1.  Technology

• Processes a firm uses to turn inputs into outputs

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• Technological change - change in the ability of a firm to produce a given level of output with a given quantity of inputs

- Improvements in process

Ex. - Change layout

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- Better quality inputs

Ex. - Training for workers, higher quality machinery

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2.   Production

a.  Time frames

(1)  Short run - period of time during which at least one of a firm's inputs is fixed

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(2)  Long run - period of time in which a firm can vary all its inputs

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b.  Production function

• Relationship between the inputs employed by a firm and the maximum output that can be produced by those inputs

Ex. - Pizzeria uses workers (L) and pizza ovens (K)

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c.  Marginal product of labor (MP_L)

• Additional output produced by one additional unit of labor

MP_L = Change in Q / Change in L

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• Marginal product initially rises due to:

- Division of labor

- Specialization

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• Law of diminishing returns - as more of an input is added to fixed inputs, the marginal product will eventually decline

Due to:

- Fewer gains from specialization

- Congestion - less fixed inputs per worker

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d.  Average product of labor  (AP_L)

• Average output produced by workers

AP_L = Q / L

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3.  Costs

a.  Concepts

(1) Explicit costs - money actually spent

Ex. - Rent paid, interest on loans, wages, cost of raw materials, cost of utilities

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(2) Implicit costs - no direct payment, measured by opportunity cost

Ex. - Foregone rent, foregone investment income, foregone income

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Costs	Amount
Pizza dough, tomato sauce, and other ingredients	$20,000
Wages	48,000
Interest payments on loan to buy pizza ovens ($100,000 @ 10%)	10,000
Electricity ($500 per month)	6,000
Lease payment for store ($2,000 per month)	24,000
Forgone salary	30,000
Forgone interest ($50,000 @ 6% per year)	3,000
Total	$141,000

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b.  Total costs

(1)  Total cost (TC) - cost of all inputs a firm uses in production

(2)  Variable costs (VC) - costs that change as output changes

Ex. - Wages, cost of raw materials, cost of utilities

(3)  Fixed costs (FC) - costs that remain constant as output changes

Ex. - Rent paid, interest on loans, all implicit costs

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TC = FC + VC

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Ex. - Wage (W) = $650 per worker, P_K = $400 per unit of capital

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• Graphical approach:

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c.  Marginal cost (MC) - change in a firm's total cost from producing one more unit

MC = Change in TC / Change in Q

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d.  Average costs

(1) Average fixed cost (AFC)

AFC = FC / Q

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(2) Average variable cost (AVC)

AVC = VC / Q

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(3) Average total cost (ATC)

ATC = TC / Q

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ATC = AFC + AVC

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• Graphical approach:

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e. Marginal / average relationship

• If marginal > average => average is increasing

• If marginal < average => average is decreasing

• If marginal = average => average is at a minimum or maximum

Ex. - GPA

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f.  Long-run costs

• All inputs and costs are variable, no fixed costs in the long run

Ex. -

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(1) Economies of scale - LRAC decreases as output increases

• Due to:

- Technology allows increased production

- Greater specialization

- Larger firms can purchase inputs at a lower cost

- Larger firms can borrow money at a lower interest rate

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(2) Constant returns to scale - LRAC remains unchanged as output increases

• Minimum efficient scale - level of output where economies of scale are exhausted

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(3) Diseconomies of scale - LRAC rises as output increases

• Due to management, coordination problems