Chapter 5

Production and Cost

2

Production

• Business firm – an organization– Owned and operated by private

individuals– Specializes in production

• Production– Process of combining inputs to make

goods and services• Technology

– Method of combining inputs to produce goods or services

3

The Production Function

• Indicates the maximum amount of output a firm can produce over some period of time from each combination of inputs

• Figure 1 The Firm’s Production Function

Different

Combinations of

Inputs

Different

Quantities

of Output

Production

Function

4

Short-Run versus Long-Run Decisions

• Long run– A time horizon long enough for a firm to

vary all of its inputs– Variable inputs - can be adjusted up or

down as the quantity of output changes• Short run

– A time period during which at least one of the firm’s inputs is fixed

– Fixed inputs - cannot be adjusted as output changes in the short run

5

Production in the Short-Run

• Total product– Maximum quantity of output that can be

produced from a given combination of inputs

• Marginal product of labor: MPL=ΔQ/ΔL– Additional output produced when one

more worker is hired

6

Total and Marginal Product

30

90

130

160

184196 Total Product

Q from hiring fourth worker = 30

Q from hiring third worker = 40

Q from hiring second worker = 60

Q from hiring first worker = 30

increasing marginal returns

diminishing marginal returns

Units of Output

Number of Workers62 3 4 51

• Figure 2 Total and Marginal Product

7

Marginal Returns To Labor

• Increasing marginal returns to labor– MPL increases as more labor is hired

• Diminishing marginal returns to labor– MPL decreases as more labor is hired

• Law of Diminishing Marginal Returns – As more and more of any input is added

to a fixed amount of other inputs, its marginal product will eventually decline

8

Thinking About Costs

• Total cost– The opportunity cost of the owners -

everything they must give up in order to produce that amount of output

• Sunk cost– A cost that has been paid or must be

paid, regardless of any future action being considered

– Should not be considered when making decisions

9

Explicit vs. Implicit Costs

• Explicit cost– Money actually paid out for the use of

inputs

• Implicit cost– The cost of inputs for which there is no

direct money payment

10

Costs in the Short Run

• Fixed costs – Costs of a firm’s fixed inputs

– Remain constant as output changes

• Variable costs – Costs of a firm’s variable inputs

– Change with output

11

Total Costs in the Short Run

• Total fixed cost (TFC)– The cost of all inputs that are fixed in the

short run

• Total variable cost (TVC)– The cost of all variable inputs used in

production

• Total cost (TC=TFC+TVC)– The costs of all inputs—fixed and

variable

12

Total Cost Curves

TC

0

Dollars

135

195

255

315

375

$435

30 90 130 160

Units of Output

184

TFC

TFC

TVC

• Figure 3 The Firm’s Total Cost Curves

13

Average Costs

• Average fixed cost (AFC=TFC/Q)– Total fixed cost divided by the quantity of

output produced

• Average variable cost (AVC=TVC/Q)– Cost of the variable inputs per unit of

output

• Average total cost (ATC=TC/Q)– Total cost per unit of output

14

Marginal Cost

• Marginal Cost (MC)–Increase in total cost from producing one more unit or output

ΔQ

ΔTCMC

• MC curve is U-shaped –When MPL rises, MC falls –When MPL falls, MC rises. –MPL rises and then falls, MC will fall and then rise.

15

Average and Marginal Costs

MC

AVCATCAFC

Units of Output

Dollars

$4

3

2

1

30 90 130 160 1960

• Figure 4 Average and Marginal Costs

184

16

Average and Marginal Costs

• At low levels of output– MC - below the AVC and ATC curves– AVC and ATC slope downward

• At higher levels of output– MC - above the AVC and ATC curves– AVC and ATC slope upward

• U-shaped curves• MC curve will intersect the minimum

points of the AVC and ATC curves

17

Production and Cost in the Long Run

• All inputs and all costs are variable• Least Cost Rule

– To produce any given level of output, the firm will choose the input mix with the lowest cost

• Long-run total cost (LRTC)– The cost of producing each quantity of

output when the least-cost input mix is chosen in the long run

18

Production and Cost in the Long Run

• Long-run average total cost (LRATC)–The cost per unit of output

•in the long run•all inputs are variable

Q

LRTCLRATC

• LRTC ≤ TC• LRATC ≤ ATC

19

Average Cost and Plant Size

• Plant - Collection of fixed inputs at a firm’s disposal

• Short run– Cannot change the plant size– Move along ATC curve

• Long run– Choose among ATC curves– Can change the plant size – Produce at lowest possible ATC

