Background To Supply

Background
to Supply
Background to Supply
The Short-run Theory

of Production
SHORT-RUN THEORY OF PRODUCTION
• Profits and the aims of the firm

• Long-run and short-run production:
– fixed and variable factors
• The law of diminishing returns
• The short-run production function:
– total physical product (TPP)
– average physical product (APP)
APP = TPP/QV
– marginal physical product (MPP)
MPP = ∆TPP/∆QV
Wheat production per year from a particular farm (tonnes)
SHORT-RUN THEORY OF PRODUCTION
• Profits and the aims of the firm

• Long-run and short-run production:
– fixed and variable factors
• The law of diminishing returns
• The short-run production function:
– total physical product (TPP)
– average physical product (APP)
APP = TPP/QV
– marginal physical product (MPP)
MPP = ∆TPP/∆QV
– graphical relationship between TPP, APP and MPP
Wheat production per year from a particular farm
Number of
40 workers TPP
0 0
Tonnes of wheat produced per year
1 3
2 10
30 3 24
4 36
5 40
6 42
7 42
20 8 40
10
0
0 1 2 3 4 5 6 7 8
Number of farm workers
Number of
40 workers TPP
0 0
1 3
2 10
30 3 24
4 36
5 40
6 42
7 42
20 8 40
10
0
0 1 2 3 4 5 6 7 8
d
40
TPP
30 Maximum output
Diminishing returns
set in here
20
b
10
0
0 1 2 3 4 5 6 7 8
40
Tonnes of wheat per year

TPP
30
20
10
∆TPP = 7
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14 ∆L = 1
12
10
8
MPP = ∆TPP / ∆L = 7
6
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
40

TPP
30
20
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
12
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
40

TPP
30
20
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
12 APP = TPP / L
10
4 APP
2
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
40

TPP
30
20 b
Diminishing returns
10 set in here
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
12
10
4 APP
2
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
d
40

TPP
30
20 Maximum
b
output
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
12
10
4 APP
2
0 d Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
d
40 Slope = TPP / L c

= APP TPP
30
20
b
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
12
10
c
8
4 APP
2
0 d Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
Short-run Costs
SHORT-RUN COSTS
• Measuring costs of production:

opportunity costs
– explicit costs
– implicit costs
• Fixed costs and variable costs
• Total costs
– total fixed cost (TFC)
– total variable cost (TVC)
– total cost (TC = TFC + TVC)
Total costs for firm X
Output TFC
100
(Q) (£)
0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40
20
0
0 1 2 3 4 5 6 7 8
Output TFC
100
(Q) (£)
0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40
20
TFC
0
0 1 2 3 4 5 6 7 8
Output TFC TVC
100
(Q) (£) (£)
0 12 0
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40
20
TFC
0
0 1 2 3 4 5 6 7 8
Output TFC TVC
100
(Q) (£) (£)
0 12 0 TVC
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40
20
TFC
0
0 1 2 3 4 5 6 7 8
Output TFC TVC TC
100
(Q) (£) (£) (£)
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40
20
TFC
0
0 1 2 3 4 5 6 7 8
Output TFC TVC TC
100
(Q) (£) (£) (£) TC
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40
20
TFC
0
0 1 2 3 4 5 6 7 8
100 TC
TVC
80
Diminishing marginal
60
returns set in here
40
20
TFC
0
0 1 2 3 4 5 6 7 8
SHORT-RUN COSTS
• Marginal cost
– marginal cost (MC) and the law of
diminishing returns
Average and marginal physical product
Diminishing returns
b set in here
Output
MPP
Quantity of the variable factor

Average and marginal physical product
c
Output
APP
MPP
Quantity of the variable factor

