chapter:
12
>
> Behind the Supply
Curve: Inputs and
Costs
Krugman/Wells
©2009 Worth Publishers 1 of 41
WHAT YOU WILL LEARN IN THIS CHAPTER
The importance of the firm’s production function,
the relationship between quantity of inputs and
quantity of output
Why production is often subject to diminishing
returns to inputs
The various types of costs a firm faces and how they
generate the firm’s marginal and average cost
curves
Why a firm’s costs may differ in the short run versus
the long run
How the firm’s technology of production can
generate increasing returns to scale
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The Production Function
A production function is the relationship between
the quantity of inputs a firm uses and the quantity of
output it produces.
A fixed input is an input whose quantity is fixed for
a period of time and cannot be varied.
A variable input is an input whose quantity the firm
can vary at any time.
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Inputs and Output
The long run is the time period in which all inputs
can be varied.
The short run is the time period in which at least
one input is fixed.
The total product curve shows how the quantity of
output depends on the quantity of the variable input,
for a given quantity of the fixed input.
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Production Function and TP Curve for
George and Martha’s Farm
Quantity of
wheat (bushels)
Adding a 7th
worker leads to Quantity Quantity MP of labor
an increase in of labor of wheat MPL=Q/L
output of only 7 L
(worker) Q (bushels per worker)
(bushels)
bushels Total product, TP 0 0
100 Adding a 2nd 19
1 19
worker leads to 17
80 an increase in 2 36
output of only 17 15
3 51
bushels 13
60 4 64
11
5 75
40 9
6 84
7
7 91
20 5
8 96
0 1 2 3 4 5 6 7 8
Quantity of labor (workers)
Although the total product curve in the figure slopes upward along its entire
length, the slope isn’t constant: as you move up the curve to the right, it flattens
out due to changing marginal product of labor.
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Marginal Product of Labor
The marginal product of an input is the additional
quantity of output that is produced by using one
more unit of that input.
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Diminishing Returns to an Input
There are diminishing returns to an input when
an increase in the quantity of that input, holding the
levels of all other inputs fixed, leads to a decline in
the marginal product of that input.
The following marginal product of labor curve
illustrates this concept clearly…
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Marginal Product of Labor Curve
Marginal
product of
labor
(bushels per
worker) There are
19 diminishing
17 returns to labor.
15
13
11
9
7
5
Marginal product of labor, MPL
0 1 2 3 4 5 6 7 8
Quantity of labor (workers)
Here, the first worker employed generates an increase in output
of 19 bushels, the second worker generates an increase of 17
bushels, and so on…
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Total Product, Marginal Product, and the Fixed Input
Quantity Marginal product
of wheat of labor
(bushels) (bushels per
worker)
160 30
140 TP
20 25
120
100 TP 20
10
80 15
60
10
40 MPL
5 20
20 MPL
10
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
Quantity of labor (workers) Quantity of labor (workers)
(a) Total Product Curves (b) Marginal Product Curves
With more land, each worker can This shift also implies that the
produce more wheat. So an marginal product of each worker is
increase in the fixed input shifts the higher when the farm is larger. As
total product curve up from TP10 to a result, an increase in acreage
TP20. also shifts the marginal product of
labor curve up from MPL10 to
MPL20.
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PITFALLS
What’s a Unit?
The marginal product of labor (or any other input) is defined
as the increase in the quantity of output when you increase
the quantity of that input by one unit.
What do we mean by a “unit” of labor? Is it an additional
hour of labor, an additional week, or a person-year?
The answer is that it doesn’t matter, as long as you are
consistent.
One common source of error in economics is getting units
confused—say, comparing the output added by an additional
hour of labor with the cost of employing a worker for a week.
Whatever units you use, always be careful that you use the
same units throughout your analysis of any problem.
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From the Production Function to Cost Curves
A fixed cost is a cost that does not depend on the
quantity of output produced. It is the cost of the fixed
input.
A variable cost is a cost that depends on the
quantity of output produced. It is the cost of the
variable input.
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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.
TC = FC + VC
The total cost curve becomes steeper as more
output is produced due to diminishing returns.
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Total Cost Curve for George and Martha’s Farm
Cost
Total cost, TC
$2,000
I
1,800
H
1,600
G
1,400
F
1,200
E
1,000
D
800
C
600
B
400
A
200
0 19 36 51 64 75 84 91 96
Quantity of wheat (bushels)
Quantity Quantity of Variable Fixed Total
Point on of labor L wheat Q cost Cost cost
graph (VC) (FC)
(worker) (bushels) (TC = FC +
VC)
A 0 0 $O $400 $400
B 1 19 200 400 600
C 2 36 400 400 800
D 3 51 600 400 1,000
E 4 64 800 400 1,200
F 5 75 1,000 400 1,400
G 6 84 1,200 400 1,600
H 7 91 1,400 400 1,800
I 8 96 1,600 400 2,000
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►ECONOMICS IN ACTION
Case: The Mythical Man-Month
“Adding another programmer on a project actually
increases the time to completion”
The source of the diminishing returns lies in the nature of
the production function for a programming project: Each
programmer must coordinate his or her work with that of
all the other programmers on the project, leading to each
person spending more and more time communicating
with others as the number of programmers increases.
