Production Terms

COST OF PRODUCTION AND PRODUCTION FUNCTION–LIST OF TERMS

Synonymous Terms:

Inputs = Factors of Production = Resources

Output = Product ( or "Total Product" TP) = Returns = Q ("quantity of output") = Volume

Variable Costs = Direct Costs

Fixed Costs = Indirect Costs = Overhead Costs

Fixed Input = "Capacity" = "Plant Size"

Average Fixed Cost = Total Fixed Cost per Unit of Output = Unit Fixed Cost = Indirect Cost per Unit

Average Variable Cost = Total Variable Cost per Unit of Output = Unit Variable Cost = Direct Cost per Unit

Diminishing Returns to the Variable Input = Decreasing Marginal Product (or Decreasing Average Product)

Economies of Scale = Increasing Returns to Scale; Diseconomies of Scale = Decreasing Returns to Scale

Basic Definitions and Formulas:

Production Function: The relation between the Variable Input (applied to the Fixed Input) and resulting Output.

Short Run: That period of time in which the amount of at least one significant input cannot be changed.

Nearly all of Chapter 13 deals with the short run, in which there exist both Variable Costs (TVC) and Fixed Costs (TFC). TC = TFC + TVC

Labor as the example of the Variable Input = L (which can be changed in the Short Run)

Variable Cost (TVC) is due to the usage of the variable input: TVC = L (x) P_L . The amount of Labor can be altered immediately, and with such a change will result different amounts of output Q and a different TVC.. It is the relationship between various amounts of Labor (L) and Output (Q) that the Total Product curve "TP curve" shows. It is the relationship between different levels output and different levels of Variable Cost (TVC) that the TVC curve shows. The TVC curve reflects the changing productivity of Labor in producing Output Q.

Capital as the example of the Fixed Input = K (which cannot be changed in the Short Run). (The variable input Labor is applied to Capital (the fixed plant size) in order to produce varying amounts of the output Q.)

Fixed Cost (TFC) is due to the existence of the Fixed Input: TFC = K (x) P_K. Since the amount of K cannot be changed in the Short Run, TFC is a fixed amount.

Long Run: A period of time long enough in which the amounts of all inputs can be changed. Therefore, in the Long Run there are no fixed costs. All costs are variable costs, and we refer to these variable costs in the long run with the notation LRAC. The LRAC curve is a composite of the ATC curves of an array of plants of different sizes (different amounts of K)

(Note that in the textbook they never draw a "long run total cost" curve, only a Long Run Average Cost (LRAC) curve. Also they don’t find it necessary to refer to "long run average variable cost" because it is well known that in the "long run" all costs are variable.)

TP Curve is used to label the curve which shows the relation between the (variable) input (L) and the output (Q). The "TP Curve" depicts the "Short-Run Production Function."

Average Product of Labor (AP_L) = Total Product per unit of input (Q/L). We refer to the "AP Curve" as the relation between the value of the Average Product of Labor at varying amounts of the variable input Labor.

Marginal Product of Labor (MP_L) = Increase in output (Q) per one unit increase in variable input = slope of TP curve. We refer to the "MP Curve" as the relation between the value of the Marginal Product of Labor for varying amounts of the variable input Labor.

Stage One of TP Curve: TP is rising (at an increasing rate), MP is positive, and MP is rising. "The Stage of Increasing Marginal Returns (MP)"

Stage Two of TP Curve: TP is rising (at a decreasing rate), MP is still positive, but MP is nevertheless decreasing. "The Stage of Decreasing Marginal Returns (MP)"–sometimes called "Diminishing Returns."

Stage Three of TP Curve: TP is falling, MP is negative, and MP is decreasing. "The Stage of Decreasing Total Returns (TP)"

TC (Total Cost) curve is used to label the curve which shows the relation between output(Q) and total cost (TC). "Short Run Costs" consist of both fixed and variable costs: TC = TFC + TVC .

Marginal Cost is the increase in Total Cost (TC) for a one-unit increase in output Q. It is the slope of the TC curve. Since by definition Fixed Costs (TFC) cannot change, then any change in TC must be due to a change in TVC. Marginal cost also has the formula: P_L/MP_L . Clearly, therefore, MP and MC move in opposite directions. The MC curve is "U-shaped."

Average Fixed Cost = Total Fixed Cost per Unit of Output: TFC/Q = AFC . With increasing output (Q), AFC continuously declines. "Spreading the overhead" refers to this declining value of AFC as more and more Output (Q) is produced. One of the main objectives of business firms is to "spread the overhead."

Average Variable Cost = Total Variable Cost per Unit of Output : TVC/Q = AVC. Average Variable Cost also has the formula: P_L/AP_L . Clearly, therefore, AP and AVC move in opposite directions. The AVC curve is "U-shaped."

Average Total Cost = Total Cost per Unit of Output.

ATC = AFC + AVC (or, TC/Q = TFC/Q + TVC/Q)

The ATC curve is "U-shaped" and is the vertical sum of the AFC and AVC curves. It is drawn above and slightly offset to the right of the AVC curve, with its minimum point slightly to the right of that of the AVC curve. Costs eventually rise (MC, AVC, and ATC all eventually rise) because of "diminishing returns" to the use of the variable input applied to fixed capacity (fixed input) . The MC curve "cuts" through both AVC and ATC at their minimums (why?).

The difference (vertical length at any given output level Q) between the ATC and AVC curves represents AFC. [Since ATC = AFC + AVC, then it must be true that AFC = ATC - AVC.]

As we move along the AVC curve (different levels of Q on the horizontal axis), AP_L is changing and is causing the AVC first to fall and later to bottom out and rise. So the shape (behavior) of AVC depends on the characteristics of AP_L . Remember: AVC = P_L/AP_L. Ditto the MC curve (= P_L/MP_L): the shape (behavior) of MC depends on the characteristics of MP_L .

But if the P_L changes (rises or falls), the AVC curve moves vertically up or down at its present location (why?). Remember: AVC = P_L/AP_L. Ditto the MC curve (= P_L/MP_L).

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