Marginal cost
MC
Diminishing marginal
returns set in here
Costs (£)
Output (Q)
SHORT-RUN COSTS
• Marginal cost
diminishing returns
– the relationship between the marginal and
total cost curves
100 TC
TVC
80
Bottom of
60
the MC curve
40
20
TFC
0
0 1 2 3 4 5 6 7 8
SHORT-RUN COSTS
• Marginal cost
diminishing returns
total cost curves
• Average cost
SHORT-RUN COSTS
• Marginal cost
diminishing returns
total cost curves
• Average cost
– average fixed cost (AFC)
SHORT-RUN COSTS
• Marginal cost
diminishing returns
total cost curves
• Average cost
– average variable cost (AVC)
SHORT-RUN COSTS
• Marginal cost
diminishing returns
total cost curves
• Average cost
– average (total) cost (AC)
SHORT-RUN COSTS
• Marginal cost
diminishing returns
total cost curves
• Average cost
– average (total) cost (AC)
– relationship between AC and MC
Average and marginal costs
MC
AC
AVC
Costs (£)
x
AFC
Output (Q)
The Long-run Theory

of Production
LONG-RUN THEORY OF PRODUCTION
• All factors variable in long run
• The scale of production:

– constant returns to scale
– increasing returns to scale
– decreasing returns to scale

Short-run and long-run increases in output
• Economies of scale
– specialisation & division of labour
– indivisibilities
– container principle
– greater efficiency of large machines
– by-products
– multi-stage production
– organisational & administrative economies
– financial economies
– economies of scope
• Diseconomies of scale
• External economies and diseconomies

of scale
• Optimum combination of factors
MPPa/Pa = MPPb/Pb ... = MPPn/Pn
Isoquant–Isocost
Analysis
ISOQUANT- ISOCOST ANALYSIS
• Isoquants
– their shape
An isoquant
45
40 Units Units Point on

of K of L diagram
35 40 5 a
20 12 b
30
Units of capital (K)
10 20 c
6 30 d
25
4 50 e
20
15
10
0
0 5 10 15 20 25 30 35 40 45 50
Units of labour (L)
An isoquant
45
40 a
Units Units Point on
of K of L diagram
35 40 5 a
20 12 b
30
10 20 c
6 30 d
25
4 50 e
20
15
10
0
0 5 10 15 20 25 30 35 40 45 50
Units of labour (L)
An isoquant
45
40 a
of K of L diagram
35 40 5 a
20 12 b
30
10 20 c
6 30 d
25
4 50 e
b
20
15
10
0
0 5 10 15 20 25 30 35 40 45 50
Units of labour (L)
An isoquant
45
40 a
of K of L diagram
35 40 5 a
20 12 b
30
10 20 c
6 30 d
25
4 50 e
b
20
15
10 c
d
5 e
0
0 5 10 15 20 25 30 35 40 45 50
Units of labour (L)
• Isoquants
– their shape
– diminishing marginal rate of substitution
Diminishing marginal rate of factor substitution
14
12 g
∆K = 2
MRS = 2 MRS = ∆K / ∆L
10 h
∆L = 1
8
2
isoquant
0
0 2 4 6 8 10 12 14 16 18 20 22
Units of labour (L)
14
12 g
∆K = 2
MRS = 2 MRS = ∆K / ∆L
10 h
∆L = 1
8
j MRS = 1
∆K = 1 k
6
∆L = 1
4
2
isoquant
0
0 2 4 6 8 10 12 14 16 18 20
Units of labour (L)
• Isoquants
– their shape
– an isoquant map
An isoquant map
30
20
10
I5
I4
I3
I2
0 I1
0 10 20
Units of labour (L)
• Isoquants
– their shape
– isoquants and returns to scale
An isoquant map
30
20
10
I5
I4
I3
I2
0 I1
0 10 20
Units of labour (L)
• Isoquants
– their shape
– isoquants and marginal returns
14
12 g
∆K = 2
MRS = 2 MRS = ∆K / ∆L
10 h
∆L = 1
8
j MRS = 1
∆K = 1 k
6
∆L = 1
4
2
isoquant
0
0 2 4 6 8 10 12 14 16 18 20
Units of labour (L)
• Isoquants
– their shape
• Isocosts
• Isoquants
– their shape
• Isocosts
– slope and position of the isocost
An isocost
30
Assumptions
25
PK = £20 000
20 W = £10 000
TC = £300 000
15
10
0
0 5 10 15 20 25 30 35 40
Units of labour (L)
An isocost
30
Assumptions
25
PK = £20 000
20 W = £10 000
TC = £300 000
15 a
b
10
c
5
TC = £300 000
0
d
0 5 10 15 20 25 30 35 40
Units of labour (L)
• Isoquants
– their shape
• Isocosts
– slope and position of the isocost
– shifts in the isocost
• Least-cost combination of factors for a

