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Production and Cost Analysis I 12
Production and Cost Analysis I
Production is not the application of
tools to materials, but logic to work.
— Peter Drucker
CHAPTER 12
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Production and Cost Analysis I 12
The Role of the Firm
• A firm is an economic institution that transforms factors of production into goods and services
• Firms:
1. Organize factors of production and/or
2. Produce goods and services and/or
3. Sell produced goods and services
12-2
Production and Cost Analysis I 12
Firms Maximize Profit
• The goal of a firm is to maximize profits
• Profit = Total Revenue – Total Cost
• For economists, total cost is explicit payments to the factors of production plusthe opportunity cost of the factors provided by the owners of the firm
12-3
Production and Cost Analysis I 12
Firms Maximize Profit
• For economists, total revenue is the amount a firm receives for selling its product or service plus any increase in the value of the assets owned by the firm
McGraw-Hill/Irwin Colander, Economics 4
Production and Cost Analysis I 12
Firms Maximize Profit
• Economists and accountants measure profit differently
• Explicit cost =money paid out (rent, wages, etc.)
• Implicit cost=opportunity cost of the factors of production used by the firm
12-5
Production and Cost Analysis I 12
Firms Maximize Profit
• Accountants focus on explicit costs and revenues
• Accounting profit = explicit revenue –explicit cost
McGraw-Hill/Irwin Colander, Economics 6
Production and Cost Analysis I 12
Firms Maximize Profit
• Economists focus on both explicit and implicitcosts and revenue
• Economic profit = (explicit and implicit revenue) – (explicit and implicit cost)
McGraw-Hill/Irwin Colander, Economics 7
Production and Cost Analysis I 12
The Production Process
Short Run
• A firm is limited in regard to what production decisions it can make
• Some inputs are fixed
Long Run
• A firm chooses from all possible production techniques
• All inputs are variable
McGraw-Hill/Irwin Colander, Economics 8
•The production process can be divided into the short run and the long run
Production and Cost Analysis I 12
What do the long run and short run mean?
• The terms short run and long run refer to the flexibility that the firm has in changing the level of output
McGraw-Hill/Irwin Colander, Economics 9
Production and Cost Analysis I 12
Production Tables and Production Functions
• A production table is a table showing the output resulting from various combinations of factors of production or inputs
12-10
Production and Cost Analysis I 12
A Production Table (P. 281)
# of
workers
Total
Output
Marginal
Product
Average
Product
0 04
6
7
6
5
3
1
0
-2
-5
---
1 4 4
2 10 5
3 17 5.7
4 23 5.8
5 28 5.6
6 31 5.2
7 32 4.6
8 32 4.0
9 30 3.3
10 25 2.5
Marginal product is the additional output that comes from an additional worker,
other inputs constant
Average product is the output per
worker
12-11
Production and Cost Analysis I 12
The Production Function
• The production function tells the maximum amount of output that can be derived from a given number of inputs
• Note it has three stages
McGraw-Hill/Irwin Colander, Economics 12
Production and Cost Analysis I 12
Graphing a Production Function Q
Increasing marginal productivity
Diminishingmarginal productivity
DiminishingAbsolute productivity
Number of workers
TP
A production function is the
relationship between then inputs and the
outputs
32
26
20
14
8
2
1 2 3 4 5 6 7 8 9 10
12-13
Production and Cost Analysis I 12
Graphing Marginal and Average Productivity
Increasing marginal
productivity
Diminishingmarginal productivity
DiminishingAbsolute productivity
Number of workers
AP
MP
Q
Marginal productivity first increasesThen marginal