20

Graphing the LRATC Curve

LRATCATC1

Use 0 automated

lines

ATC3ATC0

C

BA

ATC2

D

E

175 196184

Dollars

1.00

2.00

3.00

$4.00

Units of Output

30 90 130 160 250 3000

Use 1 automated

lines

Use 2 automated

lines

Use 3 automated

lines

• Figure 5 Long-Run Average Total Cost

21

The Shape of LRATC

• Economies of scale - LRATC decreases as output increases– LRATC curve slopes downward

• More likely to occur at lower levels of output• Spreading costs of Lumpy inputs

• Diseconomies of scale - LRATC increases as output increases– LRATC curve slopes upward

• More likely at higher output levels

22

The Shape of LRATC

• Constant returns to scale - LRATC is unchanged as output increases– LRATC curve is flat

• U-shape of LRATC curve– Economies of scale at relatively low

levels of output– Constant returns to scale at some

intermediate levels of output– Diseconomies of scale at relatively high

levels of output

23

The Shape Of LRATC

Pizzas Served per Day

LRATC

Economies of Scale Constant Returns to

Scale

Diseconomies of Scale

0

Dollars

2.00

4.00

6.00

$8.00

200 250

• Figure 6 The Shape Of LRATC

24

The Urge to Merge

• Minimum efficient scale (MES)– The lowest output level at the minimum

cost per unit in the long run

• Mergers– Significant, unexploited economies of

scale

– Because the market has too many firms for each to operate near its MES

25

The Urge to Merge• Figure 7 LRATC for a Typical Firm in a Merger-Prone Industry

Dollars

Quantity

per Month

A

B

C

LRATC

$240

200

80

8,00010,000

20,000

1. With market quantity demanded fixed at 60,000, and six firms of equal market share, each operates at A

2. But any one firm can cut price slightly, increase market share, and operate with lower cost per unit, such as at the MES (point B)

3. Other firms lose market share and end up at C

5. Mergers to create three large firms would enable each

to operate at its MES with less likelihood of price wars and losses

4. Price war - other firms must match the first-mover’s

price; each firm ends up back at A - they suffer losses

26

Appendix: Isoquant Analysis

• Every point on an isoquant represents an input mix that produces the same quantity of output

• Isoquants slope downward– An increase in one input requires a

decrease in the other input to keep total production unchanged

• Higher isoquants – Greater levels of output than lower

isoquants

27

Q=4,000

Appendix: An Isoquant Map• Figure A.1 An Isoquant Map

A

B

C

Labor

(workers)

Land (hectares)

11

3

5

5

Q=2,000

F

Q=6,000

28

Appendix: MRTS

• Marginal rate of technical substitution– The rate at which a firm can substitute

one input for another while keeping output constant

– Decreases as we move rightward along an isoquant

– Is the slope of the isoquant

MRTS = MPN/MPL

29

Appendix: Isocost Lines

• An isocost line– all combinations of the two inputs– same total cost for the firm

• Isocost lines always slope downward– To use more of one input - must use less

of the other input; to keep total cost unchanged

• The slope of an isocost line: PN / PL; constant • Higher isocost lines

– Greater total costs for the firm

30

Appendix: Isocost Lines• Figure A.2 Isocost Lines

Labor

(workers)

Land

(hectares)

10

3

9

5 7.5 10

20

15

TC=$5,000

TC=$7,500

TC=$10,000

C

31

Appendix: The Least-Cost Input Combination

• The point where an isocost line is tangent to the isoquant for that output level

• MRTS=MPN/MPL=PN /PL

• MPN/PN = MPL/PL

• Many variable inputs– the marginal product per dollar of any

input will be equal to the marginal product per dollar of any other input

32

Q=4,000

Appendix: Isocost LinesFigure A.3 The Least-Cost Input Combination for a Given Output Level

10

5

20

15

TC=$5,000TC=$7,500

TC=$10,000

C

J

K

The input combinations at

J, C, and K can all be used

to produce 4,000 units of output.

The input combination at

C - where the isoquant is

tangent to the isocost line,

is the least expensive

Land

(hectares)5 7.5 10

Labor

(workers)

10

5

20

15