production and cost analysis i - ms. lopiccolo's...

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


The Role of the Firm

• A firm is an economic institution that transforms factors of production into goods and services

• In the supply process, people offer their factors of production, such as land, labor, and capital, to the market

• Production is the transformation of factors into goods

12-2


The Role of the Firm

• Firms:

1. Organize factors of production and/or

2. Produce goods and services and/or

3. Sell produced goods and services

McGraw-Hill/Irwin Colander, Economics 3


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

12-4



• 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




• 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

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• Accountants focus on explicit costs and revenues

• Accounting profit = explicit revenue –explicit cost




• Economists focus on both explicit and implicitcosts and revenue

• Economic profit = (explicit and implicit revenue) – (explicit and implicit cost)



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


•The production process can be divided into the short run and the long run


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



Production Tables and Production Functions

• A production table is a table showing the output resulting from various combinations of factors of production or inputs

12-11


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

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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



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

12-14


Graphing Marginal and Average Productivity

Increasing marginal

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

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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



12-16


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 long run, there are NO fixed costs since all inputs are variable

• In the short run, a number of inputs and their costs will be fixed

12-17



• 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




• 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

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• 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



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

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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

12-22


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

12-23



• 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



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

12-25


The Shapes of Cost Curves (continued)

• 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

12-26



• 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!)



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

12-28


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

12-29


• 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

12-30


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

12-31


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

12-32


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

12-33

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


Making Long-Run Production Decisions

• Firms have more options in the long run and they can change any input they want

• Neither plant size or technology available is given

13-35


Making Long-Run Production Decisions

• Firms look at costs of various inputs and the technologies available for combining these inputs

• When choosing among existing technologies in the long run, firms are interested in the lowest cost (economically efficient) methods of production



Technical Efficiency and Economic Efficiency

• Technical efficiency in production means that as few inputs as possible are used to produce a given output

13-37


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



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

13-39


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

13-40


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



Economies of Scale

• Example: The cost of a blast furnace or an oil refinery is an example of an indivisible setup cost



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

13-43


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



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

13-45


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

13-46



• 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)

13-47



2. As the size of firms increase, team spirit/morale decreases

– The larger the firm, the more difficult this becomes



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

13-49


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

13-50


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

13-51


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



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)

13-53


Entrepreneurial Activity and the Supply Decision

• Supplier’s expected economic profit per unit is the difference between the expected price of a good and the expected average total cost of producing it

• Profit underlies the dynamics of production in a market economy

• The expected price must exceed the opportunity cost of supplying the good for a good to be supplied

13-54


Entrepreneurial Activity and the Supply Decision

• An entrepreneur is an individual who sees an opportunity to sell an item at a price higher than the average cost of producing it

• They visualize the demand and convince the owners of the factors of production that they want to produce those goods

• Entrepreneurs organize production

13-55


Using Cost Analysis in the Real World

• Some of the problems of using cost analysis in the real-world include the following:

• Uncertainty

13-56

•Economies of scope•Learning by doing and technological change•Many dimensions•Unmeasured costs•Joint costs•Indivisible costs

• Asymmetries

• Multiple planning and adjustment periods with many different short runs

• And many more


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

13-57


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Using Cost Analysis in the Real World:Learning by Doing and Technological Change

• 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


Using Cost Analysis in the Real World: Unmeasured Costs

• Economists include opportunity costs while accountants use explicit costs that can be measured

• Economists include the owner’s opportunity cost which is the forgone income that the owner could have earned in another job

13-59


Using Cost Analysis in the Real World: Unmeasured Costs

• In measuring the costs of depreciable assets, accountants use historical cost which is what a depreciable item costs in terms of money actually spent for it as the cost basis

• If the depreciable asset increased in value, an economist would count its increased value as revenue



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

13-61


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

13-62


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

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