productivity declinesEventually marginal
productivity is negative
8
6
4
2
0
-2
-4
-6
1 2 3 4 5 6 7 8 9 10
12-14
Production and Cost Analysis I 12
Law of Diminishing Marginal Productivity
# of
workers
Total
Output
Marginal
Product
Average
Product
0 04
6
7
6
5
3
1
0
-2
-5
---
1 4 4
2 10 5
3 17 5.7
4 23 5.8
5 28 5.6
6 31 5.2
7 32 4.6
8 32 4.0
9 30 3.3
10 25 2.5
Law of diminishing marginal productivity states as more of a variable input is added to an existing fixed input, after some point the additional output from the additional input will fall
Increasing marginal productivity
Diminishingmarginal productivity
DiminishingAbsolute productivity
12-15
Production and Cost Analysis I 12
The Costs of Production
• Fixed costs (FC) are those that are spent and cannot be changed in the period of time under consideration
• In the short run, a number of inputs and their costs will be fixed
• In the long run, there are NO fixed costs since all inputs are variable
12-16
Production and Cost Analysis I 12
The Costs of Production
• Variable costs (VC) are costs that change as output changes
• Workers are an example of VC
• Total cost (TC) is the sum of the variable and fixed costs
• TC = FC + VC
McGraw-Hill/Irwin Colander, Economics 17
Production and Cost Analysis I 12
The Costs of Production
• Average fixed costs (AFC) equals fixed cost divided by quantity produced• AFC = FC/Q
• Average variable costs (AVC) equals variable cost divided by quantity produced• AVC = VC/Q
12-18
Production and Cost Analysis I 12
The Costs of Production
• Average total cost (ATC) equals total cost divided by quantity produced
• ATC = TC/Q or ATC = AFC + AVC
• Marginal cost (MC) is the increase in total cost when output increases by one unit
• MC = ΔTC/ΔQ
McGraw-Hill/Irwin Colander, Economics 19
Production and Cost Analysis I 12
Costs of Production Table
Output FC ($) VC ($) TC ($) MC ($) AFC ($) AVC ($) ATC ($)
3 50 38 8812
16.67 12.66 29.33
4 50 50 100 12.50 12.50 25.00
9 50 100 1508
5.56 11.11 16.67
10 50 108 158 5.00 10.80 15.80
16 50 150 2007
3.13 9.38 12.51
17 50 157 207 2.94 9.24 12.18
22 50 200 25010
2.27 9.09 11.36
23 50 210 260 2.17 9.13 11.30
27 50 255 30515
1.85 9.44 11.29
28 50 270 320 1.79 9.64 11.43
32 50 400 450 1.56 12.50 14.06
12-20
Production and Cost Analysis I 12
The Shapes of Cost Curves
• The variable and total cost curves have the same shape
• Increasing output increases VC and TC
• The fixed cost curve is always constant
• Increasing output doesn’t change FC
12-21
Production and Cost Analysis I 12
Graphing Total Cost Curves
FC
Total Cost
FC curve is constant
TC and VC curves
increase as Q increases
Q
500
400
300
200
100
04 8 12 16 20 24 28 32
VC
TC
12-22
Production and Cost Analysis I 12
The Shapes of Cost Curves
• The average fixed cost (AFC) curve is downward sloping
• Increasing output decreases AFC
• The marginal cost (MC), average variable cost (AVC), and average total cost curves (ATC) are U-shaped
• Increasing output initially leads to a decrease in MC, AVC, and ATC but eventually they increase
McGraw-Hill/Irwin Colander, Economics 23
Production and Cost Analysis I 12
Graphing Per Unit Output Cost Curves
AVC
MC
ATC
AFCQ
Cost
AFC curve decreases
MC, ATC, and AVC curves
are U-shaped
35
30
25
20
15
10
5
04 8 12 16 20 24 28 32
12-24
Production and Cost Analysis I 12
The Shapes of Cost Curves
• The U-shape of ATC and AVC curves is due to:
• When output is increased in the short run, it can only be done by increasing the variable input
• The law of diminishing productivity causes marginal and average productivities to fall
12-25
Production and Cost Analysis I 12
The Shapes of Cost Curves
• As average and marginal productivities fall, average and marginal costs rise
• The marginal cost curve goes through the minimum points of the ATC and AVC curves (know this!)
