total cost has decreased to $9. (correct answer) c) Your average total cost has increased to $9. c) Your average total cost has increased to $9. d) Your average total cost has increased to $11. d) Your average total cost has increased to $11. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers AVERAGE COSTS FOR SELENA’S GOURMET SALSAS AVERAGE TOTAL COST CURVE FOR SELENA’S GOURMET SALSAS TABLE 11-2 Average Costs for Selena’s Gourmet Salsas Quantity Average total cost of Average variable cost of Figure 11-7 Total cost Average fixed cost of case of salsa case case TC AFC = FC/Q Q (cases) ATC = TC/Q AVC = VC/Q 1 $120 $120.00 $108.00 $12.00 2 156 78.00 54.00 24.00 3 216 72.00 36.00 36.00 4 300 75.00 27.00 48.00 5 408 81.60 21.60 60.00 6 540 90.00 18.00 72.00 7 696 99.43 15.43 84.00 8 876 109.50 13.50 96.00 9 1,080 120.00 12.00 108.00 10 1,308 130.80 10.80 120.00 Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  AVERAGE TOTAL COST CURVE PUTTING THE FOUR COST CURVES TOGETHER Increasing output has two opposing effects on average total Note that: cost: 1. Marginal cost slopes upward because of diminishing returns. – The spreading effect: The larger the output, the more output 2. Average variable cost also slopes upward but is flatter than the over which fixed cost is spread, leading to lower average fixed cost. marginal cost curve. – The diminishing returns effect: The larger the output, the 3. Average fixed cost slopes downward because of the spreading more variable input required to produce additional units, which effect. leads to higher average variable cost. 4. The marginal cost curve intersects the average total cost curve from below, crossing it at its lowest point. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers MARGINAL COST AND AVERAGE COST CURVES FOR LEARN BY DOING: PRACTICE QUESTION 5 SELENA’S GOURMET SALSAS Figure 11-8 At high levels of output the spreading effect is: a) stronger than the diminishing returns effect. b) weaker than the diminishing returns effect. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  LEARN BY DOING: PRACTICE QUESTION 5 (Answer) MINIMUM AVERAGE TOTAL COST At high levels of output the spreading effect is: The minimum-cost output is the quantity of output at which a) stronger than the diminishing returns effect. average total cost is lowest—the bottom of the U-shaped b) weaker than the diminishing returns effect. (correct average total cost curve. answer) Three general principles are always true about a firm’s marginal cost and average total cost curves: 1. At the minimum-cost output, average total cost is equal to marginal cost. 2. At output less than the minimum-cost output, marginal cost is less than average total cost and average total cost is falling. 3. At output greater than the minimum-cost output, marginal cost is greater than average total cost and average total cost is rising. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers DOES THE MARGINAL COST CURVE ALWAYS SLOPE THE RELATIONSHIP BETWEEN THE AVERAGE TOTAL UPWARD? (1 of 2) COST AND THE MARGINAL COST CURVES Figure 11-9 Marginal cost curves often slope downward as the output goes from zero up to some low level, and they slope upward at higher levels of production. The initial downward slope occurs when employing more workers allows them to specialize in various tasks. This specialization leads to increasing returns to the hiring of additional workers and results in the marginal cost curve sloping downward. Once enough workers exhaust the benefits of specialization, diminishing returns to labor set in and the marginal cost curve slopes upward. Typical marginal cost curves have the “swoosh” shape. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  DOES THE MARGINAL COST CURVE ALWAYS SLOPE SHORT-RUN VERSUS LONG-RUN COSTS UPWARD? (2 of 2) Figure 11-10 All inputs are variable in the long run. This means that in the long run, fixed cost (like factory size) may also vary. The firm will choose its fixed cost in the long run based on the level of output it expects to produce. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers Figure 11-11 THE LONG-RUN AVERAGE TOTAL COST CURVE CHOOSING THE LEVEL OF FIXED COST The long-run average total cost curve shows the relationship between output and average total cost when fixed cost has been There is a trade-off chosen to minimize average total cost for each level of output. between higher – (We assume the firm has chosen the cheapest plant size for fixed cost and lower each output level.) variable cost for any given output level, and vice versa. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers  SHORT-RUN AND LONG-RUN AVERAGE TOTAL COST CURVES RETURNS TO SCALE Short-run and long-run average total cost curves differ Figure 11-12 because a firm can choose its fixed cost in the long run. There are increasing returns to scale (economies of scale) when long-run average total cost declines as output increases. If the firm chooses the fixed There are decreasing returns to scale (diseconomies of cost that minimizes short-run scale) when long-run average total cost increases as output ATC at an output of 6, and produces 6, it’s at point C. increases. If it produces only 3, it’ll move There are constant returns to scale when long-run average to point B. total cost is constant as output increases. If the firm expects to produce 3 cases for a long time, it’ll reduce its fixed cost and move to point A. If it produces 9 (point Y) and expects to continue this for a long time, it’ll increase its fixed cost and move to point X. Krugman, Economics, 6e, © 2021 2020 Worth Publishers Krugman, Economics, 6e, © 2021 2020 Worth Publishers