given output
– point of tangency
Finding the least-cost method of production
35
Assumptions
30
PK = £20 000
W = £10 000
25
TC = £200
20 000
TC = £300 000
15
TC = £400 000
10
TC = £500 000
0
0 10 20 30 40 50
Units of labour (L)
Finding the least-cost method of production
35
30
25
s
TC = £500 000
20
15
TC = £400 000
r
10
t
5 TPP1
0
0 10 20 30 40 50
Units of labour (L)

given output
– comparison with marginal productivity

approach

given output
– comparison with marginal productivity

approach
• Highest output for a given cost of

production
Finding the maximum output for a given total cost
TPP5
TPP4
TPP3
TPP2
TPP1
O
Units of labour (L)
Isocost
TPP5
TPP4
TPP3
TPP2
TPP1
O
Units of labour (L)
r
s
u TPP5
TPP4
v TPP3
TPP2
TPP1
O
Units of labour (L)
r
s
K1
t
u TPP5
TPP4
v TPP3
TPP2
TPP1
O L1
Units of labour (L)
Long-run Costs
LONG-RUN COSTS
• Long-run average costs

– shape of the LRAC curve
– assumptions behind the curve
Alternative long-run average cost curves
Economies of Scale
Costs
LRAC
O Output
LRAC
Diseconomies of Scale
Costs
O Output
Constant costs
Costs
LRAC
O Output
A typical long-run average cost curve
LRAC
Costs
O Output
A typical long-run average cost curve
Economies Constant Diseconomies LRAC

of scale costs of scale
Costs
O Output
LONG-RUN COSTS

• Long-run marginal costs
Long-run average and marginal costs
Economies of Scale
Costs
LRAC
LRMC
O Output
LRMC
LRAC
Diseconomies of Scale
Costs
O Output
Constant costs
Costs
LRAC = LRMC
O Output
LRMC
Initial economies of scale,
then diseconomies of scale
LRAC
Costs
O Output
LONG-RUN COSTS

• Relationship between long-run and
short-run average costs
LONG-RUN COSTS

– the envelope curve
Deriving long-run average cost curves: factories of fixed size
SRAC1 SRAC SRAC5

2
SRAC4
SRAC3
5 factories
Costs
1 factory
2 factories
3 factories4 factories
O
Output
Deriving long-run average cost curves: factories of fixed size
SRAC1 SRAC SRAC5

2
SRAC4
SRAC3
LRAC
Costs
O
Output
Deriving a long-run average cost curve: choice of factory size
Costs
Examples of short-run
average cost curves
O
Output
Deriving a long-run average cost curve: choice of factory size
LRAC
Costs
O
Output
LONG-RUN COSTS

• Long-run cost curves in practice
LONG-RUN COSTS

– the evidence
LONG-RUN COSTS

– the evidence
– minimum efficient plant size
LONG-RUN COSTS
• Derivation of long-run costs from an

isoquant map
– derivation of long-run costs
Deriving an LRAC curve from an isoquant map
At an output of 200
LRAC = TC2 / 200
100 200
O
TC
TC
1
Units of labour (L)

Note: increasing returns

to scale up to 400 units;
decreasing returns to
scale above 400 units
700
600
500
400
300
100 200
O
TC
TC
TC
TC
TC
TC
TC
5
1
4
2
7
6
Units of labour (L)

LONG-RUN COSTS
• Derivation of long-run costs from an

isoquant map
– derivation of long-run costs
– the expansion path

Expansion path
700
600
500
400
300
100 200
O
TC
TC
TC
TC
TC
TC
TC
5
1
4
2
7
6
Units of labour (L)

