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P&R Chaps 6-7 - Production
Production
76
Economics
Graduate
09/24/2013

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Term
theory of the firm
Definition
describes how firms make cost-minimizing production decisions and how a firm's result cost varies with its output

* assumes that firm is always using cost-minimizing combination of inputs
Term
3 factors of production
Definition
1. production technology - how inputs (labor, capital and raw materials) are transformed into outputs

2. cost constraints - prices of labor, capital and other inputs

3. input choices -- how much of each input to use in producing its output (e.g. if firm operates in country with low wages, may decide to use more labor and less capital and technology)
Term
production function
Definition
indicates highest output that a firm can produce for every specified combination of inputs

q = F(K,L)

[L= Labor, K = Capital, q = production]

* applied to a given technology (i.e. understanding that production methods can change)

* describes what is technically feasible when the firm operates efficiently
Term
inputs and outputs are flows
Definition
*meaning that... unless otherwise indicated, talking about amount of labor and capital used each year and output produced each year
Term
short run
Definition
period of time in which quantities of one or more production factors CANNOT be changed

(for example, amount of capital is a fixed input.)
(over a month or two, a firm is unlikely to be able to substitute very much capital for labor)
Term
fixed input
Definition
production factor that cannot be varied (at least one input will be fixed during the short run
Term
long run
Definition
amount of time needed to make all production inputs variable

i.e.... over time, one can change variables such as capital and labor

*changes from one industry to the next. lemonade stand = 3 days. auto plant = 10 years
Term
short run vs long run
Definition
in short run, firms vary the intensity with which they utilize a given plant and machinery.

in the long run, a firm will vary the size of the plant itself.
Term
average product
Definition
output per unit of a particular input

e.g. average product of labor = output/labor input = q/L
Term
marginal product
Definition
additional output produced as an input is increased by one unit

(usually talking about small changes)
Term
average product of labor
Definition
output/labor input = q/L
Term
marginal product of labor
Definition
change in output/change in labor input = change q/ change L
Term
when capital is fixed but labor is variable...
Definition
only way for firms to increase output is by increasing labor input
Term
when MP (marginal product) > AP (average product)
Definition
AP increases
Term
when MP < AP
Definition
AP decreases
Term
AP is maximized where...
Definition
AP = MP
Term
slope of total product curve (with fixed capital)
Definition
change q/change L (or... MPL)
Term
law of diminishing marginal returns (to labor w/ fixed capital)
Definition
as the use of an input increases in equal increments (with other inputs fixed), a point will eventually be reached at which the resulting additions to output decrease)

*dont confuse diminishing marginal returns with *negative* returns -- the law describes a *declining* marginal product, but not necessarily a negative one.

i.e. product usually just increases more slowly and less per worker.
Term
slope when total output is maximized
Definition
zero
Term
effect of technological improvement
Definition
labor productivity (output per unit of labor) can increase technology improves

* delays diminishing returns?
Term
labor productivity
Definition
average product of labor for an entire industry (or for the economy as a whole)
Term
Isoquant
Definition
Curve showing all possible combinations of inputs that yield the same output

q1 = {L1, K1}

*downward sloping and convex

(two-variable inputs)
Term
isoquant map
Definition
graph combining a number of isoquants, used to describe a production function

(firms grow as q increases)
Term
marginal rate of technical substitution (MRTS)
Definition
ability of firm to replace one input (capital) with another (labor) while maintaining same level of output

i.e. amount by which the quantity of one input can be reduced when one extra unit of another input is used, so that output remains constant

MRTS = - changeK/changeL (for a fixed level of Q)
Term
slope of isoquant
Definition
measures MRTS (- changeK/changeL) at any point
Term
diminishing MRTS
Definition
MRTS falls as we move down along an isoquant