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The Mythical Man-Month
Quantity of
software code
(lines) TP
Beyond a certain
point, an additional
programmer is
counterproductive.
0 Quantity of labor (programmers)
Marginal product
of labor (lines per
programmer)
MPL
Quantity of labor (programmers)
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Two Key Concepts: Marginal Cost and Average
Cost
As in the case of marginal product, marginal cost is
equal to “rise” (the increase in total cost) divided by
“run” (the increase in the quantity of output).
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Costs at Selena’s Gourmet Salsas
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Total Cost and Marginal Cost Curves for Selena’s
Gourmet Salsas
(a) Total Cost (b) Marginal Cost
Cost Cost of
case
8th case of salsa
$1,400 increases total TC $250 MC
cost by $180.
1,200
200
1,000 2nd case of
salsa
800 150
increases
total cost by
600 $36. 10
0
400
50
200
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Quantity of salsa (cases) Quantity of salsa (cases)
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Why is the Marginal Cost Curve Upward Sloping?
Because there are diminishing returns to inputs in
this example. As output increases, the marginal
product of the variable input declines.
This implies that more and more of the variable
input must be used to produce each additional unit
of output as the amount of output already produced
rises.
And since each unit of the variable input must be
paid for, the cost per additional unit of output also
rises.
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Average Cost
Average total cost, often referred to simply as
average cost, is total cost divided by quantity of
output produced.
ATC = TC/Q = (Total Cost) / (Quantity of Output)
A U-shaped average total cost curve falls at low
levels of output, then rises at higher levels.
Average fixed cost is the fixed cost per unit of
output.
AFC = FC/Q = (Fixed Cost) / (Quantity of Output)
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Average Cost
Average variable cost is the variable cost per unit
of output.
AVC = VC/Q= (Variable Cost) / (Quantity of Output)
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Average Total Cost Curve
Increasing output, therefore, has two opposing
effects on average total cost—the “spreading
effect” and the “diminishing returns effect”:
The spreading effect: the larger the output, the greater
the quantity of output over which fixed cost is spread,
leading to lower the average fixed cost.
The diminishing returns effect: the larger the output,
the greater the amount of variable input required to
produce additional units leading to higher average
variable cost.
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Average Costs for Selena’s Gourmet Salsas
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Average Total Cost Curve for Selena’s Gourmet
Salsas
Cost of
case
$140 Average total cost, ATC
Minimum
120 average
total
cost
100
80 M
60
40
20
0 1 2 3 4 5 6 7 8 9 10
Quantity of salsa (cases)
Minimum-cost output
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Putting the Four Cost Curves Together
Note that:
1. Marginal cost is upward sloping due to diminishing
returns.
2. Average variable cost also is upward sloping but is
flatter than the marginal cost curve.
3. Average fixed cost is downward sloping because of
the spreading effect.
4. The marginal cost curve intersects the average total
cost curve from below, crossing it at its lowest point.
This last feature is our next subject of study.
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Marginal Cost and Average Cost Curves for
Selena’s Gourmet Salsas
Cost of case The bottom of the U
curve is at the level
$250
of output at which
MC the marginal cost
200 curve crosses the
average total cost
150
ATC
curve from below.
100
AVC
Is this an accident?
M
No!
50
AFC
0 1 2 3 4 5 6 7 8 9 10
Quantity of salsa (cases)
Minimum-cost output
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General Principles That Are Always True About a Firm’s
Marginal and Average Total Cost Curves
The minimum-cost output is the quantity of output
at which average total cost is lowest —the bottom of
the U-shaped average total cost curve.
At the minimum-cost output, average total cost is equal
to marginal cost.
At output less than the minimum-cost output, marginal
cost is less than average total cost and average total
cost is falling.
And at output greater than the minimum-cost output,
marginal cost is greater than average total cost and
average total cost is rising.
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The Relationship Between the Average Total Cost
and the Marginal Cost Curves
Cost of unit
MC
If marginal cost is
above average ATC
total cost, average MC
H
total cost is rising.
B
2
A
1
M B
A 1
2
MC If marginal cost is
L
below average
total cost, average
total cost is falling.
Quantity
When marginal cost equals average total cost, we must be at the
bottom of the U, because only at that point is average total cost
neither falling nor rising.
