production and cost

Business Firm

An entity that employs factors of production (resources) to produce goods and services to be sold to consumers, other firms, or the government.

Managerial Coordination and Business Firms

The process in which managers direct employees to perform certain tasks.

Why Do Business Firms Arise in the First Place?

Firms are formed when benefits can be obtained from individuals working as a team.

Problem of and Solutions for “Team” Work

Problem: Shirking - The behavior of a worker who is putting forth less than the agreed to effort.

Solution: Monitor – Person (manager) in a business firm who coordinates team production and reduces shirking.

Problem: Monitor shirkingSolution: Make the monitor a Residual

Claimants - Persons who share in the profits of a business firm.

Markets: Inside and Outside the Firm

Economics is largely about trades or exchanges; it is about market transactions.

In supply-and-demand analysis, the exchanges are between buyers of goods and services and sellers of goods and services.

In the theory of the firm, the exchanges take place at two levels: (1) at the level of individuals coming together to form a team and (2) at the level of workers “choosing” a monitor.

Firm’s Objective: Maximizing Profit

The difference between total revenue and total cost.

Profit = Total revenue - Total cost

Explicit and Implicit Cost

Explicit Cost - A cost incurred when an actual (monetary) payment is made.

Implicit Cost - A cost that represents the value of resources used in production for which no actual (monetary) payment is made.

Accounting, Economic and Normal Profit I

Accounting Profit - The difference between total revenue and explicit costs.

Economic Profit - The difference between total revenue and total cost, including both explicit and implicit costs.

Normal Profit - Zero economic profit. A firm that earns normal profit is earning revenue equal to its total costs (explicit plus implicit costs). This is the level of profit necessary to keep resources employed in that particular firm.

Accounting, Economic and Normal Profit II

Production and Cost: Fixed and Variable Inputs

Fixed Input - An input whose quantity cannot be changed as output changes.

Variable Input - An input whose quantity can be changed as output changes.

Production and Cost:Short and Long Run

Short Run - A period of time in which some inputs in the production process are fixed.

Long Run - A period of time in which all inputs in the production process can be varied (no inputs are fixed).

Marginal Physical Product (MPP)

Marginal Physical Product (MPP) - The change in output that results from changing the variable input by one unit, holding all other inputs fixed

Production in the Short Run and the Law of Diminishing Marginal

ReturnsIn the short run, as additional units of a

variable input are added to a fixed input, the marginal physical product of the variable input may increase at first.

Eventually, the marginal physical product of the variable input decreases.

The point at which marginal physical product decreases is the point at which diminishing marginal returns have set in.

Law of Diminishing Marginal Returns

Law of Diminishing Marginal Returns - As ever-larger amounts of a variable input are combined with fixed inputs, eventually, the marginal physical product of the variable input will decline.

Production in the Short Run and the Law of Diminishing Marginal

Productivity

Fixed, Variable, Total and Marginal Cost

Fixed Costs (FC) - Costs that do not vary with output; the costs associated with fixed inputs.

Variable Cost (VC) - Costs that vary with output; the costs associated with variable inputs.

Total Cost (TC) - The sum of fixed costs and variable costs. TC = TFC + TVC

Marginal Cost (MC) - The change in total cost that results from a change in output: MC = ΔTC/Δ Q.

Marginal Physical Product and Marginal Cost I

Marginal Physical Product and Marginal Cost II

The marginal physical product of labor curve is derived by plotting the data from columns 2 and 4 in the exhibit.

The marginal cost curve is derived by plotting the data from columns 3 and 8 in the exhibit. See next slide.

Notice that as the MPP curve rises, the MC curve falls; and as the MPP curve falls, the MC curve rises.

Average Productivity

Q = OutputL = Number of units of labor

Average Fixed, Variable and Total Cost

Average Fixed Cost (AFC) - Total fixed cost divided by quantity of output: AFC = TFC / Q.