- tells us that productivity for any one input is limited. production usually needs a mix of both inputs (cant rely fully on labor or capital)
Term
returns to scale
Definition
rate at which output increases as inputs are increased proportionately
Term
increasing returns to scale
Definition
situation in which output more than doubles when all inputs are doubled
Term
constant returns to scale
Definition
situation in which output doubles when all inputs are doubled
Term
decreasing returns to scale
Definition
situation in which output less than doubles when al inputs are doubled
Term
accounting cost
Definition
actual expenses plus depreciation charges for capital equipment.
Term
economic cost
Definition
cost to a firm of utilizing economic resources in production, including opportunity cost

*"economic" tells us to distinguish between costs that a firm can control and those it cannot.
Term
opportunity cost
Definition
cost associated with opportunities that are forgone when a firm's resources are not put to their best alternative use

(e.g. guy quitting his job to start a new company)
(e.g. a company not renting out the building it owns)
Term
sunk cost
Definition
expenditure that has been made and cannot be recovered

e.g. equipment that can only be used for its original purpose and cannot be converted for alternative use
- or... r&d and marketing costs

**the book assumes that firms treat any sunk cost *of capital* as a fixed cost spread out over time
Term
should sunk costs influence a firm's decisions?
Definition
no it should not, even though they are more obvious then opportunity costs.
Term
should opportunity costs influence a firm's decisions?
Definition
yes they should, even if they are hidden.
Term
prospective sunk cost
Definition
- an investment
e.g. a firm considering buying specialized equipment. the firm must decide whether the purchase is economical -- i.e. whether it will generate revenues that can justify its cost.
Term
total cost (TC or C)
Definition
total economic cost of production, consisting of fixed and variable costs
Term
fixed costs (FC)
Definition
cost that does not vary with the level of output -- it must be paid even if there is no output -- and that can be eliminated only by shutting down.

eg: rent

*over a very short time horizon, most costs are fixed, due to contracts and labor inflexibility
Term
variable cost (VC)
Definition
a cost that varies as output varies

eg: wages, salaries, raw materials used
Term
shutting down
Definition
doesnt necessarily mean going out of business -- can involve downsizing by shuttering certain stores/factories
Term
amortization
Definition
policy of treating a one-time expenditure as an annual cost spread out over some number of years
Term
amortizing sunk costs
Definition
- shutting down still wont make the annual cost go away (so its not *really* fixed)
- still... simplifies economic analysis by, say, making it easier to understand the tradeoff that a firm faces in its use of labor versus capital.
Term
Marginal Cost (MC)
Definition
the increase in cost resulting from the production of one extra unit of output

- also sometimes called incremental cost

MC = changeVC/changeQ
or...
MC = changeTC/changeQ

(this is because fixed cost does not change as the firm's level of output changes)
Term
Average Total Cost (ATC)
Definition
total cost divided by its level of output
Term
Average Fixed Cost (AFC)
Definition
fixed cost divided by level of output (FC/q)

- declines as the rate of output increases, since fixed costs are constant.
Term
Average Variable Cost (AVC)
Definition
variable cost divided by level of output
Term
determinants of short-run costs
Definition
Term
diminishing marginal returns to labor occur when...
Definition
the marginal product of labor is decreasing (ch. 6)
Term
if labor is only input...
Definition
to produce more output, firm must hire more labor. then... if the marginal product of labor decreases as the amount of labor hired is increased (due to diminishing returns), successively greater expenditures must be made the produce output at the higher rate. As a result, variable and total costs increase as the rate of output is increased.

on the other hand... if the marginal product of labor decreases only slightly as the amount of labor is increased, costs will not rise so quickly when the rate of output is increased.
Term
formulas in 7.2
Definition
check these

Marginal Costs = ∆Variable Costs/∆Q = wages(∆ Labor)/∆ Q

therefore...

MC = wages/Marginal Product of labor (MPL)

*don't forget: MPL = ∆ in output/∆ in labor input = ∆ q/ ∆ L
Term
diminishing marginal returns
Definition
means that the marginal product of labor (MPl) declines as the quantity of labor employed increases.

