Production in Short-Run

ECON 8500 – Managerial Economics

Where we are in the course
Up to now we examined consumers’ behaviour: buyers, demand side
of the markets.

Market demand is the result of millions of consumers going shopping

Now we start looking at producers.

Any private firm’s objective is to maximize

profit 𝜋 = 𝑅 − 𝐶 = 𝑃 ∗ 𝑄 − 𝐶(𝑄)
Profits in different market structures
𝜋 = 𝑅 − 𝐶 = 𝑃 ∗ 𝑄 − 𝐶(𝑄)
Goals of Firms
• Economists generally make two key assumptions
about firms’ behaviour:

1. Firms are assumed to be profit-maximizers.

2. Each firm is assumed to be a single, consistent,

decision-making unit.

• Based on these assumptions, economists can

predict the behaviour of firms in various market
environments.
Production, Costs, and Profits

• Production
In order to be able to produce output firms need some inputs
In reality firms hire many inputs in order to produce something. To
simplify the analysis we will focus on just two types of inputs:
Capital (K) and labor (L)
All inputs are purchased in respective input markets that are competitive:
• Capital market = borrowing financial capital and paying interest
• Labor market
N.B.: each firm takes input prices as given (determined by the markets)
Production
• The production function shows the maximum output that
can be produced by a combination of inputs.
• The production function describes the technological
relationship between the inputs that a firm uses and the
output that it produces.
• In terms of functional notation:
Q = f(L, K)

• Production is a flow concept

Costs and Profits (1 of 3)
• Explicit costs involve a purchase of goods or services by the firm.

• Explicit costs include the hiring of workers, the rental of

equipment, interest payments on debt, and the purchase of
intermediate inputs.
• Explicit costs are associated with making and actual payment
and therefore are easy to measure (there is a ‘receipt’ for the
payment)

Accounting profits = Revenues – Explicit Costs

Costs and Profits (2 of 3)
Opportunity Cost – what must be sacrificed in order to do something
That brings the idea that some of the costs are implicit – are not
associated with an actual payment.
Implicit costs are the costs of items for which there is no market
transaction but for which there is still an opportunity cost for the firm.
• To find economic profit, subtract explicit costs and implicit
costs from revenues.
• Implicit costs include the opportunity cost of the owner’s time
and the opportunity cost of the owner’s capital.
Costs and Profits (3 of 3)
• Economic profit is the difference between the revenues received
from the sale of output and the opportunity cost of the inputs
used to make the output.
• Economic profit = Revenues – (Explicit costs +
Implicit costs)
• Economic profit = Accounting profits – Implicit costs
• Negative economic profits are called economic losses.
Profit-Maximizing Output
• When we talk about a firm’s profit, we will always mean economic
profit.
• A firm’s economic profit is the difference between the total revenue
(R) each firm derives from the sale of its output and the total cost (C)
of producing that output.

For managers understanding opportunity costs and marginal costs is

crucial for running a business efficiently.

For you on a personal level understanding these concepts is also very

important in order to make decisions that are in your best interest.
Time Horizons for Decision Making (1 of 2)
The SHORT-RUN is a time frame in which some factors are
fixed and are impossible to adjust
In this class when we talk about production, in the SR
there will be some fixed factors that cannot be changed.
A fixed factor is usually capital (K)
Inputs that can be varied in the short run are called
variable factors.
Conventionally the variable factor is labor(L).
Time Horizons for Decision Making (2 of 2)
The long run is the length of time over which all of the firm’s
factors of production can be varied, but its technology is fixed
(Note: in the LR some factors can still be constant, e.g. the
opportunity cost of the owner’s time).

The very long run is the length of time over which all the
firm's factors of production and its technology can be varied.

These topics are outside of the scope of this class

 Production in the Short Run 2)
There are three measures of productivity we need to learn

• Total and Average Products

• Total product (TP) is the total amount produced during a given period of time. It’s
out familiar Q for quantity
• Average product (AP) is the total product divided by the number of units of the
variable factor used to produce it.
• If we let the number of units of labour be denoted by L, then:
AP = TP / L = Q/L
 Production in the Short Run (2 of 2)
• Marginal Products
• Marginal product is the change in total output that results from using one
more unit of a variable factor (keeping all other inputs fixed).

• The marginal product (MP) of labour is given by:

∆𝑄 ഥ
𝜕𝑄(L,𝐾)
• 𝑀𝑃𝐿 = =
∆𝐿 𝜕𝐿

∆𝑄 𝜕𝑄 𝐿ത ,𝐾
You can guess that the marginal product of capital is 𝑀𝑃𝐾 = =
∆𝐾 𝜕𝐾
Imaginary Pastry Production Story
Suppose in the SR bakery owns K = 3 ovens.
Based on the numbers:
Total product (TP) = Q = output produced

𝐿𝑜 = 2 𝑄𝑜 = 6
𝐿′ = 3 𝑄′ = 8

• Average product = output per worker

𝐴𝑃𝑜 = = 𝐴𝑃′ = =

As the bakery hires `plus one` worker:

• Marginal product (of labor) MP =

 Relationship Between MP and AP
• In our example, as worker # 3 was hired what happened to the
average product?