McGraw-Hill/Irwin Colander, Economics 26
Production and Cost Analysis I 12
The Relationship Between Marginal Cost and Average Cost
AVC
MC
Q
Costs per unit
ATCThe marginal cost curve goes through the minimum point
of both the ATC and AVC curves
12-27
Production and Cost Analysis I 12
The Relationship Between Marginal Productivity and Marginal Costs
AVC
Q
MC
Q
Output per worker
Costs per unit
If marginal productivity is rising, marginal costs are falling
If average productivity is falling, average costs are rising
MP of workers
AP of workers
12-28
Production and Cost Analysis I 12
• If MC > ATC, then ATC is rising
• If MC > AVC, then AVC is rising
• If MC < ATC, then ATC is falling
• If MC < AVC, then AVC is falling
• If MC = AVC and MC = ATC, then AVC and ATC are at their minimum points
The Relationship Between Marginal Cost and Average Cost
12-29
Production and Cost Analysis I 12
Chapter Summary
• Accounting profit is explicit revenue less explicit cost
• Economists include implicit revenue and cost in determining
economic profit
• Implicit revenue includes the increases in the value of assets
owned by the firm
• Implicit costs include opportunity cost of time and capital
provided by owners of the firm
• In the long run a firm can choose among all possible
production techniques; in the short run it is constrained in
its choices because at least one input is fixed
12-30
Production and Cost Analysis I 12
Chapter Summary
• The law of diminishing marginal productivity states that as more
of a variable input is added to a fixed input, the additional
output will eventually be decreasing
• Costs are generally divided into fixed costs, variable costs, and
marginal costs
• TC = FC + VC
• MC = ΔTC/ΔQ
• AFC = FC/Q
• AVC = VC/Q
• ATC = AFC + AVC
12-31
Production and Cost Analysis I 12
Chapter Summary
• AVC and MC are mirror images of the average and marginal
products
• The law of diminishing marginal productivity causes marginal
and average costs to rise
• MC goes through the minimum points of the AVC and ATC
• If MC > ATC, then ATC is rising
• If MC = ATC, then ATC is constant
• If MC < ATC, then ATC is falling
12-32
Production and Cost Analysis II 13
Production and Cost Analysis II
Economic efficiency consists of making
things that are worth more than they cost.
— J. M. Clark
CHAPTER 13
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Production and Cost Analysis II 13
Making Long-Run Production Decisions
• Firms have more options in the long run and they can change any input they want
• Firms look at costs of various inputs and the technologies available for combining these inputs
13-34
Production and Cost Analysis II 13
Technical Efficiency and Economic Efficiency
• Technical efficiency in production means that as few inputs as possible are used to produce a given output
13-35
Production and Cost Analysis II 13
Technical Efficiency and Economic Efficiency
• The economically efficient method of production produces a given level of output at the lowest possible cost
• In the long run, firms will look at all available production techniques and choose the technology that, given available inputs and prices, is economically efficient
McGraw-Hill/Irwin Colander, Economics 36
Production and Cost Analysis II 13
Determinants of the Shape of the Long-Run Cost Curve
• The law of diminishing marginal productivity does not apply in the long run since all inputs are variable
• The shape of the long-run cost curve is due to the existence of economies and diseconomies of scale
13-37
Production and Cost Analysis II 13
Economies of Scale
• Economies of scale exist when long-run average total costs decrease as output increases
• These are shown by the downward sloping portion of the long-run average total cost curve
• Indivisible setup costs create many real-world economies of scale
13-38
Production and Cost Analysis II 13
Economies of Scale
• An indivisible setup cost is the cost of an indivisible input for which a certain minimum amount of production must be undertaken before the input becomes economically feasible to use
• This is important because as output increases, the costs per unit decrease
McGraw-Hill/Irwin Colander, Economics 39
Production and Cost Analysis II 13
Economies of Scale
• Example: The cost of a blast furnace or an oil refinery is an example of an indivisible setup cost
McGraw-Hill/Irwin Colander, Economics 40
Production and Cost Analysis II 13
Economies of Scale
• The minimum efficient level of production is the amount of production that spreads setup costs out sufficiently for firms to undertake production profitably
13-41
Production and Cost Analysis II 13
Economies of Scale
• The minimum efficient level of production is reached once the size of the market expands to a size large enough for firms to take advantage of all economies of scale
• This is where average total costs are at a minimum
McGraw-Hill/Irwin Colander, Economics 42
Production and Cost Analysis II 13