Revenue
REVENUE
• Defining total, average and marginal

revenue
• Revenue curves when firms are price

takers (horizontal demand curve)
– average revenue (AR)
– marginal revenue (MR)

Price (£)
Deriving a firm’s AR and MR: price-taking firm
AR, MR (£)
S
Pe
D
O O
Q (millions) Q (hundreds)
(a) The market (b) The firm

Price (£)
Deriving a firm’s AR and MR: price-taking firm
AR, MR (£)
S
D = AR
Pe
= MR
D
O O
Q (millions) Q (hundreds)
(a) The market (b) The firm

REVENUE
• Defining total, average and marginal

revenue
• Revenue curves when firms are price

takers (horizontal demand curve)
– total revenue (TR)

Total revenue for a price-taking firm
6000 Quantity Price = AR
(units) = MR (£)
0 5
5000
200 5
400 5
600 5
4000
TR (£)
800 5
1000 5
1200 5
3000
2000
1000
0
0 200 400 600 800 1000 1200
Quantity
6000 Quantity Price = AR TR
(units) = MR (£) (£)
0 5 0
5000
200 5 1000
400 5 2000
600 5 3000
4000
TR (£)
800 5 4000
1000 5 5000
1200 5 6000
3000
2000
1000
0
0 200 400 600 800 1000 1200
Quantity
6000 Quantity Price = AR TR TR
(units) = MR (£) (£)
0 5 0
5000
200 5 1000
400 5 2000
600 5 3000
4000
TR (£)
800 5 4000
1000 5 5000
1200 5 6000
3000
2000
1000
0
0 200 400 600 800 1000 1200
Quantity
6000
TR
5000
4000
TR (£)
3000
2000
1000
0
0 200 400 600 800 1000 1200
Quantity
REVENUE
• Revenue curves when price varies with

output (downward-sloping demand
curve)
Revenues for a firm facing a
downward-sloping demand curve
AR and MR curves for a firm facing a downward-sloping D curve
8 Q P
(units) =AR
1 (£)
8
2 7
6 6
3
4 5
5 4
AR, MR (£)
4 6 3
7 2
2 AR
0
1 2 3 4 5 6 7 Quantity
-2
-4
8 Q P TR MR
(units) =AR (£) (£)
1 (£)
8 8
6
2 7 14
6 6 18
4
3
2
4 5 20
0
5 4 20
-2
AR, MR (£)
4 6 3 18
-4
7 2 14
2 AR
0
1 2 3 4 5 6 7 Quantity
-2
-4 MR
REVENUE

curve)
TR curve for a firm facing a downward-sloping D curve
20
16
Quantity P = AR TR
12
(units) (£) (£)
TR (£)
1 8 8
8 2 7 14
3 6 18
4 5 20
4 5 4 20
6 3 18
7 2 14
0
0 1 2 3 4 5 6 7
Quantity
20
16
Quantity P = AR TR TR
12
(units) (£) (£)
TR (£)
1 8 8
8 2 7 14
3 6 18
4 5 20
4 5 4 20
6 3 18
7 2 14
0
0 1 2 3 4 5 6 7
Quantity
REVENUE

curve)
– revenue curves and price elasticity of
demand
Elasticity = -1
20
In
tic
el
as
as
El
tic
16
TR
12
TR (£)
0
0 1 2 3 4 5 6 7
Quantity
8
Elastic
Elasticity = -1
6
AR, MR (£)
4 Inelastic
2 AR
0
1 2 3 4 5 6 7 Quantity
-2
-4 MR
REVENUE

curve)
– revenue curves and price elasticity of
demand
• Shifts in revenue curves

Profit
Maximisation
PROFIT MAXIMISATION
• Using total curves

– maximising difference between TR and TC
Finding maximum profit using total curves
24
20
16
TR, TC, TΠ (£)
12
0
1 2 3 4 5 6 7 Quantity
-4
-8
24
20
16
TR, TC, TΠ (£)
TR
12
0
1 2 3 4 5 6 7 Quantity
-4
-8
24 TC
20
16
TR, TC, TΠ (£)
TR
12
0
1 2 3 4 5 6 7 Quantity
-4
-8
PROFIT MAXIMISATION

