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Production and Cost Review for AP Economics (page 3)

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By — McGraw-Hill Professional
Updated on Mar 2, 2011

Graphically Speaking

If marginal product is the slope of total product, it should be no surprise that marginal cost is the slope of total cost, or total variable cost. We can see that marginal cost initially falls due to specialization, but soon begins to rise as more output is produced. This is the Law of Increasing Costs and is a direct result of the Law of Diminishing Marginal Returns to production. Both being U-shaped curves, average variable and average total costs initially fall, hit a minimum point, and begin to rise. Average Total Cost is vertically above AVC by the amount of AFC. Figure 8.4 illustrates this.

Marginal cost and average variable and average total cost are related in much the same way as marginal product is related to average product of labor. When the marginal cost of producing another cup of lemonade exceeds the current average cost the average is rising. When the marginal cost of producing another cup of lemonade falls below the current average cost the average is falling. Therefore, marginal cost equals average total cost at the minimum of ATC and equals average variable cost at the minimum of AVC.

Production and Cost

Bridge over (Troubling) Economic Waters

Many students think that production and cost concepts are two sets of theoretical topics. This separation creates the impression that "there's twice as much to remember." These students are surprised to find out that production and cost are closely connected.

Think about it from Molly's point of view. If the next worker employed has a high marginal product, then the marginal cost of producing that increased product must be quite low. When things are going well with production, they must be going well with cost. Try to see the concepts of production and cost not as two isolated bodies of theory, but as two related sets of concepts that just need to be bridged. Let us try to build this bridge with a little algebra.

Marginal Product and Marginal Cost

MC = ΔTVC/ΔQ and since the only variable input is labor being paid a fixed wage w,

MC = wΔL/ΔQ which can be modified as,

MC = w/(ΔQ/ΔL) = w/MPL. MC and MPL are inverses of each other!

Average Product and Average Variable Cost

AVC = TVC/Q and with the only variable input being labor paid a fixed wage w,

AVC = wL/Q which can be modified as,

AVC = w/(Q/L) = w/APL. AVC and APL are inverses of each other!

If we put smoother versions of our production and cost figures together, we can see these relationships in Figures 8.5 and 8.6. The output q1 where MPL is at a maximum is the same as the output where MC is at a minimum. Likewise, the output q2 where APL is at a maximum is the same as the output where AVC is at a minimum.

Production and Cost

Long-Run Costs

Since all inputs are variable in the long run, discussion of production levels isn't so much about output per hour or day; it's more a question of plant size or capacity. In the short run, the firm asks, "With our current plant size, how much must we produce today?" The long run is long enough to adjust the plant capacity so the issue is really one of scale. The firm might ask itself, "At what scale do we want to operate?"

Long-Run Average Cost

I like to think of the firm's short-run average costs as a snapshot of the firm's ability to produce efficiently at the fixed plant size. Over time, the firm may grow and expand the plant size and begin to produce efficiently, but at the larger fixed plant size, giving us another snapshot. This process repeats itself as the firm expands or contracts and each time we receive another short-run snapshot of average cost. If we could put these short-run snapshots together into a kind of motion picture, we would see a more continuous long-run home movie of the firm's average costs. The example and Figure 8.7 illustrate the connection between short- and long-run average costs.

Example:

  • In year one, Molly's firm operates at a "small" scale, producing on SRAC1.
  • In year two, Molly could expand and operate at a "medium" scale, producing on SRAC2, but only if she can sell more than 100 gallons of lemonade. At quantities below 100, SRAC1 < SRAC2, so expansion would not be wise.
  • In year three, Molly might expand to operate at a "large" scale and move to SRAC3, but only if she can sell more than 250 gallons.
  • Beyond the "large" scale exists a "grande" scale, but very quickly SRAC4 > SRAC3 and so this plant capacity actually begins to pay rising per unit costs.

Each of these four short-run snapshots of average costs can be smoothed out into the home movie long-run average cost curve, which is composed of sections of each short-run average cost curve at each of the four plant sizes that Molly might choose for her firm. In Figure 8.7, the long-run average cost curve would lie along the segments a→b→c→d→e.

Economies of Scale

Construction of a smoother version of Figure 8.7 allows us to see more easily some important stages of the long-run average cost curves (Figure 8.8).

  1. Economies of scale are advantages of increased plant size and are seen on the downward part of the LRAC curve. LRAC falls as plant size rises.
    1. Labor and managerial specialization is one reason for this.
    2. Ability to purchase and use more efficient capital goods also can explain economies of scale.
  2. Constant returns to scale can occur when LRAC is constant over a variety of plant sizes.
  3. Production and Cost

  4. Diseconomies of scale are illustrated by the rising part of the LRAC curve and can occur if a firm becomes too large.
    1. Some reasons for this include distant management, worker alienation, and problems with communication and coordination.
    2. Production and Cost

Review questions for this study guide can be found at:

The Firm, Profit, and the Costs of Production Review Questions for AP Economics

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