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Transcript of The Costs of Production Chapter 6. In This Chapter… 6.1. The Production Process 6.2. How Much to...
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The Costs of Production
Chapter 6
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In This Chapter…
6.1. The Production Process6.2. How Much to Produce? 6.3. The Right Size: Large or Small?
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6.1. The Production Process
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6.1. The Production Process
Factors of Production(Inputs)
Final Goods and Services(Output)
Production Process
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6.1.The Production Process
Factors of production – Resource inputs used to produce goods and
services. land, labor, capital, entrepreneurship.
It takes some or all factors of production to produce a good or service – no matter what the good; OUTPUT
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6.1. The Production Process
Production function : is the technical relationship that expresses the
maximum quantity of a good that can be produced (attainable) from different combinations of factors (inputs).
The technical relationship between the quantities of inputs used in the production process and the maximum output that can be produced.
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The purpose of a production function is to tell us how much output we can produce with varying amounts of factor inputs
Varying Input Levels During some time period the amount of some inputs
that can be employed are fixed or can’t be varied….Fixed Inputs (E.g. Land; Plant Size)
While the amount of some other inputs can be easily changed… Variable Input (E.g., Labor)
6.1. The Production Process
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Short-Run …. The time period during which the quantity
(and quality) of some inputs cannot be changed.
When there are fixed inputs, we’re dealing with a short run production condition.
6.1. The Production Process
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In the Long Run, however, all inputs can be varied Thus long run is a time period that allows us to
sufficiently vary the amount of inputs we can use in the production process.
When we vary the amounts of input we use in the production process it affects productivity
6.1. The Production Process
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Productivity - Output per unit of input, for example, output per labor hour.
The productivity of any factor of production depends on the amount of other resources available to it.
6.1. The Production Process
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6.1. The Production Process: In the Short Run
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The Production Function
01 2 3 4 5 6 7 8Labor Input (machine operators per day)
Jean
s O
utpu
t (p
airs
per
day
)
510152025303540455055
Total output
A
B
C
DE F H
IG
Amount of Output depends on Input levels
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Marginal Productivity
An important Concept
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Marginal Productivity
Marginal physical product (MPP): is the change in total output that results from
employment of one additional unit of the variable input.
quantityinputinchangeoutputtotalinchange
(MPP)productphysicalMarginal
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Number of
WorkersTotal
Output
Marginal Physical Product
A 0 0
B 1 15 15
C 2 34 19
D 3 44 10
E 4 48 4
F 5 50 2
G 6 51 1
H 7 51 0
I 8 47 -4
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Marginal Physical Product
01 2 3 4 5 6 7 8
Labor Input (machine operators per day)
Jean
s O
utpu
t (p
airs
per
day
)
510152025303540455055 Total output
Bb
C
c
E
e
F
f
G
g
H
h
I
i
+ 10 jeans
Third worker
D
d
aA
MPP
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MPP:…Important Feature…
When the MPP of labor (MPPL >0), then total output increases.
Improving the ratio of the variable input (labor) to other factors increases the MPP of the variable input (labor).
But there is a limit to which we can do this because the capacity of the fixed resources will be exhausted
This leads to eventual decline in the additional and total output we could produce
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Diminishing Marginal Returns
I.e., as more labor is hired, each unit of labor will have less capital and land to work with.
Thus output begins to rise more and more slowly as more workers are hired and will eventually fall
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Law of Diminishing Returns
According to the law of diminishing returns, the marginal physical product of a variable input declines as more of it is employed with a given quantity of other (fixed) inputs.
All types of production are subject to this natural law
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Diminishing Marginal Returns
01 2 3 4 5 6 7 8
Labor Input (machine operators per day)
Jean
s O
utpu
t (p
airs
per
day
)
510152025303540455055 Total output
Bb
C
c
E
e
F
f
G
g
H
h
I
i
+ 10 jeans
Third worker
D
d
aA
MPP
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Resource Costs
6.2. The Costs of Production (The components of the
Costs of Production)
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Resource Costs
A production function tells us how much a firm can produce but not how much it should produce.
Goal of a firm: Maximizing profit Profit: The difference between Total Revenue
(PxQ) and Total Cost (TC) Requires every firm to decide on its most
desirable level of output
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Explicit vs. Implicit Cost
Explicit costs: are the payments made for the use of a
resource.
Implicit costs : are the value of resources used, even when
no direct payment is made.
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Economic vs. Accounting Profit
Accounting Profit Accountants typically count dollar costs only
and ignore any resource use that doesn’t result in an explicit dollar cost.
Economic Profit: Economists consider implicit costs as well as
explicit costs to be part of the total costs of production.
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Economic vs. Accounting profit
I.e., Economic cost represents he value of all resources used to produce a good or service; opportunity cost.
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Dollar Costs (Economic Costs)
The dollar costs of production are directly related to the underlying production function.
