Chapter
8
Production
and Costs
Marginal Physical Product (MPP)
output Q
MPPl 

labor
L
• What is the variable input?
• What is the variable cost?
So…
• As more labor (VARIABLE INPUT) are added to
land (FIXED INPUT) the variable inputs would
yield smaller and smaller additions to output
Marginal Physical Product
Part (a)
(1)
VARIABLE
INPUT,
LABOR
(wo rke rs )
(2)
FIXED
INPUT,
CAPITAL
(units )
(3)
QUANTITY OF
OUTPUT, Q
(units )
0
1
0
1
2
1
1
18
37
3
4
1
1
57
76
5
1
94
6
7
1
1
111
127
(4)
MARGINAL
PHYS ICAL
Marg inal Phys ic al Pro duc t
PRODUCT OF 20
VARIABLE
INPUT (units ) 19
(3)(1)
18
18
19
17
16
MP
20
19
18
17
16
0
1
2 3 4 5 6 7
Numbe r o f Wo rke rs
Crowding Problem
• The point at which MPP declines
• Shows the law of diminishing returns
Average Physical Productivity
• Output divided by Inputs (usually labor)
•
Q
APP 
L countries.
Good for comparing firms or
So find that…
• MC and MPP are related
• What is the relationship?
 MPP  MC
 MPP  MC
Law of Diminishing Marginal Returns
(1)
VARIABLE
INPUT,
LABOR
(Wo rke rs )
(2)
FIXED
INPUT,
CAPITAL
(units )
(3)
QUANTITY OF
OUTPUT, Q
(units )
0
1
0
1
2
1
1
18
37
3
4
1
1
57
76
5
1
94
6
7
1
1
111
127
8
9
1
1
137
133
10
1
125
(4)
MARGINAL PHYS ICAL
PRODUCT OF VARIABLE
INPUT (units )
(3)(1)
18
19
20
19
18
17
16
10
–4
–8
Marginal Cost
Part (b)
(5)
TOTAL
FIXED
COS T
(dollars )
(6)
TOTAL
VARIABLE
COS T
(do llars )
(7)
TOTAL
COS T
(do llars )
(5) + (6)
$40
$0
$40
40
20
60
40
40
40
60
80
100
40
40
80
100
120
140
40
120
160
40
140
180
(8)
Marg inal Co s t (do llars )
MARGINAL
COS T
(do llars )
1.25
(7)(3)
or
1.17
(6)(3)
1.11
$1.11
$1.05
$1.00
MC
1.05
1.00
$1.05
$1.11
$1.17
$1.25
0
18 37 57 76 94 111 127
Quantity o f Output
Does this relationship make sense?
• Yes..
• If productivity increases what would happen to
costs??
– Decrease (MPP increase & MC decrease)
• Productivity decreases??
– Increase (MPP decreases & MC increases)
MPP determines shape of MC
• MPP must have a declining part because of
diminishing returns
• Can also define MC as:
wage
MC 
MPP
In-class exercise 11
How do we calculate these costs??
Give two ways to get to the cost…
Average-Marginal Rule
• Can use to see what the ATC and AVC curve look
like
• Tells us what happens when MC is above or below
the “average” curves
• If MC is above AVC and ATC
– AVC and ATC are rising
• If MC is below AVC and ATC
– AVC and ATC are falling
From Average-Marginal Rule can
infer…
• MC intersects the AVC and ATC curves at their
MINIMUM POINTS
• Cannot infer anything about AFC
Average and Marginal Cost Curves
Part (b)
Co s t
MC
ATC
L
Re g io n
1
0
Re g io n
2
Quantity o f Output
Average and Marginal Cost Curves
Co s t
Part (a)
MC
AVC
L
Re g io n
1
0
Re g io n
2
Quantity o f Output
So…
• MC gains it shape from???
– MPP and law of diminishing marginal returns
• MC below ATC: What is ATC curve doing?
– Falling
• MC above ATC: What is ATC curve doing?
– Rising
Average and Marginal Cost Curves
Part (c )
Co s t
MC
ATC
AVC
AFC
0
Quantity o f Output
MC c urve c uts
bo th AVC and
ATC c urve s at
the ir re s pe c tive
lo w po ints .
Tying Products to Costs
A CLOSER LOOK
MPP
Variable Input
MC
When MC is below
ATC, AVC
Production in the
short run: at
least one fixed input
MPP
Variable Input
MC
When MC is above
ATC, AVC
Now switching to the Long Run
• When does Long Run start?
– As soon as all inputs (costs) are VARIABLE
– No fixed costs
• Important curves
– LRTC
– LRATC
– LRMC
Short Run vs. Long Run
• Short Run assumes FIXED plant size
• Each plant size has a unique ATC curve associated
with it
– SRATC
• LRATC combines all the SRATC curves
• Which points of the SRATC???
• Minimum points
Why minimum?
• LRATC shows the lowest average cost at which a
firm can produce any given level of output
• LRATC is the lower ENVELOPE of the SRATC
curves
• Called envelope curve
Long-Run Average Total Cost Curve
(LRATC)
Part (a)
Ave rag e Co s t (do llars )
S RATC2
S RATC1
B
6
5
A
S RATC3
D
C
LRATC
(blue
c urve )
0
Q1
Q2
Quantity o f Output
Isn’t the LRATC curve smooth??
