PAC - Production and Costs Overview

Production and Costs Overview

Introduction

To properly understand the derivation of the market supply curve, it is necessary to explore the decisions facing individual firms in terms of production and costs. We will begin by discussing the basic forms of business organizations. Then, the module will progress to highlight the theory of production and explore how changes in output impact costs at the firm. Moving from the firm to the market, you will consider how these changes can impact the development of the long run supply curve.

Essential Questions

1. What are the strengths and weaknesses of sole proprietorships, partnerships, and corporations?
2. What is the difference between the short run and the long run? How do changes in inputs impact output?
3. What does the production function show?
4. Why will the production function eventually demonstrate diminishing returns?
5. What are the seven cost measures of the firm and how are they related?
6. How is the production function related to the costs at the firm?
7. How does a typical LRAC curve demonstrate economies of scale, constant returns to scale, and diseconomies of scale?
8. What is a long run supply curve and what does it indicate about long run costs?
9. How is cost minimization related to productive efficiency?

Key Terms

Click here to download the key terms document for this module. Links to an external site.

Sole Proprietorship – a business organization owned by one person who has the rights to all profits and unlimited liability for all debts of the firm; most common form of business organization in the U.S.

Partnership – a business organization owned by two or more people who share the profits and have unlimited (general partnership) or limited liability (limited partnership) for all debts and obligations of the firm.

Corporation – a form of business organization recognized by law as a separate legal entity with all the rights and responsibilities of an individual, including the right to buy and sell property, enter into contracts, sue, and be sued.

Total Product – the total quantity of output produced for a given quantity of labor (or capital).

Average Product (of labor) – the total product divided by the labor employed

Marginal Product (of labor) – the change in the total product resulting from a change in the labor input

Production Function – the mechanism for combining production resources, with existing technology, into finished goods and services.

Law of Diminishing Marginal Returns – this law states that as successive units of a variable input are added to a fixed input, beyond some point the marginal product declines.

Fixed Costs – costs that do not change as production changes

Variable Costs – costs that change as production changes

Total Costs – the sum of fixed and variable costs at any level of output

Marginal Cost – the additional cost of producing one more unit of output

Average Variable Cost (AVC) – the total variable cost divided by output or the variable cost per unit

Average Fixed Cost (AFC) – total fixed cost divided by output or the fixed cost per unit.

Average Total Cost (ATC) – the total cost divided by output or the total cost per unit.

Long Run – a period of time long enough for the firm to alter all production inputs, including plant size.

Short Run – a period of time too short to change the size of the plant, but many other, more variable, resources can be adjusted to meet demand.

Long Run Average Total Cost (LRATC) – the per unit cost of output when all factors of production are variable.

Economies of Scale – a situation when the downward portion of the long run average total cost curve demonstrates a decrease in costs as plant size increases.

Diseconomies of Scale - a situation when the upward portion of the long run average total cost curve demonstrates costs are rising as plant size increases.

Constant Returns to Scale - a situation when the horizontal range of the long run average total cost curve demonstrates costs are constant over a range of plant sizes.

Economies of Scope – a situation in which long run average total cost declines due to the production of multiple distinct goods.

Minimum Efficient Scale – the lowest level of production at which long run average total costs are minimized.

Increasing Cost Industry - Increasing Cost Industries exist when the entry of new firms causes the long-run average cost curve of each firm to shift upward and increases the minimum efficient scale of production. It results in an upward sloping long run supply curve for the industry.

Decreasing Cost Industry - Decreasing Cost Industries exist when the entry of new firms causes the long-run average cost curve of each firm to shift downwards and decreases the minimum efficient scale of production. It results in a downward sloping long run supply curve.

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