1. Total Fixed Costs (TFC)
2. Total Variable Costs (TVC)
3. Total Costs (TC)
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Costs of Production
Rate of Output
Fixed Cost(TFC)
Variable Cost(TVC)
Total Cost(TC) (FC + VC)
0 $120 $ 0 $120 10 120 85 205 15 120 125 245 20 120 150 270 30 120 240 360 40 120 350 470 50 120 550 670 51 120 633 753
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Fixed Cost
Fixed costs are the costs of production that do not change when the rate of output is altered, such as the cost of basic plant and equipment.
0 15 30 45 60 75
100200300400500600700800900
1,0001,100
$1,200
Rate of Output (pairs of jeans per day)
Pro
duct
ion
Cos
ts (
dolla
rs p
er d
ay)
TFC=$120
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Variable Cost
Variable costs are the costs of production that change when the rate of output is altered, such as labor and material costs.
0 15 30 45 60 75
100200300400500600700800900
1,0001,100
$1,200
Rate of Output (pairs of jeans per day)
Pro
duct
ion
Cos
ts (
dolla
rs p
er d
ay)
TVC
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Total Cost
Total cost is the market value of all the resources used to produce a good or service.
0 15 30 45 60 75
100200300400500600700800900
1,0001,100
$1,200
Rate of Output (pairs of jeans per day)
Pro
duct
ion
Cos
ts (
dolla
rs p
er d
ay)
Total cost
G
BA
Fixed costs
Variable costs
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Total Cost
How fast total costs rise depends on variable costs only.
Total cost is equal to the fixed costs when output is zero.
There is no way to avoid fixed costs in the short run.
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The Cost of Jeans Production
0 15 30 45 60 75
100200300400500600700800900
1,0001,100
$1,200
Rate of Output (pairs of jeans per day)
Pro
duct
ion
Cos
ts (
dolla
rs p
er d
ay)
Total cost
G
BA
Fixed costs
Total cost include variable and fixed costs
Variable costs
Variable costs
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Average Costs
One of the most common cost is average, or per-unit, cost.
4. Average Fixed Cost (AFC)
5. Average Variable Cost (AVC)
6. Average Total Cost (ATC)
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Average Costs
Average fixed cost (AFC) is total fixed cost divided by the quantity produced in a given time period.
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Average Costs
Average variable cost (AVC) is total variable cost divided by the quantity produced in a given time period.
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Average Costs
Average total cost (ATC) is total cost divided by the quantity produced in a given time period.
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Average Costs
Average total cost is the sum of average fixed and average variable cost.
ATC = AFC + AVC
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Average Costs
Rate ofOutput
Total Cost AverageFixed Cost
AverageVariable
Cost
AverageTotal Cost
AFC + AVC0 $120 —10 205 $12.00 $ 8.50 $20.5015 245 8.00 8.33 16.3320 270 6.00 7.50 13.5030 360 4.00 8.00 12.0040 470 3.00 8.75 11.7550 670 2.40 11.00 13.4051 753 2.35 12.41 14.76
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$24
20
16
12
8
4
0 10 20 30 40 50Rate of Output (pairs per day)
Cos
ts (
dolla
rs p
er p
air)
I
J
KL M N
O
ATC
AVC
AFC
Average Costs
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Characteristic of Average Costs
Falling AFC As the rate of output increases, AFC
decreases as the fixed cost is spread over more output.
Any increase in output lowers average fixed cost.
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Falling and then Rising AVC AVC will eventually rise as the rate of output
increases. AVC rises because of diminishing returns in
the production process.
Characteristic of Average Costs
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U-Shaped ATC
The initial dominance of falling AFC, combined with the later resurgence of rising AVC, is what gives the ATC curve its characteristic U shape.
Characteristic of Average Costs
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Minimum Point of the Average Total Cost The bottom of the U-shaped average total
cost curve represents the minimum average total costs.
It identifies the lowest possible opportunity costs to produce the product.
Note: Profit aren’t necessarily maximized where average total costs are minimized.
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7. Marginal Cost (MC)
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Marginal Cost
Marginal cost refers to the change in total costs associated with one more unit of output.
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Marginal Cost
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Marginal Cost
$35
30
25
20
15
10
5
10 20 30 40 50
pq
r
s t
u
v
Higher output level becomes increasingly expensive
Rate of Output (pairs per day)
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Relationship between MPP and MC
Whenever MPP is increasing, the marginal cost of producing a good must be falling.
If marginal physical product declines, marginal cost increases.
Diminishing returns in production cause marginal costs to increase as the rate of output is expanded.
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Falling MPP Implies Rising Marginal Cost
Diminishing marginal productivity implies . . . Rising marginal cost
Mar
gina
l Phy
sica
l Pro
duct
Labor Input
24
20
16
12
8
4
0 1 2 3 4 5 6 7 8
Add
ition
al L
abor
Cos
t
1.20
1.00
0.80
0.60
0.40
0.20
0 1 2 3 4 5 6 7Labor Input
Dim
inishing
marginal physical product
i
b
c
d
ef
g h1/b 1/c 1/d
1/e
1/f
1/g
Ris
ing
mar
gina
l cos
t
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Summarizing the Relationship between different types of Costs of Production
and their Implication
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Relationships
Output decision (how much to produce) has to be based not only on the capacity to produce (the production function) but also on the costs of production (the cost functions).