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Does the Marginal Cost Curve Always Slope
Upward?
In practice, marginal cost curves often slope
downward as a firm increases its production from
zero up to some low level, sloping upward only at
higher levels of production.
This initial downward slope occurs because a firm
that employs only a few workers often cannot reap
the benefits of specialization of labor. This
specialization can lead to increasing returns at first,
and so to a downward-sloping marginal cost curve.
Once there are enough workers to permit
specialization, however, diminishing returns set in.
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More Realistic Cost Curves
Cost of unit
MC
2. … but diminishing returns ATC
set in once the benefits
from specialization are
exhausted and marginal AVC
cost rises.
1. Increasing specialization
leads to lower marginal
cost…
Quantity
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Short-Run versus Long-Run Costs
In the short run, fixed cost is completely outside the
control of a firm. But all inputs are variable in the
long run: This means that in the long run fixed cost
may also be varied. In the long run, in other words,
a firm’s fixed cost becomes a variable it can choose.
The firm will choose its fixed cost in the long run
based on the level of output it expects to produce.
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Choosing the Level of Fixed Cost of Selena’s
Gourmet Salsas
Cost of At low output levels, At high output
case low fixed cost yields levels, high fixed
lower average total cost yields lower
$250
cost average total cost
There is a trade-off
200
between higher
150 Low fixed cost fixed cost and lower
100
ATC1
variable cost for
ATC
2
any given output
50 High fixed cost level, and vice
versa.
0 1 2 3 4 5 6 7 8 9 10
Quantity of salsa (cases) But as output goes
Low fixed cost (FC = $108)
Averag
High fixed cost (FC = $216)
Averag
up, average total
Quantit
y of
High
variable Total
e total
cost of
Low
variabl Total
cost
e total
cost of
cost is lower with
salsa
(salsa) cost cost case
ATC1
e cost case
ATC2 the higher amount
1
2
$12
48
$120
156
$120.00
78.00
$6
24
$222
240
$222.00
120.00
of fixed cost.
3 108 216 72.00 54 270 90.00
4 192 300 75.00 96 312 78.00
5 300 408 81.60 150 366 73.20
6 432 540 90.00 216 432 72.00
7 588 696 99.43 294 510 72.86
8 768 876 109.50 384 600 75.00
9 972 1,080 120.00 486 702 78.00
10 1,200 1,308 130.80 600 816 81.60
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The Long-run Average Total Cost Curve
The long-run average total cost curve shows the
relationship between output and average total cost
when fixed cost has been chosen to minimize
average total cost for each level of output.
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Short-Run and Long-Run Average Total Cost
Curves
Cost of case
Consta
nt
Increasing returns to scale returns Decreasing returns to scale
to scale
ATC ATC ATC LRATC
3 6 9
B Y
A X
C
0 3 4 5 6 7 8 9
Quantity of
salsa (cases)
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Returns to Scale
There are increasing returns to scale
(economies of scale) when long-run average
total cost declines as output increases.
There are decreasing returns to scale
(diseconomies of scale) when long-run average
total cost increases as output increases.
There are constant returns to scale when long-
run average total cost is constant as output
increases.
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SUMMARY
1. The relationship between inputs and output is a producer’s
production function. In the short run, the quantity of a
fixed input cannot be varied but the quantity of a variable
input can. In the long run, the quantities of all inputs can
be varied. For a given amount of the fixed input, the total
product curve shows how the quantity of output changes
as the quantity of the variable input changes.
2. There are diminishing returns to an input when its
marginal product declines as more of the input is used,
holding the quantity of all other inputs fixed.
3. Total cost is equal to the sum of fixed cost, which does
not depend on output, and variable cost, which does
depend on output.
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SUMMARY
4. Average total cost, total cost divided by quantity of
output, is the cost of the average unit of output, and
marginal cost is the cost of one more unit produced. U-
shaped average total cost curves are typical, because
average total cost consists of two parts: average fixed
cost, which falls when output increases (the spreading
effect), and average variable cost, which rises with output
(the diminishing returns effect).
5. When average total cost is U-shaped, the bottom of the U
is the level of output at which average total cost is
minimized, the point of minimum-cost output. This is also
the point at which the marginal cost curve crosses the
average total cost curve from below.
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SUMMARY
6. In the long run, a producer can change its fixed input and
its 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 chosen to minimize
average total cost at each level of output.
7. As output increases, there are increasing returns to
scale if long-run average total cost declines; decreasing
returns to scale if it increases; and constant returns to
scale if it remains constant. Scale effects depend on the
technology of production.
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The End of Chapter 12
Coming attraction:
Chapter 13:
Perfect Competition and the
Supply Curve
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