- as a result, when there are diminishing marginal returns, marginal cost will increase as output increases.
Term
how wages affect MC
Definition
MC = w/MPl
Term
the shape of the total cost curve (TC)
Definition
determined by vertically adding the fixed cost curve to the variable cost curve. (distance between TC and VC is constant)
Term
whenever the marginal cost curve lies below average cost curve...
Definition
... average cost curve falls.
Term
whenever the marginal cost curve is above the average cost curve...
Definition
... average cost curve rises.
Term
the vertical distance between the ATC curve and the AVC curve...
Definition
decrease as output increases, because ATC is the sum of AVC and AFC and the AFC curve declines everywhere.

* MC = AVC at its minimum point and ATC at its minimum point
Term
user cost of capital
Definition
annual cost of owning and using a capital asset, equal to economic depreciation +(interest rate)(value of capital)
Term
isocost line
Definition
graph showing all possible combinations that can be purchased for a given total cost.

... K=C/r - (w/r)L

slope: ∆K/∆L = -(w/r)
Term
rental rate
Definition
cost per year of renting one unit of capital

*in a competitive capital market, the rental rate should be equal to the user cost, r
i.e... capital that is purchased can be treated as though it were rented at a rental rate equal to the user cost of capital

** book assumes that firm rents all of its capital at a rental rate, or "price" r, just as it hires labor at a wage rate, or "price" w
Term
when a firm minimizes the cost of producing a particular output...
Definition
MPl/MPk = w/r
or...
MPl/w = MPk/r

MPl/w is the additional output that results from spending an additional dollar for labor
Term
expansion path
Definition
curve passing through points of tangency between a firm's isocost lines and its isoquants

- describes the combinations of labor and capital that the firm will choose to minimize costs at each output level

* as long as the use of both labor and capital increases with output, the curve will be upward sloping
Term
long-run average cost curve (LAC)
Definition
curve relating to average cost of production to output when all inputs, including capital, are variable

- U-shaped
Term
short-run average cost curve (SAC)
Definition
curve relating to the average cost of production to output when level of capital is fixed

- U-shaped
Term
long-run marginal cost curve (LMC)
Definition
curve showing the change in long-run total costs as output is increase incrementally by 1 unit.
Term
LMC and LAC intersect...
Definition
... at where the LAC curve achieves its minimum.
Term
economies of scale
Definition
situation in which output can be doubled for less than a doubling of cost

- marginal cost will be less than average cost (both are falling)

- often measured in terms of cost-output elasticity:
Ec = (∆C/C)/(∆q/q) = MC/AC
Term
diseconomies of scale
Definition
situation in which a doubling of output requires more than a doubling of cost

- marginal cost will be higher than average cost (both are rising)
Term
increasing returns to scale
Definition
output more than doubles when the quantities of all inputs are doubled

(compare this to diseconomies of scale...)
Term
product transformation curve
Definition
shows the various combinations of two different outputs (products) that can be produced with a given set of inputs
Term
economies of scope
Definition
situation in which joint output of a single firm is greater than the output that could be achieved by two different firms when each produces a single product
Term
diseconomies of scope
Definition
situation in which joint output of a single firm is less than could be achieved by separate firms when each produces a single product
Term
degree of economies of scope
Definition
percentage of cost savings resulting when two or more products are produced jointly rather than individually.
Term
learning curve
Definition
graph relating amount of inputs needed by a firm to produce each unit of output to its cumulative output

(don't know if need to know this... more in book)
Term
cost-output elasticity (Ec)
Definition
the percentage change in the cost of production resulting from a 1-percent increase in output.

*often used to measure economies of scale

Ec = (∆C/C)/(∆q/q)
or...
Ec = (∆C/∆q)/(C/q) = MC/AC
Term
when there are economies of scale...
Definition
(i.e. when costs increase less than proportionately with output)

- marginal cost is less than average cost (both are declining)
- Cost-output elasticity (Ec) is less than 1
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