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Chapter 5 Supply Decisions Supply • Supply is the ability and willingness to sell (produce) specific quantities of a good at alternative prices in a given time period, ceteris paribus. Factors of Production • Factors of production are needed to produce a good or service. • These are the resource inputs used to produce goods and services: – Land, labor, capital, and entrepreneurship The Production Function • A technological relationship expressing the maximum quantity of a good attainable from different combinations of factor inputs. Production Function • Production functions tell us how much output we can produce with varying amounts of factor inputs. Short-Run Production Function Efficiency • Every point on the production function represents the most output that can be produced with a given number of workers. • Producing any less means production is inefficient. Capacity • A production function shows how much output can be produced with a given amount of inputs. • Land and capital constraints place a ceiling on potential output. • To produce at capacity, a firm needs to use its inputs efficiently. Marginal Physical Product (MPP) • The change in total output associated with one additional unit of input: M arginal physical product (MPP) Change in total output Change in input quantity Marginal Physical Product (MPP) • An improved ratio of labor to other factors of production results in increasing marginal physical product. • A worker’s productivity (MPP) depends in part on the amount of other resources in the production process. Law of Diminishing Returns • The marginal physical product of a variable input declines or diminishes as more of it is employed with a given quantity of other (fixed) inputs. • The additional resources (inputs) are less valuable to the firm. Resource Constraints • Marginal physical product may initially increase due to specialization of labor. • As more labor is hired, each unit of labor has less capital and land to work with. • As a result, marginal physical product begins to decline. Resource Constraints • The relative scarcity of other inputs (capital and land) constrains the marginal physical product of labor. Negative Marginal Physical Product (MPP) • Marginal physical product may become negative if too much labor is added to a fixed level of capital and land. Short Run vs. Long Run • Short run: – The period in which the quantity (and quality) of some inputs cannot be changed. • Long run: – A period of time long enough for all inputs to be varied (no fixed costs). Costs of Production • A production function tells us how much a firm could produce but not how much it will want to produce. • The most desired rate of output is one that maximizes total profit. – Profit is the difference between total revenue and total cost. Total Profit • Total profit is the difference between total revenue and total cost. Total Cost • The market value of all resources used to produce a good or service. Total Costs of Production Fixed Costs • Costs of production that do not change with the rate of output. • Fixed costs cannot be avoided in the short run. • Examples of fixed costs include plant, equipment, and property taxes. Variable Costs • Costs of production that change when the rate of output is altered. • Any short-run change in total costs is a result of changes in variable costs. • Examples of variable costs include labor and materials. The Costs of Jeans Production Which Costs Matter? • Should the firm consider both fixed and variable costs when making production and pricing decisions? • To answer this question, the concepts of average and marginal cost need to be introduced. Average Total Cost (ATC) • Total cost divided by the quantity produced in a given time period: total cost Average total cost (ATC) total output Average Total Cost (ATC) Average Total Cost (ATC) • Average costs start high, fall, then rise once again, giving the ATC curve a distinctive U shape. Average Total Cost (ATC) Marginal Cost (MC) • The change in total cost when one more unit of output is produced: change in total cost Marginal Cost (MC) = change in total output Marginal Cost (MC) Marginal Cost (MC) Marginal Cost (MC) • Marginal cost rises because of the law of diminishing marginal product. • As more workers have to share limited space and equipment in the short run, this “crowding” increases MC and reduces MPP. Supply Horizons • The supply decision has two dimensions: – A short-run horizon which concerns the production decision. – A long-run horizon which concerns the investment decision. The Short-Run Production Decision • The nature of the supply decision varies with the relevant time frame. • The short-run production decision is the selection of the short-run rate of output (with existing plant and equipment). • The short run is characterized by the existence of fixed costs. Focus on Marginal Cost • Marginal cost is a basic determinant of short-run supply (production) decisions. • Covering marginal cost is a minimal condition for supplying additional output. Focus on Marginal Cost • Fixed costs are unavoidable in the shortrun and are thus ignored when making short-run production decisions. • To remain in business in the long run, firms must cover average total costs as well. The Long-Run Investment Decision • The decision to build, buy or lease plant and equipment: to enter or exit an industry. • In the long run, businesses have no lease or purchase commitments. • There are no fixed costs in the long run. Economic vs. Accounting Costs • Economic costs need not conform to actual dollar costs. • Accountants often count dollar costs only and ignore any resource use that doesn’t result in an explicit dollar cost. Accounting Costs • Accounting costs are the direct dollar costs of producing goods or services. • This includes any actual out-of-pocket expenses. Economic Costs • The essential economic question is how many resources are used in production. • Economic costs - the dollar value of all resources used to produce a good or service: the opportunity cost of resource use. Economic Costs • Opportunity costs are counted by economists but not necessarily by accountants. • Economic costs and accounting costs will diverge whenever any factor of production is not paid an explicit cost. Economic Costs • The economist considers both explicit and implicit costs. – Economic costs = explicit costs + implicit costs The Cost of Homework • Some out-of-pocket expenses are incurred - perhaps paying someone to write term papers. • There are implicit costs too - the value of the next best use of your time represents the opportunity cost of doing homework. Economic Profit • In economic terms, profit is the difference between total revenue and total economic costs: Profit = Total revenue – Total costs Economic Profit • Economists keep a consistent eye on profit by keeping track of both explicit and implicit costs. Invest in Labor or Capital? • The U.S. labor force continues to grow by more than a million workers per year. • If capital investments don’t keep pace, these added workers will strain production facilities. – If this occurs, the law of diminishing marginal productivity will push wages lower and reduce living standards. Invest in Labor or Capital? • Some possible ways of increasing productivity include the following: – Increasing education – Vocational training – Increased capital investment Invest in Labor or Capital? • Improvements in productivity reduce costs. • The ATC and MC curves shift down when productivity increases. Improvements in Productivity Reduce Costs Supply Decisions End of Chapter 5