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Economics 103
Lecture # 10
Costs of Production
When we introduce the idea of Comparative Advantage, we’re
talking about different people or different inputs having
different costs.
Now we want to look at a different situation: the same input may
experience different costs when used in different proportions with
other inputs.
We start with the idea of a production function:
The production function embodies the best technology.
It gives you the most output for a given input.
What will your
dog do?
For the “moment” this function describes “the firm”.
(2L, 2K)
But we are not going to worry about returns to scale, we will
focus in on changes in proportions.
That is, changing the L/K ratio.
Let’s assume that K is fixed. Then changes in L will change the
L/K ratio.
Let’s also define the Marginal Product of Labor as:
We’ll define the Average Product of Labor as:
We’ll also assume the production function has three stages
when the L/K ratio changes.
This three stage function
includes our 5th principle.
In stage 1 we have:
In stage 3 we have:
But in Stage 2 we have what is relevant.
Now let’s go back to the graph.
What section shows
diminishing MP?
What is happening to
AP over these three stages?
What is the use of a
marginal product curve?
A marginal product curve (in stage 2) is actually the demand
for labor ... When you multiply by the price of the output.
for labor.
The equilibrium amount of
labor hired is where the price
equals the value of the
marginal product.
Even if you’re the best
darn rock picker in the world,
why might your wage be low?
When there is more than one variable input, it still holds that the
demand for labor equals the value of the marginal product.
So, suppose both capital and labor are variable. Then we have the
following equilibrium.
Now the equilibrium
conditions are:
w = pMPL
v = pMPK
If we have :
w = pMPL
v = pMPK
Then we get:
Equating marginal products is what lies behind:
In an emergency you first help the ones who are at the margin.
In Oregon, the state health
insurance will not pay for care
I) is extremely expensive, or
II) has no proven benefit.
Again, this equates the marginal product per dollar.
Should the government devote research money to finding cures for
extremely rare diseases?
The most effective naval weapon in the Second World War was:
90% of enemy shipping
was destroyed by subs.
But then why have battleships?
So at the margin, the first battleship was more productive than
the 1000th submarine.
This explains why we don’t see a hockey team made up of:
Back to Marginal Products
Marginal Products and Marginal Costs are inversely related.
What is the intuition behind this?
So now we have two reasons for why MC curves are increasing.
1. As output increases, different inputs are used. At first the
low cost inputs are used, then the high cost inputs are used.
That is, there is an extensive adjustment.
2. As output increases, each input is used more intensively
relative to the amount of capital. This lowers the inputs
marginal product, and increases the marginal cost. This is
an intensive adjustment.
Aside from Marginal Costs, there are three other types of costs
we need to worry about.
1. Average Fixed/Sunk costs: AFC = FC / Q.
Total cost = fixed costs + variable costs.
Divide by Q
If we have the three stage production function,
then these cost curves look as follows:
Why would they be
this shape?
Where would
the Marginal
Cost curve fit in
What would happen to the cost curves if you put on a
a. tax per unit of output?
b. a lump sum tax?
What would happen to the cost curves if
a. labor became more productive?
b. wages increased?