The relationship between the different cost components is thus important
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Basic Cost Curves-relationships
$32
28
24
20
16
12
8
4
0 1 2 3 4 5 6 7 8
Co
st (
dol
lars
per
uni
t)
Rate of Output (units per time period)9
ATC
n
mAVC
AFC
MC
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Relationships…
The marginal cost curve always intersects the ATC curve at its lowest point.
If MC > ATC, ATC is increasing
If MC < ATC, ATC is decreasing
If MC = ATC, ATC at minimum
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Number of Employees
(L)
Output(Bottles
per Day); Q
Fixed Cost(TFC)
Variable cost
(TVC)
Total Cost(TC)
Average Fixed Cost
(AFC)
Average Variable
Cost(AVC)
Average Total Cost
(ATC)
Marginal Cost (MC)
A 0 0 $40
B 1 80
C 2 200
D 3 260 $36
E 4 300 $48
F 5 330
G 6 350
H 7 362 $84
Complete the Table Below
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Number of Employees
(L)
Output(Bottles per Day)
Total Cost(TC)
Total Revenue TR=P x Q
ProfitTR-TC
A 0 0
B 1 80
C 2 200
D 3 260
E 4 300
F 5 330
G 6 350
H 7 362
Bottles sell for 35 cents each. Complete the table below
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Long-Run Costs
The short-run is characterized by some costs that cannot be changed (fixed costs).
In the long run, there are no fixed costs.
The long run is a period of time long enough for all inputs to be varied (no fixed costs).
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Long-Run Average Costs
The long-run cost curve is a summary of our best short-run cost possibilities.
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Long-Run Average Costs
ATC1
ATC2
ATC3
Long-run average total cost (LATC)
Cos
ts (
dolla
rs p
er p
air)
0 40 a 60 b cRate of Output (pairs of jeans per day)
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Long-Run Marginal Costs
The long-run marginal costs curve intersects our long-run cost curve at its lowest point.
0 q2
Rate of Output (jeans per day)
Cos
ts (
dolla
rs p
er p
air)
LMC
LATC
ATC2
m2
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What is the appropriate Size?
In the long run, there are many optional plant sizes available to the firm. Decision as to which size is appropriate has to be made.
A firm can decide to use one large plant or several smaller plants to produce a given amount of output.
What guides the firm on such a decision?
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Economies of Scale
Three Types: Constant returns to scale
are increases in plant size do not affect minimum average cost – minimum per-unit costs are identical for small plants and large plants.
Economies of scale: are reductions in minimum average costs that
come about through increases in the size (scale) of plant and equipment.
Diseconomies of scale: occur when an increase in plant size results in
reducing operating efficiency.
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Economies of Scale
QM0
Economies of scale
c
ATC2
m2
ATCS
RATE OF OUTPUT (units per period)
QM0
Diseconomies of scale
c
ATC3
m3ATCS
RATE OF OUTPUT (units per period) QM
0
CO
ST
(do
llars
per
uni
t)Constant returns to scale
c
ATC1
m1
RATE OF OUTPUT (units per period)
ATCS
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Economies of Scale
QM0
Diseconomies of scale
c
ATC3
m3ATCS
RATE OF OUTPUT (units per period)
QM0
Economies of scale
c
ATC2
m2
ATCS
RATE OF OUTPUT (units per period)
QM0
CO
ST
(do
llars
per
uni
t)
Constant returns to scale
c
ATC1
m1
RATE OF OUTPUT (units per period)
ATCS
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Economies of Scale
QM0
CO
ST
(do
llars
per
uni
t)
Constant returns to scale
c
ATC1
m1
RATE OF OUTPUT (units per period)
ATCS
QM0
Economies of scale
c
ATC2
m2
ATCS
RATE OF OUTPUT (units per period)
QM0
Diseconomies of scale
c
ATC3
m3ATCS
RATE OF OUTPUT (units per period)
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Global Competitiveness: Low Wages and Advances in Productivity Global competitiveness ultimately depends on
the costs of production.
Low wages are not a reliable measure of global competitiveness.
A worker’s productivity (MPP) depends on the quantity and quality of other resources in the production process.
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Global Competitiveness: Low Wages and Advances in Productivity What should American Firms do to remain
globally competitive?
American productivity must increase as fast as other nations in order for America to stay competitive in global markets.
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Unit Labor Costs
Both factor costs and productivity are taken into account to measure competitiveness.
Unit labor cost a true measure of global competitiveness.
MPP
rate wagecost labor Unit
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Improvements in Productivity Reduce Costs
TO
TA
L O
UT
PU
T(u
nits
per
tim
e pe
riod)
When the production function shifts up
Resource Inputs (dollars per unit)
Cost curves shift down
Rate of Output(units per time period)
CO
ST
(do
llars
per
uni
t)
ATC1
ATC2
MC1
MC2