Average Variable Cost (AVC) - Total variable cost divided by quantity of output: AVC = TVC / Q.

Average Total Cost (ATC), or Unit Cost - Total cost divided by quantity of output: ATC = TC / Q.

Total, Average & Marginal Costs I

Total, Average & Marginal Costs II

Average-Marginal Rule

When the marginal magnitude is above the average magnitude, the average magnitude rises; when the marginal magnitude is below the average magnitude, the average magnitude falls.

Average and Marginal Cost Curves

Tying Production to Costs

What happens in terms of production (MPP rising or falling) affects MC, which in turn eventually affects AVC and ATC.

Production and Costs in the Long Run

In the short run, there are fixed costs and variable costs; therefore, total cost is the sum of the two.

A period of time in which all inputs in the production process can be varied (no inputs are fixed). In the long run, there are no fixed costs, so variable costs are total costs.

Long-Run Average Total Cost (LRATC) Curve

A curve that shows the lowest (unit) cost at which the firm can produce any given level of output.

Long-Run Average Total CostCurve (LRATC )

There are three short-run average total cost curves for three different plant sizes.

If these are the only plant sizes, the long-run average total cost curve is the heavily shaded, blue scalloped curve.

Long-Run Average Total CostCurve (LRATC )

The long-run average total cost curve is the heavily shaded, blue smooth curve.

The LRATC curve is not scalloped because it is assumed that there are so many plant sizes that the LRATC curve touches each SRATC curve at only one point.

Economies of Scale I

Economies of Scale exist when inputs are increased by some percentage and output increases by a greater percentage, causing unit costs to fall.

Constant Returns to Scale exist when inputs are increased by some percentage and output increases by an equal percentage, causing unit costs to remain constant.

Diseconomies of Scale exist when inputs are increased by some percentage and output increases by a smaller percentage, causing unit costs to rise.

Why Economies of Scale?

Up to a certain point, long-run unit costs of production fall as a firm grows. There are two main reasons for this:

Growing firms offer greater opportunities for employees to specialize.

Growing firms can take advantage of highly efficient mass production techniques and equipment that ordinarily require large setup costs and thus are economical only if they can be spread over a large number of units.

2/3 rule

Why Diseconomies of Scale?

In very large firms, managers often find it difficult to coordinate work activities, communicate their directives to the right persons in satisfactory time, and monitor personnel effectively.

Economies of Scale II

The lowest output level at which average total costs are minimized.

A firm’s cost curves will shift if there is a change in:TaxesInput pricesTechnology.

Shifts in Cost Curves

36

Isoquants

An isoquant is a graph that shows all the combinations of capital and labour that can be used to produce a given amount of output.

37

Properties of Isoquant Maps

There are an infinite number of combinations of labour and capital that can produce each level of output.

Every point lies on some isoquant.The slope of an isoquant is equal to: -

MPlabour / MPcapital = - MPL / MPK = ΔK / ΔLThe slope of the isoquant is called the marginal rate of

technical substitution which can be defined as the rate at which a firm can substitute capital for labour and hold output constant.

38

Isoquants Showing All Combinations of Capital and Labour That Can Be Used to

Produce 50, 100, and 150 Units of Output

39

The Slope of an Isoquant Is Equal to the Ratio of MPL to

MPK

40

Isocosts

An isocost is a graph that shows all the combinations of capital and labour available for a given cost.

41

Isocost Lines Showing the Combinations of Capital and Labour

Available for $5, $6, & $7

42

Isocost Line Showing All Combinations of Capital and

Labour Available for $25

The slope of an isocost line is

equal to - PL / PK.

The simple way to draw an isocost is to calculate the endpoints on the line and connect them.

