Bus 301 Managerial Economics Lecture Notes

BUS 301 Managerial Economics Lecture Notes

By Bill Y. Chen

Lecture Notes

Chapter 8 Production and Cost in the Short Run

1. Basic concepts of production theory

1. production: the creation of goods and services from inputs or resources;
2. production function: a schedule (table, or mathematical equation) showing the maximum amount of output that can be produced from any specified set of inputs, given the existing technology;

Q = f (X1, X2, …, Xn), where X1, X2, …, Xn are inputs; specifically

Q = f (L, K), where L-Labor, K-Capital.

1. Technical efficiency: production of the maximum level of output that can be obtained from a given combination of inputs; i.e. largest Q!
2. Economic efficiency: production of given amount of output at the lowest possible cost; i.e. given Q, the lowest cost of the inputs!
3. Short run and long run:

1. fixed input:  an input for which the level of usage cannot readily be changed;
2. variable input: an input for which the level of usage may be changed quite readily;
3. short run: that period of time in which the level of usage of one or more of the inputs is fixed; such as Q = f(L, [pic 1]) =f(L), where [pic 2]means fixed;
4. long run: that period of time (for planning horizon) in which all inputs are variable.
5. Variable proportions production: at which a given level of output can be produced with more than one combination of inputs;
6. Fixed proportions production: at which one, and only one, ratio of fixed of inputs can be used to produce a good;

1. Production in the short run

Assume that Q = f (L, [pic 3])

1. Total product: given [pic 4], the amount of output (Q) with different L level;
2. Average product of labor (AP): the total product (output) divided by the number of workers; AP =Q/L;
3. Marginal product (MP): the additional output attributable to using one additional worker (others fixed), MP =ΔQ/ΔL;
4. Law of diminishing marginal product: the principle that as the number of units of the variable input increases, other inputs held constant, a point will be reached beyond which the marginal product decreases. In other words, MP is a decreasing function of the input after some point!
5. Changes in fixed inputs.

Draw graphs from Page 327

1. The nature of economic costs

1. opportunity cost: what the firm’s owners give up to use a resource; the sum of explicit and implicit costs.
2. Explicit cost: an out-of pocket monetary payment for the use of a resource (such as salary to employees);
3. Implicit cost: the forgone return the firm’s owners could have received had they used their own resources in their best alternative use (such as owners’ talents);
4. Normal profit: the implicit cost of using owner-supplied resources (that is regular reasonable compensation to the owners for their own resources);
5. Fixed costs: payments for fixed inputs, fixed regardless of the level of output;
6. Variable costs: payments for variable inputs;
7. Total fixed cost (TFC) and total variable cost (TVC):

TC = TFC + TVC;

1. average fixed cost (AFC), average variable cost (AVC), average total cost (ATC):

AFC =TFC/Q; AVC =TVC/Q; ATC =TC/Q =AFC + AVC;

1. short run marginal cost(SMC): the change in either total variable cost or total cost per unit change in output:

SMC = ΔTVC/ΔQ =ΔTC/ΔQ;

Draw a graph from Page 338 (Short-run average and marginal cost curves).

1. Relations between short-run costs and production

TVC =w L, TFC =rK, TC =wL + rK,  where w and r are wage rate and the price of unit capital, respectively.

(1) average variable cost and average product: