CHAPTER 23 –Production Costs

How much output can a firm produce?How do the costs of production vary

with the rate of outputDo larger firms have a cost advantage

over smaller firms?We are talking about the Production

Function…i.e. Costs of Production

Next Step for Production FunctionHow many inputs does it take to arrive at the desired mix

of outputs. (from the factors)*How many workers will it take to make the new Board

Game… I LOVE ECONOMICS?

Definition of Production Function: Relationship between the maximum quantity of a good

attainable from different combinations of factor inputs.

Maximum Output/Minimum InputsProduction of goods equates cost!Idea for a firm (large or small) is to minimize

the cost while maximizing output.How best to produce?What’s the smallest amount of resources

needed to produce a specific product? *What is the least number of workers we can hire to handle the noon counter trade? (McDonalds). Can we lay off another 1,000 workers and still be competitive (IBM) Ford lays off 15,000 workers

(Factors of production=land,labor,capital, entrepreneurship

Answers to Production QThe Production Function will answer what

maximum amount of output is attainable from various combinations of factor inputs. (this is getting the mixing bowl filled with right ingredients)

With a fixed amount of capital adding labor inputs can predict outputs---up to a certain point---then more capital needs to be added.

Law of Diminishing Returns *Did you ever fall asleep reading your

economics text after a long day at work? Or maybe you just procrastinated on getting that book open.. Of course you have…..… you have experienced

Diminishing returns. In the short run—Production

function defines the limit to output and how much each worker will contribute to that limit.

The factor that can be adjusted quickly in the SR is Labor.

Yet… as more labor is hired, each unit of labor has less capital and land to work with…

Things get constrained.. Hence. Marginal Physical Product declines

This refers to how many widgets

Example/Build a City game

Set up a small factoryFixed factor of production(4

machines)Functions of machinesAdd variable factors one at a

time.

• If you keep adding workers- will reach a point where the marginal worker adds nothing to our total output.

• A business person must be aware of the law of diminishing returns if he wants to operate efficiently.

Machines Workers Total Output

Approx Average Output

Marginal Product

4 0 0 0 0

4 1 20 20 20

4 2 45 22.5 25

4 3 80 26.5 35

4 4 130 32.5 50

4 5 160 32 30 ***

4 6 180 30 20

4 7 190 27.1 10

4 8 185 23.1 -5

Bottom LineIf we keep adding workers we will reach a

Point where--- the Marginal Worker adds nothing to our total output * All the checkout lanes are filled with Tom Thumb Employees… very few people are checking out. (Is this productive for TT?)

What happens to their Profit Margin?Cost exceeds any benefits of hiring

additional workers.

Long run/short run productivity

Short run= period in which the quantity (and quality of some inputs) cannot be changed.

General assumption: In SR labor can change while capital is held constant

Generally, as amount of labor used increases, the output will also increase (with reservations) See diminishing returns*

Marginal Productivity

• MPP (marginal physical product)=The change in total output that results from

employment of one additional unit of input.

Formula: MPP = change in total output change in input quantity *same figure as approximate avg output.On diminishing returns chart…

MPP and Assembly Lines

Employment Dilemmas

Sometimes employeesdon’t measureup

*Output doesnot justifyTheir negativeinputs

Marginal Physical Product MPP-

• Marginal Productivity• When the MPP of labor (MPPL >0), then

total output increases.• Improving the ratio of labor to other

factors increases the MPP of labor.

MPP Chart

Fixed Input Variable Input labor

Quantity of Output Q

MPP of Variable Input

1 0 0

1 1 18 18

1 2 37 19

1 3 57 20

1 4 76 19

1 5 94 18

Marginal Physical Marginal Physical ProductProduct

MPP = ∆Q ∆ L

MPP GraphMPP Graph(actually (actually diminishing marginal diminishing marginal

physical product.physical product.

01 2 3 4 5 6 7 8

5101520253035404550 Total output

(per day)

Bb

C

c

E

e

I

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+ 10 jeans

Third worker

D

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aA

Marginal physical product (per worker)

Falling MPP implies Rising MC

• The MPP actually mirrors the output/worker.• MPP is the additional output obtained by

employing one more unit of input..• If MPP for each additional unit of input is producing less, it ultimately adds more cost

to each additional output.• . (i.e. input cost is rising= marginal cost is

increasing

Diminishing marginal productivity implies . . . Rising marginal cost

Mar

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Labor Input

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Dim

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Reducing output with indivisible inputs

• Often the production process is set so that it cannot be minimized.

• Machinery all set-up, cannot just make a l/2 widget to reduce outputs

• Example: Railway has tracks that run between cities – need both sets to run trains – cannot establish a half a set of tracks and get shipment there.

• What about Marginal Revenue? The change in total revenue associated with one additional unit of input.

• If marginal costs are increasing marginal revenue is decreasing.

Productivity- Right Mix of Output

REVIEW TERMINOLOGYFactors of production- Resource inputs used to

produce goods and services (land,labor,capital, entrepreneurship)

Productivity-Output per unit of input (output per labor hour)

Efficiency-maximum output of a good from the resources used in production

Opportunity Cost-The MOST DESIRABLEG&S that are forgone in order to obtain something else.Short Run-The period in which the quantity (and/or

quality) of some inputs cannot be changed.

Quick quiz

1. If input prices are rising, will Marginal cost be rising?

2. If you have a fixed amount of capital and continue to add labor inputs, will marginal product always increase?

3. What is marginal physical product?

Costs, Prices, Output in Competitive Markets

• All competition that is not PURE is IMPERFECT• Whether a firm exists in a perfectly

competitive market or imperfectly competitive market, it will TRY to

• MAXIMIZE PROFITS or MINIMIZE LOSSES.

Fixed, Variable, Total CostsWhat is a definition of profit?

What economic conditions might exist for this scenario?

ANSWER!• TR-TC=PROFIT

• How much money am I taking in? (TR)• How much is it costing me to produce my

output? (TC)

WHAT IS PROFIT?

Economic Profit vs Accounting Profit

(the difference lies in how cost is defined)

Economic Cost = Explicit Cost + Implicit Cost

Accounting Costs are all the costs that have an explicit dollar cost attached to it. TR-TC

•Economic cost represents in addition to explicit cost the opportunity cost of resources used.

You start a business- you own the building – you earn $50,000 in revenue- costs are $20,000. (what could you have rented the building for if you were not using it?

Accounting, Economic and Normal Profit II

Suppose a company incurs the following costs: labor, $400; equipment, $300; and materials, $100. The company owns the building so it doesn’t have to pay the usual $800 in rent.

a) What is the total accounting cost?b) What is the total economic cost?c) How would accounting and economic costs

change if the company sold the building and then leased it back?

Fixed Costs:All costs are classified as fixed or variable. In the

short run, the firm can only use its existing facilities to increase its output. During the short-run, there are several important costs that are fixed.

Fixed costs do not change when the firm changes its level of output

Name some—-interest on debts of the firm, payments for

rent, insurance premiums, taxes on real property, salaries.

Average Fixed Cost AFC

• Average fixed cost, AFC declines as the firm increases its output.

• Divide TFC by Q = AFC

TFC/Q = AFC

Graph

2 3 4 5 6 7 8 9 10

cOSTS

Quantity

AFC

Graph explanation

If a firm had nothing but fixed costs, the more it produced the lower its unit cost (AFC) However, the firm is also confronted by variable costs.

What are Variable Costs?Variable Costs increase as the firm increases its

output.All costs that are not fixed---are variable!

Continued Variable CostsWhen a firm increases its output, it must

acquire more productive resources.Examples:More laborersWagesElectricityPaint, sugar, plastic, steel, etc.***Variable costs: any costs that rises as the

firm produces more; and costs that fall as the firm produces less.

****This is the cost that producers have control over.

Quick QuizIdentify which is Fixed or Variable Cost1. Mortgage payments on a factory2. Electric bills at a print shop3. The cost of a new robot at General Motors

plant4. Premiums on liability insurance at the XYZ

Corporation5. Wages paid to auto workers6. Contract paid to top management at GE

Bottom Line--- The bottom line is

productivity whether it is a worker on an assembly line or a CEO.

“Whenever you are asked if you can do a job, tell 'em, 'Certainly I can!' Then get busy and find out how to do it.” ― Theodore Roosevelt

Why is productivity measured by the federal government?

Total Variable Cost and Average Variable Cost

AVC is found by dividing TVC by QTVC/Q = AVC

Although Average fixed cost declines continually, average variable cost does not. At first AVC usually declines as the firm’s output increases. After reaching a minimum, then AVC begins to rise.

AVC and Diminishing Returns

The AVC curve will have the general shape of the letter U. This is explained by the Law of diminishing returns.

