Production and Costs: Microeconomics Study Notes

Production and Costs

Seller’s Problem

In microeconomics, firms aim to maximize profit. To achieve this, sellers must address three fundamental questions:

• How to make the product?

• What is the cost of making the product?

• How much can the seller get for the product in the market?

How to Make a Product

Production involves transforming inputs into outputs. Inputs can include labor, machinery, and raw materials. The process of making a product, such as baking a cake, illustrates how various resources are combined to create goods.

• Inputs: Resources used in production (e.g., flour, eggs, labor).

• Outputs: Finished goods or services (e.g., cake).

Variable vs. Fixed Factors of Production

Inputs in production are classified as either variable or fixed, depending on whether their quantity can be changed in a given period.

• Variable factor of production: An input that can be changed in a certain period of time and whose quantity changes if the level of output changes (e.g., labor).

• Fixed factor of production: An input that cannot be changed in a certain period of time, regardless of how much output is produced (e.g., factory size).

Short Run vs. Long Run

The concepts of short run and long run relate to a firm's ability to adjust its inputs.

• Short run: A period of time when some of the firm's inputs cannot be changed.

• Long run: A period of time when all of the firm's inputs can be changed.

Firms and Technology

Firms use various inputs—such as workers, machines, and natural resources—to produce outputs. The method by which inputs are transformed into outputs is called technology.

• Technology: The process by which a firm combines inputs to produce outputs.

• Example: A restaurant uses pizza ovens and workers to make pizzas.

Production

Production at a Restaurant

To simplify analysis, consider a restaurant that uses only two inputs: pizza ovens and workers, to produce pizzas.

• Inputs: Pizza ovens (capital) and workers (labor).

• Output: Quantity of pizzas produced per week.

Production Function

The production function describes the relationship between the inputs employed and the maximum output of the firm.

Quantity of Workers	Quantity of Pizza Ovens	Quantity of Pizzas per Week
0	2	0
1	2	200
2	2	450
3	2	550
4	2	600
5	2	625
6	2	640

Example: Increasing the number of workers increases the number of pizzas produced, but at a decreasing rate after a certain point.

Marginal Product of Labor (MP)

The marginal product of labor is the additional output produced by hiring one more worker.

Quantity of Workers	Quantity of Pizza Ovens	Quantity of Pizzas	Marginal Product of Labor
0	2	0	–
1	2	200	200
2	2	450	250
3	2	550	100
4	2	600	50
5	2	625	25
6	2	640	15

• Formula: $MP = \frac{\Delta Q}{\Delta L}$, where $\Delta Q$ is the change in output and $\Delta L$ is the change in labor.

• Law of Diminishing Returns: As more workers are hired, the marginal product of labor eventually decreases.

Total Product and Marginal Product

Initially, the marginal product increases due to specialization, but eventually falls due to the law of diminishing returns. Marginal product can even become negative if too many workers are hired.

• Specialization: Early increases in marginal product are due to workers specializing in tasks.

• Diminishing Returns: After a certain point, each additional worker contributes less to output.

• Negative Marginal Product: Occurs when additional workers decrease total output due to overcrowding or inefficiency.

Average Product of Labor (AP)

The average product of labor is the total output produced divided by the number of workers.

• Formula: $AP = \frac{Q}{L}$, where $Q$ is total output and $L$ is the number of workers.

• Comparison: Marginal product and average product can be compared to understand productivity trends.

Costs

Types of Costs

Firms incur costs when using inputs in production. Costs are associated with the factors of production and depend on the time frame (short run or long run).

• Variable costs: Costs that change with the level of output (e.g., wages, raw materials).

• Fixed costs: Costs that do not change with output in the short run (e.g., rent, equipment).

• Total cost: $TC = FC + VC$

Explicit vs. Implicit Costs

• Explicit cost: A cost that involves a direct monetary payment (e.g., paying wages).

• Implicit cost: A non-monetary opportunity cost (e.g., foregone income from using resources elsewhere).

Short-Run Costs

In the short run, some costs are fixed. The following table illustrates costs for a graphic T-shirt business:

Number of Shirts (Q)	Total Fixed Costs (FC)	Total Variable Costs (VC)	Total Cost (TC)
0	$100	$0	$100
30	$100	$20	$120
70	$100	$40	$140
82	$100	$60	$160
90	$100	$80	$180
96	$100	$120	$220

• Fixed costs: Remain constant regardless of output.

• Variable costs: Increase as output increases.

• Total cost: Sum of fixed and variable costs.

Short-Run Average Costs

• Average Fixed Cost (AFC): $AFC = \frac{FC}{Q}$

• Average Variable Cost (AVC): $AVC = \frac{VC}{Q}$

• Average Total Cost (ATC): $ATC = \frac{TC}{Q} = AFC + AVC$

The ATC curve is typically U-shaped due to spreading fixed costs and diminishing returns.

Short-Run Marginal Cost (MC)

The marginal cost is the change in total cost resulting from a one-unit increase in output.

• Formula: $MC = \frac{\Delta TC}{\Delta Q}$

• Relationship: The MC curve is initially downward-sloping due to specialization, then upward-sloping due to diminishing returns.

Cost Curves Together

Key relationships among cost curves:

• MC intersects ATC and AVC at their minimum points.

• AFC declines as output increases.

• ATC and AVC converge as output increases because AFC becomes very small.

Long Run and Average Costs

Long-Run Average Cost Curve

In the long run, all costs are variable. The long-run average cost (LRAC) curve shows the lowest cost at which a firm can produce a given quantity of output when all inputs can be varied.

• Economies of scale: LRAC falls as output increases due to increased efficiency.

• Constant returns to scale: LRAC remains unchanged as output increases.

• Diseconomies of scale: LRAC rises as output increases due to inefficiencies (e.g., management difficulties).

Scale	Effect on LRAC	Reason
Economies of Scale	LRAC decreases	Specialization, bulk buying
Constant Returns to Scale	LRAC constant	Efficiencies exhausted
Diseconomies of Scale	LRAC increases	Management inefficiency

Minimum Efficient Scale: The lowest level of output at which all economies of scale are exhausted.

Additional info: These notes expand on the brief points in the slides, providing definitions, formulas, and examples for key microeconomic concepts related to production and costs.