• Yes!!
• Have infinitely many SRATC curves so it would be
smooth if use all curves
• Each SRATC curve touches the LRATC curve only
once
Shape of LRATC
• U-shaped
• Decreasing, Flat, then Increasing
• Important when finding optimal long run output
level
Long-Run Average Total Cost Curve (LRATC)
Part (b)
Ave rag e Co s t (do llars )
S RATC7
S RATC1
S RATC6
S RATC2
S RATC5
S RATC3 S RATC
4
Ec o no mie s
o f S c ale
A
Co ns tant
Re turns
to S c ale
0
B
Dis e c o no mie s
o f S c ale
Quantity o f Output
Minimum
e ffic ie nt s c ale
LRATC
Economies of Scale
• Downward part of LRATC
• Average costs decrease as output increases
• If have a 1% increase in input usage what happens
to output??
– Increases by MORE than 1%
• Specialization
Constant Returns to Scale
• Flat portion of LRATC
• Costs remain the same as increase output
• If have a 1% increase in input usage what happens
to output??
– Output increases by EXACTLY 1%
• First point of constant returns to scale is called
MINIMUM EFFICIENT SCALE
Diseconomies of Scale
• Upward sloped portion of LRATC
• Costs are rising as we increase output
• If have a 1% increase in input usage what happens
to output?
– Increases by LESS THAN 1%
• Why???
– Firm too large (bad communication or coordination
problems)
Long-Run Average Total Cost Curve (LRATC)
Part (b)
Ave rag e Co s t (do llars )
S RATC7
S RATC1
S RATC6
S RATC2
S RATC5
S RATC3 S RATC
4
Ec o no mie s
o f S c ale
A
Co ns tant
Re turns
to S c ale
0
B
Dis e c o no mie s
o f S c ale
Quantity o f Output
Minimum
e ffic ie nt s c ale
LRATC
Are economies, diseconomies, and constant
returns to scale in SR, LR, or both???
• LONG RUN ONLY!!!
• Why?
– Inputs necessary for production are able to be changed
– No fixed inputs
Is this the same as diminishing returns?
• NO
• Diminishing returns is from using ONE plant size
intensely
– Short run
• Economies of scale is from CHANGING plant size
– Long run
Review
• Economies of Scale
– LRATC falling
• Constant Returns to Scale
– LRATC flat
• Diseconomies of Scale
– LRATC rising
Why does economies of scale exist?
• Large firms offer more opportunity for workers to
specialize
• Growing firms can take advantage of efficient mass
production techniques
– Smooth cost over more units produced
Why does diseconomies of scale exist?
• Communication problems
• Shirking
• Management problems
Why is minimum efficient scale
important?
• Lowest output level at which ATC are minimized
• Which has a cost advantage??
– Small firm at minimum efficient scale point
– Larger firm producing more output but still within
constant returns to scale area
– Neither
Long-Run Average Total Cost Curve (LRATC)
Part (b)
Ave rag e Co s t (do llars )
S RATC7
S RATC1
S RATC6
S RATC2
S RATC5
S RATC3 S RATC
4
Ec o no mie s
o f S c ale
A
Co ns tant
Re turns
to S c ale
0
B
Dis e c o no mie s
o f S c ale
Quantity o f Output
Minimum
e ffic ie nt s c ale
LRATC
Minimum Efficient Scale for Six Industries
INDUS TRY
Re frig e rato rs
Cig are tte s
Be e r bre wing
Petro le um refining
Paints
S ho e s
MES AS A
PERCENTAGE
OF U.S .
CONS UMPTION
14.1 %
6.6
3.4
1.9
1.4
0.2
S OURCE: F. M. S c he re r, Alan
Be c he ns te in, Eric h Kaufe r, and R. D.
Murphy, The Ec o no mic s o f Multiplant
Ope ratio n (Cambridg e , Mas s .: Harvard
Unive rs ity Pre s s , 1975), p. 80.
Where would you expect to find less
firms? (using MES)
• Firms with higher MES
• Why??
– Produce until MES
– If MES is higher then each firm will be producing more…so
need less firms to cover quantity wanted by economy
• Many SHOE companies (MES = .2)
• Few REFRIGERATOR companies (MES = 14)
Efficient Number of Firms
• 100 divided by MES
• 100% of goods are wanted by consumers
• MES is the percentage of consumption each firm will
provide
• Cigarette firm’s MES = 6.6
– Need 15 firms
• Petroleum firm’s MES = 1.9
– Need 52 firms
• Thus a larger MES means less firms needed
What cause SRTC, LRTC, and MC to
shift?
• Taxes
– Does it affect FC??
• Only if it is a lump sum tax (tax for existing)
• If it is a per unit tax then FC doesn’t change
– How does it change curves??
• Input prices
– How does it change curves??
• Technology
– Either improves production process (use less inputs)
or lower input prices
– How does it change curves??
Homework
• Chapter 8
– Questions: 3, 5, 10, and 11
• Working with numbers and graphs
– Questions 3, 6, and 7
In-class exercise 12
Do we understand Chapter 8??