The Supply Side of the Market The Supply Side of the Market in in - PowerPoint PPT Presentation

Econ Dept, UMR Presents The Supply Side of the Market The Supply Side of the Market in in Three Parts: Three Parts: I. An Introduction to Supply and I. An Introduction to Supply and Producer Surplus Producer Surplus II. The Production Function II. The Production Function III. Cost Functions III. Cost Functions

Part II: The Production Part II: The Production Function Function

Starring Starring Supply N Supply N Production O Production O Cost O Cost O Producer Surplus N Producer Surplus N

Featuring Featuring The Law of Diminishing Marginal Product N The Law of Diminishing Marginal Product N The MP/ P Rule N The MP/ P Rule N Economic Cost vs. Accounting Cost N Economic Cost vs. Accounting Cost N Economic Profit vs. Accounting Profit N Economic Profit vs. Accounting Profit N The Unimportance of Sunk Cost N The Unimportance of Sunk Cost N

Behind the Supply Curve Behind the Supply Curve N Necessary compensation for effort is Necessary compensation for effort is N based on cost based on cost N And, Cost is based on the production And, Cost is based on the production N function and input prices function and input prices O The production function relates inputs to The production function relates inputs to O output and is governed by technology output and is governed by technology O The input mix required for any output The input mix required for any output O times the input prices gives output cost times the input prices gives output cost O What we want is obtained efficiently only What we want is obtained efficiently only O if it is produced at minimum output cost if it is produced at minimum output cost

Production - Cost - Supply Production - Cost - Supply N Supply, Cost, and the Production Function are Supply, Cost, and the Production Function are N interdependent interdependent N We assume input prices are fixed We assume input prices are fixed N N As is Technology As is Technology N N Production technology relates inputs to outputs Production technology relates inputs to outputs N N The optimal method of production, for a profit- The optimal method of production, for a profit- N maximizing firm, is the one that minimizes costs maximizing firm, is the one that minimizes costs N Two periods are important for decision making Two periods are important for decision making N O The Short Run The Short Run O O The Long Run The Long Run O

Short Run vs. Long Run Short Run vs. Long Run N The short run is a period of time The short run is a period of time N such that there is a fixed factor of such that there is a fixed factor of production or constraint-it is the production or constraint-it is the period we are in period we are in N The long run is a period of time The long run is a period of time N such that there are no fixed factors such that there are no fixed factors of production or constraint-it is the of production or constraint-it is the period we are planning period we are planning

Now we will look at the Now we will look at the production process and three production process and three ways to measure productivity ways to measure productivity of inputs of inputs N Total Product Total Product N N Average Product Average Product N N Marginal Product Marginal Product N Then we will see how the production relationships link to costs

Total Product (TP) Total Product (TP) N A mathematical or numerical A mathematical or numerical N expression of a relationship expression of a relationship between inputs and outputs: between inputs and outputs: O q = f(K,L) is the function relating the q = f(K,L) is the function relating the O production of q to just two inputs: capital, production of q to just two inputs: capital, K; and labor, L K; and labor, L N Graphically shows units of total Graphically shows units of total N product as a function of units of a product as a function of units of a variable input with other inputs variable input with other inputs fixed fixed

Average Product (AP) Average Product (AP) N The average amount of output The average amount of output N produced by each unit of a produced by each unit of a variable factor of production, or variable factor of production, or input input N Output per unit of an input, e.g., Output per unit of an input, e.g., N AP L = q/ L is the average AP L = q/ L is the average product of labor product of labor

Marginal Product (MP) Marginal Product (MP) N The additional output that can be The additional output that can be N produced by adding one more unit produced by adding one more unit of a specific input, ceteris paribus of a specific input, ceteris paribus N If Labor is the variable input: If Labor is the variable input: N ˛ q/ q/ ˛ ˛ L (over a range) ˛ = MP L L (over a range) O MP L = O ˛ refers to change in) (where ˛ refers to change in) (where MP L = dq/ dL (using calculus, O MP L = dq/ dL (using calculus, O the 1st derivative of the the 1st derivative of the production function wrt L) production function wrt L)

Calculus?--Don’t Worry Calculus?--Don’t Worry N Often to show the mathematical Often to show the mathematical N relationships, we will use formulas relationships, we will use formulas derived from calculus, e.g., Calculus 8 derived from calculus, e.g., Calculus 8 not a prerequisite so any Calculus is not N Calculus is a prerequisite so any N formulas will be provided formulas will be provided

Consider a lawn service with a fixed Consider a lawn service with a fixed capital base, e.g, 2 mowers, 3 trimmers, etc. capital base, e.g, 2 mowers, 3 trimmers, etc. Labor Total Marginal Average Units Product Product Product 0 0 --- --- 1 2.67 5 2.67 2 9.30 8 4.65 3 18.00 9 6.00 4 26.67 8 6.67 5 33.33 5 6.67 6 36.00 0 6.00 TP = q = 3L 2 - L 3 / 3 ; = dq/ dL = 6L - L 2 ; AP L = q/ L MP L

This data can be plotted as This data can be plotted as follows: follows: Average Product (L) Total Product Marginal Product (L) 10 40 9 35 8 30 7 25 6 MP 5 20 4 15 AP 3 10 2 5 1 0 0 0 1 2 3 4 5 6 0 1 2 3 4 4.5 5 6 Number of employees/ t Number of employees/ t

The Law of Diminishing The Law of Diminishing Returns Returns N After a certain point, when After a certain point, when N additional units of a variable input additional units of a variable input are added to fixed inputs, the are added to fixed inputs, the marginal product of the variable marginal product of the variable input declines input declines N At this point, output starts At this point, output starts N increasing at a decreasing rate increasing at a decreasing rate

In the lawn service, as more In the lawn service, as more employees are added to the fixed employees are added to the fixed inputs, eventually MP falls. inputs, eventually MP falls. Average Product (L) Marginal Product (L) 10 9 Diminishing returns Diminishing returns 8 7 sets in after the sets in after the 6 5 third worker is third worker is 4 M P 3 hired hired 2 A P 1 0 0 1 2 3 4 4.5 5 6 Number of employees/ t

Adding More Inputs to the Adding More Inputs to the Variable Input Makes the Variable Variable Input Makes the Variable Input More Productive Input More Productive N More, or better tools makes Labor more More, or better tools makes Labor more N productive productive N An increase in capital stock increases: An increase in capital stock increases: N O the total product of labor the total product of labor O O the average product of labor the average product of labor O O the marginal product of labor the marginal product of labor O

Returning to our lawn service, suppose Returning to our lawn service, suppose the owners can invest in four mowers the owners can invest in four mowers rather than two rather than two Units of Two Mowers Four Mowers Units of Two Mowers Four Mowers Labor TP MP TP MP Labor TP MP TP MP 0 0 --- 0 --- 0 0 --- 0 --- 1 2.67 5 3.67 7 1 2.67 5 3.67 7 2 9.30 8 13.33 12 2 9.30 8 13.33 12 3 18.00 9 27.00 15 3 18.00 9 27.00 15 4 26.67 8 42.67 16 4 26.67 8 42.67 16 5 33.33 5 58.33 15 5 33.33 5 58.33 15 6 36.00 0 72.00 12 6 36.00 0 72.00 12 With 4 mowers, q = 4L 2 - L 3 / 3 ; MP L = 8L - L 2