– the total profit curve
24 TC
20
16
TR, TC, TΠ (£)
TR
12
0
1 2 3 4 5 6 7 Quantity
-4
-8 TΠ
24 TC
b
20
16
TR, TC, TΠ (£)
a TR
12
c d
0
1 2 3 4 5 6 7 Quantity
-4
-8 TΠ
24 TC
22
20 d
18
16
TR, TC, TΠ (£)
14
e TR
12
10
8
6
4
f
2
0
-2 1 2 3 4 5 6 7 Quantity
-4
-6
-8 TΠ
PROFIT MAXIMISATION

• Using marginal and average curves
PROFIT MAXIMISATION

– stage 1:
profit maximised where MR = MC
Finding the profit-maximising output using marginal curves
16
12
Costs and revenue (£)
0
1 2 3 4 5 6 7
Quantity
-4
16 MC
12
0
1 2 3 4 5 6 7
Quantity
-4
16 MC
12
4 e Profit-maximising
output
0
1 2 3 4 5 6 7
Quantity
-4 MR
PROFIT MAXIMISATION

– stage 1:
profit maximised where MR = MC
– stage 2:
using AR and AC curves to measure maximum
profit
Measuring the maximum profit using average curves
16 MC
12
0
1 2 3 4 5 6 7
Quantity
-4 MR
16 MC
12
AR
0
1 2 3 4 5 6 7
Quantity
-4 MR
16 MC
Total profit =
12 £1.50 x 3 = £4.50
8 AC
a
6.00
TOTAL PROFIT b
4.50
4
AR
0
1 2 3 4 5 6 7
Quantity
-4 MR
PROFIT MAXIMISATION
• Some qualifications
– long-run profit maximisation
– the meaning of profit
• What if a loss is made?
– loss minimising:
still produce where MR = MC
Loss-minimising output
MC
AC
AC
LOSS
AR
AR
O Q
Quantity
MR
PROFIT MAXIMISATION
– short-run shut-down point:
P = AVC
The short-run shut-down point
P= AC
AVC
AVC
AR
O Q
Quantity
PROFIT MAXIMISATION
– short-run shut-down point:
P = AVC
– long-run shut-down point:
P = LRAC

Background To Supply

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Background To Supply

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Background

The Short-run Theory

• Profits and the aims of the firm

• Profits and the aims of the firm

Tonnes of wheat per year

Tonnes of wheat per year

Tonnes of wheat per year

Tonnes of wheat per year

Tonnes of wheat per year

Tonnes of wheat per year

• Measuring costs of production:

Quantity of the variable factor

Quantity of the variable factor

The Long-run Theory

• All factors variable in long run

• The scale of production:

– increasing returns to scale

– decreasing returns to scale

• External economies and diseconomies

40 Units Units Point on

• Least-cost combination of factors for a

• Least-cost combination of factors for a

– comparison with marginal productivity

• Least-cost combination of factors for a

– comparison with marginal productivity

• Highest output for a given cost of

• Long-run average costs

Economies Constant Diseconomies LRAC

• Long-run average costs

• Long-run average costs

• Long-run average costs

SRAC1 SRAC SRAC5

SRAC1 SRAC SRAC5

• Long-run average costs

• Long-run average costs

• Long-run average costs

• Derivation of long-run costs from an

Units of labour (L)

Note: increasing returns

Units of labour (L)

• Derivation of long-run costs from an

– the expansion path

Units of labour (L)

• Defining total, average and marginal

• Revenue curves when firms are price

– marginal revenue (MR)

(a) The market (b) The firm

(a) The market (b) The firm

• Defining total, average and marginal

• Revenue curves when firms are price

– marginal revenue (MR)

– total revenue (TR)

• Revenue curves when price varies with

• Revenue curves when price varies with

• Revenue curves when price varies with

• Revenue curves when price varies with

• Shifts in revenue curves

• Using total curves

• Using total curves

• Using total curves

• Using total curves

• Using total curves