In this unit, we dive into the world of production. Our focus is on understanding the behavior of producers and the costs associated with their operations in the short and long run. In other words, we explore the relationship between the quantity of output a firm produces and the cost of producing that output. We also analyze the relationship between various cost functions and identify the production function's characteristics in different timeframes. This chapter lays the foundation for a deeper understanding of how businesses operate and make crucial production-related decisions.
Completing this unit should take you approximately 3 hours.
Imagine a scenario where you could manufacture your iPod, iPhone, and Mac at home for the same price or even less than you can buy in a store. Would Apple still exist?
Firms primarily exist because they organize the factors of production (labor, land, capital, and technology) to reduce the costs individual consumers would face if they tried to produce everything themselves. We can define a firm as an institution that organizes factors of production to produce output and maximize its profit (revenue minus cost).
Once we understand that firms exist to reduce transaction costs (any costs associated with engaging in production or consumption activities) and their goal is to maximize profit, several questions arise:
We begin to answer these questions by considering the time frame. In microeconomics, the distinction between the short run and the long run is critical, especially on the production side.
Watch this video, which explains the difference between the short run
and the long run. Consider how long it takes firms to change their
factors of production.
A firm's decision regarding the quantity of output to produce depends on the market structure where it operates (we learn about market structures in Unit 7) and the cost of production. The analysis of production costs takes us back to Unit 1 – we need to consider the direct costs and the opportunity costs of production, also known as implicit costs.
Watch this video on the difference between accounting costs (direct
costs) and economic costs (explicit and implicit costs). You might have
to readjust your thinking about what cost means in economic analysis.
The long run is the time period when all costs are variable because the firm has time to change all the factors of production. In this section, we study how the firm makes profit-maximizing decisions in the long run. We start by analyzing the long-run production function to then explore the costs in the long run and the relationship between short and long-run costs.
Think of the production function as the magical cookbook for firms'
decisions. It is like having a high-tech cooking device to turn the
factors of production into the optimum number of delicious chef-like
dishes.
Read this text to review the factors of production introduced in Unit 1
and to learn how to obtain and interpret the production function in the
short run. Understanding the production function will pave the way for
grasping concepts like total and marginal product (or output). The text
also introduces the critical law of diminishing marginal returns.
The previous reading introduced several new concepts. Watch this video
on total, average, and marginal products and the law of diminishing
marginal returns to labor to ensure a solid understanding of these
essential economic ideas and relationships.
As you know, a firm's costs depend on the quantities of factors of production the firm uses and the cost of those factors of production. We now focus on the analysis of costs in the short run. Why do you think costs differ in the short and the long run?
Read this text, which explores short-run costs. Make sure you can
define, calculate, and graph total cost, average total cost, average
variable cost, and marginal cost.
Let's watch the following four videos to further clarify the new concepts
introduced in the reading. We start by reviewing the concepts of fixed
versus variable costs and then dive into a dynamic explanation of the
cost curves. And because we understand that all those diagrams can make
you dizzy, we have included a video on why it is crucial to grasp them
all.
Once you complete the videos, you should be well-prepared to answer the following review questions.
You have just completed a challenging section packed with new concepts.
With the relevant information in your hands, you should be able to
answer the question posed at the beginning: how many units of pizza to
prepare daily if you can only change the number of workers you hire?
The long run is the time period when all costs are variable because the
firm has time to change all the factors of production. In this section,
we study how the firm makes profit-maximizing decisions in the long run.
We start by analyzing the long-run production function to then explore
the costs in the long run and the relationship between short and
long-run costs.
Read this short section, which compares short-run and long-run production and introduces the long-run production function.
You should now be able to explain why the long-run production function represents the most efficient way to produce any level of output. If the answer readily comes to your mind, you are prepared to explore the analysis of costs in the long run.
Read this text on how to calculate the long-run total cost. Compare the
long-run average cost curve with the short-run average cost curve. Make
sure you can differentiate economies of scale, diseconomies of scale,
and constant returns to scale. You should also be able to compare
economies of scale and diminishing marginal returns.
Watch this video to review how we obtain and graph the long-run average
total cost curve and its relation to the short-run average total cost
curve.
To finish this unit, watch this video to review the essential economic concept of economies of scale. By the end, you should be well-prepared to address the question posed: "Why are people and economic activity concentrated in cities rather than distributed evenly across a country?"
We started this unit by asking these questions:
As previously mentioned, the answers to these questions depend on several factors, including the time frame considered, the costs of the firm, and the market structure within which the firm operates. In this unit, we have delved into the first two aspects. In the upcoming unit, we explore the various market structures where a firm can conduct its business.
Take this assessment to see how well you understood this unit.