Diseconomies of Scale
• Diseconomies of scale exist when long-run average total costs increase as output increases
• These are shown by the upward sloping portion of the long-run average total cost curve
• Diseconomies of scale usually, but not always, start occurring as firms get large
13-43
Production and Cost Analysis II 13
A Typical Long-Run Average Total Cost Curve
Q
Costs per unit
11
$50
$55
17
$60
14 20
Long-run average total cost (LRATC)
ATC falls because of economies of scale
ATC is constant because of constant returns to
scale
ATC rises because of diseconomies of
scale
Minimum efficient level
of production
13-44
Production and Cost Analysis II 13
Diseconomies of Scale
• Two reasons for diseconomies of scale are:
1. As the size of firms increase, monitoring costs generally increase
– Monitoring costs: the costs incurred by the organizer of production (seeing to it that the employees do what they are supposed to do)
13-45
Production and Cost Analysis II 13
Diseconomies of Scale
2. As the size of firms increase, team spirit/morale decreases
– The larger the firm, the more difficult this becomes
McGraw-Hill/Irwin Colander, Economics 46
Production and Cost Analysis II 13
Constant Returns to Scale
• Constant returns to scale exist when average total costs do not change as output increases
• This is shown by the flat portion of the long-run average total cost curve
• Constant returns to scale occur when production techniques can be replicated again and again to increase output
13-47
Production and Cost Analysis II 13
A Typical Long-Run Average Total Cost Table
QTC of Labor
($)
TC of Machines
($)TC ($) ATC ($)
11 381 254 635 58
12 390 260 650 54
13 402 268 670 52
14 420 280 700 50
15 450 300 750 50
16 480 320 800 50
17 510 340 850 50
18 549 366 915 51
19 600 400 1000 53
20 666 444 1110 56
ATC falls because of economies of
scale
ATC is constant because of
constant returns to scale
ATC rises because of
diseconomies of scale
13-48
Production and Cost Analysis II 13
The Envelope Relationship
• The envelope relationship is the relationship between long-run and short run average total costs
• Remember:
• In the long run, all inputs are flexible/variable
• In the short run, some inputs are fixed
13-49
Production and Cost Analysis II 13
The Envelope Relationship (continued)
• So, if we have a LRATC we can see that it is an envelope of SRATCs
• Each short-run cost curve touches the long-run cost curve at only one point
• Each SRATC curve will always be above or tangent to the LRATC curve
McGraw-Hill/Irwin Colander, Economics 50
Production and Cost Analysis II 13
The Envelope of Short-Run Average Total Cost Curves
SRMC3
SRATC3
SRMC4
SRATC4
SRMC1
SRATC1
SRMC2
SRATC2
LRATC
Q
Costs per unit
The long-run average
total cost curve (LRATC)
is an envelope of the
short-run average total
cost curves (SRATC1-4)
13-51
Production and Cost Analysis II 13
Using Cost Analysis in the Real World
• The cost of production of one product often depends on what other products a firm is producing
• There are economies of scope when the costs of producing goods are interdependent so that it is less costly for a firm to produce one good when it is already producing another
13-52
Production and Cost Analysis II 13
13-53
Using Cost Analysis in the Real World
• Learning by doing means that as we do something, we learn what works and what doesn’t, and over time we become more proficient at it
• Technological change is an increase in the range of production techniques that leads to more efficient ways of producing goods and the production of new and better goods
Production and Cost Analysis II 13
Chapter Summary
• An economically efficient production process must be technically efficient, but a technically efficient process may not be economically efficient
• The long-run average total cost curve is U-shaped because economies of scale cause average total cost to decrease; diseconomies of scale eventually cause average total cost to increase
• Marginal cost and short-run average cost curves slope upward because of diminishing marginal productivity
13-54
Production and Cost Analysis II 13
Chapter Summary
• The long-run average cost curve slopes upward because of diseconomies of scale
• The envelope relationship between short-run and long-run average cost curves reflects that the short-run average cost curves are always above the long-run average cost curve, except at just one point
• An entrepreneur is an individual who sees an opportunity to sell an item at a price higher than the average cost of producing it
13-55
Production and Cost Analysis II 13
Chapter Summary
• Once we start applying cost analysis to the real world, we must include a variety of other dimensions of costs that the standard model does not cover
• Costs in the real world are affected by:
• Economies of scope
• Learning by doing and technological change
• Many dimensions to output
• Unmeasured costs, such as opportunity costs
13-56