What You Will Learn in this Chapter

• 
  The importance of the firm’s production function, the relationship between quantity of inputs and quantity of output
• 
  Why production is often subject to diminishing returns to inputs
• 
  The various types of costs a firm faces and how they generate the firm’s marginal and average cost curves
• 
  Why a firm’s costs may differ in the short run versus the long run
• 
  How the firm’s technology of production can generate increasing returns to scale

The Farmer’S Margin

How intensively an acre of land is worked—a decision at the margin—depends on the price of wheat a farmer faces.

Terrance Klassen/AgeFotostock

“O BEAUTIFUL FOR SPACIOUS skies, for amber waves of grain.” So begins the song “America the Beautiful.” And those amber waves of grain are for real: though farmers are now only a small minority of America’s population, our agricultural industry is immensely productive and feeds much of the world.

If you look at agricultural statistics, however, something may seem a bit surprising: when it comes to yield per acre, U.S. farmers are often nowhere near the top. For example, farmers in Western European countries grow about three times as much wheat per acre as their U.S. counterparts. Are the Europeans better at growing wheat than we are?

No: European farmers are very skillful, but no more so than Americans. They produce more wheat per acre because they employ more inputs—more fertilizer and, especially, more labor—per acre. Of course, this means that European farmers have higher costs than their American counterparts. But because of government policies, European farmers receive a much higher price for their wheat than American farmers. This gives them an incentive to use more inputs and to expend more effort at the margin to increase the crop yield per acre.

Notice our use of the phrase “at the margin.” Like most decisions that involve a comparison of benefits and costs, decisions about inputs and production involve a comparison of marginal quantities—the marginal cost versus the marginal benefit of producing a bit more from each acre.

In this chapter and in Chapter 7, we will show how the principle of marginal analysis can be used to understand these output decisions—decisions that lie behind the supply curve. The first step in this analysis is to show how the relationship between a firm’s inputs and its output—its production function—determines its cost curves, the relationship between cost and quantity of output produced. That is what we do in this chapter. In Chapter 7, we will use our understanding of the firm’s cost curves to derive the individual and the market supply curves.