Supply Decisions

Supply

Supply is the ability and willingness to sell (produce) specific quantities of a good at alternative prices in a given time period, ceteris paribus.

Capacity Constraints: The Production Function

Factors of production are needed to produce a good or service.

Factors of Production

Factors of production are the resource inputs used to produce goods and services.

Land, labor, capital, entrepreneurship.

Production Function

A technological relationship expressing the maximum quantity of a good attainable from different combinations of factor inputs.

Production functions tell us just how much output we can produce with varying amounts of factor inputs.

The output of any factor of production depends on the amount of other resources available to it.

A Production Function

Short-Run Production Function

Efficiency

Every point on the production function represents the most possible output produced with a given number of workers.

Producing any less means production is inefficient.

Capacity

A production function shows how much output that can be produced with a given amount of inputs.

Land and capital constraints place a ceiling on potential output.

Marginal Physical Product (MPP)

The change in total output associated with one additional unit of input.

Marginal Physical Product (MPP)

An improved ratio of labor to other factors of production may result in increasing marginal physical product.

A worker's productivity (MPP) depends in part on the amount of other resources in the production process.

Law of Diminishing Returns

The marginal physical product of a variable input declines as more of it is employed with a given quantity of other (fixed) inputs.

Resource Constraints

Marginal physical product may initially increase due to specialization of labor.

As more labor is hired, each unit of labor has less capital and land to work with.

The relative scarcity of other inputs (capital and land) constrains the marginal physical product of labor.

Negative MPP

Marginal physical product may become negative if too much labor is added to a fixed level of capital and land.

Short Run vs. Long Run

Short run

The period in which the quantity (and quality) of some inputs cannot be changed.

Long run

A period of time long enough for all inputs to be varied (no fixed costs).

Costs of Production

A production function tells us how much a firm could produce but not how much it will want to produce.

The most desired rate of output is one that maximizes total profit.

Total Cost

The market value of all resources used to produce a good or service.

Total Costs of Production

Fixed Costs

Costs of production that do not change with the rate of output.

Fixed costs cannot be avoided in short run.

Examples of fixed costs include the cost of plant or equipment, basic phone service, and property taxes.

Variable Costs

Costs of production that change when the rate of output is altered.

Any short-run change in total costs are a result of changes in variable costs.

Variable Costs

Examples of variable costs include labor or material costs.

The Costs of Jeans Production

Which Costs Matter?

Should the firm consider both fixed and variable costs when making production and pricing decisions?

To answer this question, the concepts of average and marginal cost need to be introduced.

Average Total Cost (ATC)

Total cost divided by quantity produced in a given time period.

Average costs start high, fall, then rise once again, giving the ATC curve a distinctive U shape.

Average Total Cost (ATC)

Marginal Cost (MC)

The change in total cost when one more unit of output is produced.

Marginal costs rise because of the law of diminishing marginal product.

Supply Horizons

The supply decision has two dimensions.

A short-run horizon which concerns the production decision.

A long-run horizon which concerns the investment decision.

The Short Run Production Decision

The nature of the supply decision varies with the relevant time frame.

The short run production decision is the selection of the short-run rate of output (with existing plant and equipment).

The Short Run

The short run is characterized by the existence of fixed costs.

Focus on Marginal Cost

Marginal cost is a basic determinant of short-run supply (production) decisions.

Covering marginal cost is a minimal condition for supplying additional output.

Fixed costs are unavoidable in the short-run and are thus ignored when making short-run production decisions.

The Long Run Investment Decision

The decision to build, buy or lease plant and equipment, and . . .

. . . to enter or exit an industry.

No Fixed Costs

In the long run, businesses have no lease or purchase commitments.

There are no fixed costs in the long run.

Economic vs. Accounting Costs

Economic costs need not conform to actual dollar costs.

Accounting Costs

Explicit Expenses

The direct dollar costs of producing goods or services.

Any actual out- of-pocket expense.

Economic Costs

The dollar value of all resources used to produce a good or service.

It is the opportunity cost of resource use.

Opportunity costs are counted by economists but not necessarily by accountants.

Economic cost = explicit costs + implicit costs

Economic costs and accounting costs will diverge whenever any factor of production is not paid an explicit cost.

The Cost of Homework

Some output of pocket expenses is incurred.

Paper, pencil, and, in some cases, paying someone to write term papers.

The Cost of Homework

Implicit expenses are also incurred.

Invest in Labor or Capital?

The U.S. labor force continues to grow by more than a million workers per year.

If capital investments don't keep pace, these added workers will strain production facilities.

Some possible ways of increasing productivity include the following:

Improvements in productivity reduce costs.