Supply decisions are constrained by the capacity to produce and the costs of using that capacity.
In the short run, some inputs (e.g., land and capital) are fixed in quantity. Increases in (short-run) output result from more use of variable inputs (e.g., labor).
A production function indicates how much output can be produced from available facilities, using different amounts of variable inputs. Every point on the production function represents efficient production. Capacity output refers to the maximum quantity that can be produced from a given facility.
Output tends to increase at a diminishing rate when more labor is employed in a given facility. Additional workers crowd existing facilities, leaving each worker with less space and machinery to work with.
The costs of production include both fixed and variable costs. Fixed costs (e.g., space and equipment leases) are incurred even if no output is produced. Variable costs (e.g., labor and material) are incurred when plant and equipment are put to use.
Average cost is total cost divided by the quantity produced. The ATC curve is typically U-shaped.
Marginal cost is the increase in total cost that results when one more unit of output is produced. Marginal costs increase because of diminishing returns in production.
The production decision is the short-run choice of how much output to produce with existing facilities. A producer will be willing to supply output only if price at least covers marginal cost.
The long run is characterized by an absence of fixed costs. The investment decision entails the choice of whether to acquire fixed costs, that is, whether to build, buy, or lease plant and equipment.
The economic costs of production include the value of all resources used. Accounting costs typically include only those dollar costs actually paid (explicit costs).
Historically, advances in technology and the quality of our inputs have been the major source of productivity growth. These advances have shifted production functions up and pushed cost curves down.