Law says: as more and more units of a variable factor of production are added to a fixed factor of production (such as capital equipment) eventually a point will be reached at which the output accounted for by each additional unit of the variable factor will start to decline.

Total Cost

Total Cost is the sum of total fixed cost and total variable cost.

When a firm increases its output, total cost tends to rise

Fixed cost remains unchanged, naturally, but total cost will be pulled up by the rise in total variable cost with the rise in output.

ATC= TC/Q or adding AFC + AVC

Marginal Cost- controllable cost

• Marginal Resource Cost• Marginal cost (MC) is the increase in total

costs associated with a one unit increase in production.

How to determine marginal costTotal Output

Total FC Total VC Total Cost Marginal Cost

0 $2000 $ 0 $2,000 $ 0

1 $2000 $l,500 $3,500 $1,500

2 $2000 $2,600 $4,600 $1,100

3 $2000 $3,600 $5,600 $1,000

4 $2000 $4,800 $6,800 $1,200

5 $2000 $6,125 $8,125 $1,325

6 $2000 $7,800 $9,800 $1,675

7 $2000 $9,800 11,800 $2,000

8 $2000 12,000 14,000 $2,200

Graph ATC/AVC/AFC$24

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0 10 20 30 40 50Rate of Output (pairs per day)

Cos

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dolla

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air)

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ATC

AVC

AFC

Minimum Average 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.******

A Cost Summary

• The output decision has to be based not only on the capacity to produce (the production function) but also on the costs of production (the cost functions).

A Cost Summary

• The marginal cost curve always intersects the ATC curve at its lowest point.

ATCmc

Basic Cost Curves$32

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Rate of Output (units per time period)9

ATC

n

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AFC

MC

Mathematical RuleWhenever a number added to a series of

numbers is less than their average, the average must decline……….

When a number added to a series of numbers is larger than their average, the average must rise…..

Marginal Cost helps a firm decide whether to increase or decrease output.

Marginal cost is the cost that the firm can control most directly.

Adding numbers

A Cost Summary

If MC > ATC, ATC is increasing

If MC < ATC, ATC is decreasing

If MC = ATC, ATC at minimum

Identify these curves!

$32

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Rate of Output (units per time period)

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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).

LONG RUN CostsOver the long-run---ALL COSTS ARE VARIABLE.Taxes, interest rates, and other costs that are fixed in the

SR can change.The size of the firm can also affect costs. The principle that

explains this is called:

ECONOMIES OF SCALE- (means as firms enlarge their plants, their unit costs decline because of mass production and other factors such as:

Specialization, factor substitution, better equipment, research, marketing advantages, stability.

Long- Run Costs ContinuedThere are no fixed costs in the long-runThe long-run cost curve is just a summary of

our best short-run cost possibilities using existing technology facilities.

Like all average cost curves, the long-run LATC curve has its own marginal cost curve. The long-run marginal cost LMC curve is not a composite of short-run marginal cost curves. Rather it is computed on the basis of the costs reflected in the long-run ACT curve itself.

Marginal Physical Product and Marginal Cost I

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

Sunk Cost

• A cost incurred in the past that cannot be changed by current decisions and therefore cannot be recovered.

Long-Run Average CostsLR Costs are determined by SR options.

The key word is efficiency- operating at efficient point

ATC1ATC2

ATC3

Long-run average total cost (LATC)

Cos

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dolla

rs p

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air)

0 40 a 60 b cRate of Output (pairs of jeans per day)

Best for output levels below aBest for output levels in Excess of b

Long-Run Marginal Costs

• The long-run marginal costs curve intersects our long-run cost curve at its lowest point.

Long-Run Costs with Unlimited Options

0 q2Rate of Output (jeans per day)

Cos

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dolla

rs p

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air)

LMC

LATC

ATC2

m2

Economies of Scale

• There are many optional plant sizes available in long-run production.

One option is the decision to use one large plant or several smaller plants to produce a given amount of output.

Constant Returns to Scale and Diseconomies of Scale

Constant Returns= increases in plant size do not affect minimum average cost… minimum per-unit costs are identical for small plants and large plants.

Diseconomies of Scale=increase in plant size results in reducing operating efficiency

Economies of Scale

QM0

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Constant returns to scale

c

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m1

RATE OF OUTPUT (units per period)

ATCS

QM0

Economies of scale

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ATCS

RATE OF OUTPUT (units per period)

QM0

Diseconomies of scale

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m3ATCS

RATE OF OUTPUT (units per period)

Next Assignment

Time to begin thinking outside the box!