Costs of ProductionCosts of Production

SummarySummary

Types of ProductionTypes of Production

There are three main sectors in the There are three main sectors in the economyeconomy– the primary sector consists of industries that the primary sector consists of industries that

extract or cultivate natural resourcesextract or cultivate natural resources– the secondary sector consists of industries the secondary sector consists of industries

that fabricate or process goodsthat fabricate or process goods– the service sector consists of trade and the service sector consists of trade and

information industriesinformation industries

Productive EfficiencyProductive Efficiency

Businesses choose from different Businesses choose from different production processesproduction processes– a labour-intensive process employs more a labour-intensive process employs more

labour and less capitallabour and less capital– a capital-intensive process employs more a capital-intensive process employs more

capital and less labourcapital and less labour

The lowest-cost process provides The lowest-cost process provides productive efficiencyproductive efficiency

Economic CostsEconomic Costs

Economic costs includeEconomic costs include– explicit costs which are payments to resource explicit costs which are payments to resource

supplies outside a businesssupplies outside a business– implicit costs which are what owners give up implicit costs which are what owners give up

by being involved in a businessby being involved in a business

Economic profit is found by subtracting Economic profit is found by subtracting economic costs (both explicit and implicit) economic costs (both explicit and implicit) from total revenuefrom total revenue

Production in the Short RunProduction in the Short Run

In the short runIn the short run– some inputs are fixed (such as capital)some inputs are fixed (such as capital)– other inputs are variable (such as labour)other inputs are variable (such as labour)

Inputs are combined to make a business’s Inputs are combined to make a business’s total producttotal product– average productaverage product is total product divided by the is total product divided by the

number of workersnumber of workers– marginal productmarginal product is the extra total product is the extra total product

(output produced) from employing an additional (output produced) from employing an additional workerworker

ProductionProduction in the Short Run in the Short Run

The Law of Diminishing The Law of Diminishing Marginal ReturnsMarginal Returns

Short-run production is determined by the Short-run production is determined by the law of diminishing marginal returnslaw of diminishing marginal returns– the addition of more variable input causes the addition of more variable input causes

marginal product to fall after some pointmarginal product to fall after some point– average product also falls after some pointaverage product also falls after some point

The Law of Diminishing The Law of Diminishing Marginal ReturnsMarginal Returns

It is possible to prove the law of It is possible to prove the law of diminishing returns through a type of diminishing returns through a type of argument known by the latin term argument known by the latin term “reductio ad absurdum”.“reductio ad absurdum”.

““opposite leads to absurdity”opposite leads to absurdity”

The Law of Diminishing The Law of Diminishing Marginal ReturnsMarginal Returns

Consider what would happen if you used a Consider what would happen if you used a flower pot to grow food: flower pot to grow food: – If the law of DMR were false, then, as you If the law of DMR were false, then, as you

used more labour, the total product of food used more labour, the total product of food grown in the flower pot would rise at a faster grown in the flower pot would rise at a faster and faster rate, until the world’s entire food and faster rate, until the world’s entire food supply could be provided from this single pot. supply could be provided from this single pot. Since this conclusion is obviously “absurd”, Since this conclusion is obviously “absurd”, the law of DMR must be true!the law of DMR must be true!

Relating Average and Marginal Relating Average and Marginal ValuesValues

Average and marginal values are related Average and marginal values are related using three rulesusing three rules– if an average value rises then the marginal if an average value rises then the marginal

value must be above the average valuevalue must be above the average value– if an average value falls then the marginal if an average value falls then the marginal

value must be below the average valuevalue must be below the average value– if an average value stays constant then the if an average value stays constant then the

marginal value must equal the average valuemarginal value must equal the average value

Total, Marginal, and Average ProductTotal, Marginal, and Average ProductFigure 4.4, page 106

Costs in the Short RunCosts in the Short Run

Short-run costs includeShort-run costs include– fixed costs (costs of all fixed inputs)fixed costs (costs of all fixed inputs)– variable costs (costs of all variable inputs)variable costs (costs of all variable inputs)– total cost (fixed costs + variable costs)total cost (fixed costs + variable costs)

Marginal CostMarginal Cost

Marginal cost is the extra cost of Marginal cost is the extra cost of producing an extra unit of outputproducing an extra unit of output– it equals the change in total cost divided by it equals the change in total cost divided by

the change in total productthe change in total product

The marginal cost curve is shaped like a The marginal cost curve is shaped like a “J” because of the law of diminishing “J” because of the law of diminishing marginal returnsmarginal returns

Per-Unit CostsPer-Unit Costs

Per-unit costs includePer-unit costs include– average fixed cost (fixed costs divided by total average fixed cost (fixed costs divided by total

product)product)– average variable cost (variable costs divided average variable cost (variable costs divided

by total product)by total product)– average costaverage cost

either total cost divided by total producteither total cost divided by total product

or average fixed cost + average variable costor average fixed cost + average variable cost

The Family of Short-Run Cost CurvesThe Family of Short-Run Cost CurvesFigure 4.8, page 111

Copyright © 1998 by McGraw-Hill Ryerson Limited. All rights reserved.

Returns to Scale (a)Returns to Scale (a)

All inputs can be changed by the same All inputs can be changed by the same proportion in the long runproportion in the long run– increasing returns to scale means the % increasing returns to scale means the %

change in output > the % change in inputschange in output > the % change in inputs– constant returns to scale means the % constant returns to scale means the %

change in output = the % change in inputschange in output = the % change in inputs– decreasing returns to scale means the % decreasing returns to scale means the %

change in output < the % change in inputschange in output < the % change in inputs

Returns to Scale (b)Returns to Scale (b)

Increasing returns to scale are caused by Increasing returns to scale are caused by the division of labour or specialized capital the division of labour or specialized capital or specialized managementor specialized management

Constant returns to scale arise whenever Constant returns to scale arise whenever making more of a product means making more of a product means repeating exactly the same tasksrepeating exactly the same tasks

Decreasing returns to scale are caused by Decreasing returns to scale are caused by management difficulties or limited natural management difficulties or limited natural resourcesresources

Costs in the Long Run (a)Costs in the Long Run (a)

Long-run average cost is the minimum Long-run average cost is the minimum short-run average cost at every outputshort-run average cost at every output

The long-run average cost curve is The long-run average cost curve is saucer-shaped because of various ranges saucer-shaped because of various ranges of returns to scaleof returns to scale– initial range of increasing returns to scaleinitial range of increasing returns to scale– middle range of constant returns to scalemiddle range of constant returns to scale– final range of decreasing returns to scalefinal range of decreasing returns to scale

Costs in the Long Run (b)Costs in the Long Run (b)Figure 4.9, page 116

Critic of the Modern CorporationCritic of the Modern Corporation

John Kenneth Galbraith (pp.118-119)John Kenneth Galbraith (pp.118-119)– suggests that ownership and control are suggests that ownership and control are

separated in large corporationsseparated in large corporations– argues that shareholders (the owners) give up argues that shareholders (the owners) give up

control to managerscontrol to managers– holds out the possibility that managers are holds out the possibility that managers are

more interested in maximizing sales than in more interested in maximizing sales than in maximizing profitmaximizing profit