43

The Cost Minimizing Equilibrium Condition

Slope of isoquant = - MPL / MPK

Slope of isocost = - PL / PK

For cost minimization we set these equal and rearrange to obtain:

MPL / PL = MPK / PK

44

Finding the Least-Cost Combination of Capital and Labour to Produce 50 Units of Output

Profit-maximizing firms will minimize costs by producing their chosen level of output with the technology represented by the point at which the isoquant is tangent to an isocost line.Point A on this diagram

45

Minimizing Cost of Production for qx = 50, qx

= 100, and qx = 150

Plotting a series of cost- minimizing combinations of inputs - shown here as A, B and C - enables us to derive a cost curve.

46

A Cost Curve Showing the Minimum Cost of Producing Each

Level of Output

47

Review Terms & Concepts

isocost lineisoquantmarginal rate of technical substitution

The Cobb-Douglas Production Function

Y = AKL(1-)

The Cobb-Douglas Production Function

History

Developed by Paul Douglas and C. W. Cobb in the 1930’s

The Cobb-Douglas Production Function

History

Developed by Paul Douglas and C. W. Cobb in the 1930’sDouglas went on

to be professor at Chicago and U.S. Senator

Cobb - ??

The Cobb-Douglas Production Function

The General Problem

An increase in a nation’s capital stock or labor force means more output.

Is there a mathematical formula that relates capital, labor and output?

The Cobb-Douglas Production Function

The General Form

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The Cobb-Douglas Production Function

Increasing Capital

1

1

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LKAY

LAKY

The Cobb-Douglas Production Function

Increasing Capital

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oo

ooo

YLAK

LKAY

LAKY

22

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1

1

The Cobb-Douglas Production Function

Increasing Capital

ooo

oo

ooo

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LKAY

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22

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1

1

Diminishing returns to proportion

The Cobb-Douglas Production Function

Increasing Labor

1

1

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LAKY

LAKY

The Cobb-Douglas Production Function

Increasing Labor

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oo

ooo

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LAKY

LAKY

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1

1

22

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The Cobb-Douglas Production Function

Increasing Labor

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LAKY

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1

1

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Diminishing returns to proportion

The Cobb-Douglas Production Function

Increasing Both

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The Cobb-Douglas Production Function

Increasing Both

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1

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The Cobb-Douglas Production Function

Increasing Both

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oo

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1

1

Constant returns to scale

The Cobb-Douglas Production Function

Substitution

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Capital and Labor Can be Substituted

The Cobb-Douglas Production Function

An Illustration

2/12/1

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The Cobb-Douglas Production Function

An Illustration

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The Cobb-Douglas Production Function

An Illustration

KLAY

The Cobb-Douglas Production Function

An Illustration

KLAY A =3 L =10

K =10

The Cobb-Douglas Production Function

An Illustration

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The Cobb-Douglas Production Function

Doubling Capital

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Y

The Cobb-Douglas Production Function

Constant Returns to Scale

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The Cobb-Douglas Production Function

Substitution

5

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x

xY

The Cobb-Douglas Production Function

Estimation

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1

t

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The Cobb-Douglas Production Function

Estimation

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1

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The Cobb-Douglas Production Function

Estimation

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2

1

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KY

Statistical issues abound!

The Cobb-Douglas Production Function

Factor Payments

= % of Income going to owners of capital

1- = % of Income going to workers

The Cobb-Douglas Production Function

How well does it work?

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You can’t beat something with nothing

The Cobb-Douglas Production Function

Leontief Production Function

K

L

The Cobb-Douglas Production Function

Leontief Production Function

K = aYL = bY

K

L

The Cobb-Douglas Production Function

Leontief Production Function

K = aYL = bY

K

L

The Cobb-Douglas Production Function

Leontief Production Function

K = aYL = bY

K

L

= 0

The Cobb-Douglas Production Function

Leontief Production Function

K = aYL = bY

K

L

Doesn’t work. We can and do substitute labor for capital all the

time

The Cobb-Douglas Production Function

Other Factors?

1

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The Cobb-Douglas Production Function

And in Conclusion…

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