Why?
The relationship between MP and AP is:
 Is there a relationship between MP
and TP?
Recall that the slope of a curve = rise/run

In this case rise = run =

Therefore:
 How does MP behave?
Remember: in SR K is fixed, if a firm wants to change
output it can only do so by changing the amount of labor
employed.

Stage 1: Coffee Shop Story

K = 1 espresso machine. At L=0 Q= 0
At L=1 Q = 20 (MP = 20)
At L=2 Q =
How does MP behave:
Stage 1 pictures:

Stage 2: remember, K is still fixed, so as we add more

workers…..

Finally, Stage 3: what will eventually happen when we keep

adding more and more workers to the fixed number of
machines?
Typical 3 Stage production process:
More on costs (IMPORTANT!)
Whether of fixed or variable, costs can also be classified as :

- Avoidable – costs that can be either avoided or recovered.

- Sunk – cannot be avoided or recovered
EXAMPLE: you have signed up for a non-refundable/non-
transferable $200 monthly membership in a badminton club. On
top of the membership, court booking is $20/hour/person.
What are your monthly costs of playing badminton (Q = hours
of play)?
Total cost is C =
Fixed Costs
Fixed cost is called fixed because it does not change with
output.
Usually FC = capital cost
In competitive market chapter we will also learn that in SR
fixed cost is sunk (unavoidable) – has to be paid even if
Q=0
Suppose FC = $100
Average Fixed Cost AFC
𝐹𝐶
Is fixed cost per unit of output 𝐴𝐹𝐶 =
𝑄
Draw AFC if FC = $100:
Variable Cost
Recall that in the SR if a firm wants to increase output it needs to
hire more labor units, therefore variable cost is usually = labor cost.
Labor cost is avoidable – if a firm does not wish to produce any
output, it will not have to hire any labor and effectively VC = zero

VC = wage*units of labor = w*L

Average Variable Cost
AVC = labor cost per unit of output. This is going
to be a very important in SR competitive
equilibrium.

𝑤𝐿
AVC = VC/Q = 𝐴𝑉𝐶 = =
𝑄
AVC and Average Product of Labor
Simple calculation:
Suppose L=5 workers produce Q=20 units of output (in
one hour).
Wage is determined in labor market and the firm takes it
as given. Suppose w=$8/hour.
At Q = 20 Variable cost is VC = $
Variable cost per unit of output is AVC =
Average product of labor is AP =
Check: AVC=w/AP
Total Cost
Is literally the sum of all costs, fixed and variable:
C = FC + VC

Recall that this is economic cost.

This cost will be relevant in the LR in the next chapter: for a

firm to stay in the market the total revenue must at least
cover total (opportunity) cost
Average Total Cost
Is the cost per unit of output = how much a unit costs on
average (not to be confused with MC!!!)
𝐶
𝐴𝑇𝐶 =
𝑄
Since C = FC + VC

𝐹𝐶 + 𝑉𝐶 𝐹𝐶 𝑉𝐶
𝐴𝑇𝐶 = = +
𝑄 𝑄 𝑄

𝐴𝑇𝐶 = 𝐴𝐹𝐶 + 𝐴𝑉𝐶

AVC, ATC, and AFC:
SUPERIMPORTANT cost for Profit-max
• Marginal cost (MC) is the increase in total cost resulting from increasing
output by one unit.

∆𝐶 𝑑𝐶
𝑀𝐶 = =
∆𝑄 𝑑𝑄

• Marginal costs are always marginal variable costs because fixed costs
do not change as output varies.
Understanding MC
Think of MC as ‘cost of producing one ADDITIONAL’ unit
of output.
Notice that in general MC is not equal ATC (ATC counts
AFC which has nothing to do with cost of INCREASING
output).

This is similar to the observation that MP of labor is in

general not equal to average productivity of labor.
 Shape of MC
Recall that
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝐶
MC =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡
Let’s think about what happens to costs and production as
a firm hires ‘plus one worker’
• Total cost will
• Output will

Sub into the formula: MC = -------

MC example:
Suppose that at Q = 20 units C = $200. At output Q = 25 C = $240.
What is the marginal cost in this range of output?
Another cost example
• Suppose that total cost is 𝐶 = 100 + 2𝑞 + 𝑞2

FC = AFC =

VC = AVC =

MC =
ATC =
MC, AVC, MP, and AP put together
Reminder: when MARGINAL > AVERAGE, Average will increase as more labor is
hired and more output is produced for BOTH costs and products: