Chapter 7

PowerPoint Slides prepared by: Andreea CHIRITESCU

Eastern Illinois University

PowerPoint Slides prepared by: Andreea CHIRITESCU

Eastern Illinois University

Production and Cost

CHAPTER

1© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Production• Profit

– Total revenue minus total cost• Business firm

– Organization, owned and operated by private individuals

– Specializes in production• Production

– Process of combining inputs to make goods and services


Production• Technology

– Methods available for combining inputs to produce a good or service

• Assumption– Production technology– Firm uses only two inputs: capital and

labor• Long run

– A time horizon long enough for a firm to vary all of its inputs


Production• Variable input

– An input whose usage can change over some time period

• Fixed input – An input whose quantity must remain

constant over some time period• Short run

– A time horizon during which at least one of the firm’s inputs cannot be varied


Production in the Short Run• Total product

– The maximum quantity of output that can be produced from a given combination of inputs

– E.g.: maximum output for each number of workers

• Total product curve– Horizontal axis: number of workers– Vertical axis: total product


TableShort-Run Production at Spotless Car Wash


1

Production in the Short Run• Marginal product of labor (MPL= ΔQ/ΔL)

– The additional output produced when one more worker is hired

– Change in total product (ΔQ) divided by the change in the number of workers employed (ΔL)

– Tells us the rise in output produced when one more worker is hired


Production in the Short Run• Increasing marginal returns to labor

– The marginal product of labor increases as more labor is hired

• Diminishing marginal returns to labor – The marginal product of labor decreases

as more labor is hired• Law of diminishing (marginal) returns

– As we continue to add more of any one input, holding the other inputs constant

– Its marginal product will eventually decline8

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

FigureTotal and Marginal Product


1

Number of workers

Units of output

1 2 3 4 5 6

130

160

184196

30

90

Total product

ΔQ from hiring first worker = 30

ΔQ from hiring second worker = 60

ΔQ from hiring third worker = 40

ΔQ from hiring fourth worker = 30

Increasing marginal

returns

Diminishing marginal returns

Thinking About Costs• A firm’s total cost

– Of producing a given level of output– Is the opportunity cost of the owners

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

• Implicit and explicit costs


Thinking About Costs• Sunk cost

– Cost that has been paid or must be paid– Regardless of any future action being

considered– Should not be considered when making

decisions


Thinking About Costs• Explicit costs

– Involve actual payments• Implicit costs

– No money changes hands• Forgone rent• Forgone interest• Forgone labor income


TableA Firm’s Costs


2

Thinking About Costs• Least-Cost Rule

– A firm produces any given output level using the lowest cost combination of inputs available

• Least-cost input combination depends on– Nature of the firm’s technology– Prices the firm must pay for its inputs– Time horizon for the firm’s planning


Cost in the Short Run• Fixed costs

– Costs of fixed inputs– Remain constant as output changes

• Variable costs – Costs of variable inputs– Change with output


TableShort-Run Costs for Spotless Car Wash


3

Cost 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

producing a particular level of output• Total cost (TC = TFC + TVC)

– The costs of all inputs, fixed and variable, used to produce a given output level in the short run


Figure

At any level of output, total cost (TC) is the sum of total fixed cost (TFC) and total variable cost (TVC)

The Firm’s Total Cost Curves


2

Units of Output

Dollars

30 18490 130 160

510

630

750

$870

270

390

TC

TVC

TFC

TFC = $150

Cost in the Short Run• Average fixed cost (AFC = TFC / Q)

– Total fixed cost divided by the quantity of output produced

• Average variable cost (AVC = TVC / Q)– Total variable cost divided by the quantity

of output produced• Average total cost (ATC = TC / Q)

– Total cost divided by the quantity of output produced


Cost in the Short Run• Marginal cost (MC = ΔTC / ΔQ)

– The increase in total cost from producing one more unit of output

– It tells us how much cost rises per unit increase in output


Figure

Average variable cost (AVC) and average total cost (ATC) are U-shaped, first decreasing and then increasing. Average fixed cost (AFC), the vertical distance between ATC and AVC, becomes smaller as output increases. The marginal cost (MC) curve is also U-shaped, reflecting first increasing and then diminishing marginal returns to labor. MC passes through the minimum points of both the AVC and ATC curves.

Average and Marginal Costs


3

Units of

Output

Dollars

30 18490 130 160

2

196

4

6

8

$10

AFCATC

AVC

MC

Cost in the Short Run• Explaining the shape of the MC curve

– When the marginal product of labor (MPL) rises, marginal cost (MC) falls

– When MPL falls, MC rises– Since MPL ordinarily rises and then falls,

MC will do the opposite – MC curve is U-shaped

• Increasing then diminishing marginal returns to labor


TableAverage and Marginal Test Scores


3

Cost in the Short Run• ATC curve is U-shaped

– Because AFC decreases and AVC first decreases, then increases

– At low levels of output, AVC and AFC are both falling, so the ATC curve slopes downward

– At higher levels of output, rising AVC overcomes falling AFC, and the ATC curve slopes upward


Cost in the Short Run• AVC curve is U-shaped

– Because MC curve is U-shaped (increasing and then diminishing returns to labor)

• MC curve – Crosses both the AVC curve and the ATC

curve at their respective minimum points


Production and Cost in the Long Run• In the long run

– No fixed inputs; no fixed costs– All inputs and all costs are variable

• Output production– Least-cost rule

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

when all inputs are variable and the least-cost input mix is chosen


Production and Cost in the Long Run• Long-run average total cost (LRATC =

LRTC / Q)– Cost per unit of producing each quantity of

output, in the long run, when all inputs are variable

– Long-run total cost divided by quantity • Relationship between long-run and short-

run costs– LRTC ≤ TC– LRATC ≤ ATC


TableFour Ways to Wash 196 Cars per Day


5

TableLong-Run Costs for Spotless Car Wash


6

Production and Cost in the Long Run• Plant

– The collection of fixed inputs at a firm’s disposal

• Size of the firm’s plant– Can be changed in the long run – Cannot be changed in the short run


Production and Cost in the Long Run• A firm’s LRATC curve

– Combines portions of each ATC curve available to the firm in the long run

– For each output level, the firm will always choose to operate on the ATC curve with the lowest possible cost


Production and Cost in the Long Run• In the short run

– A firm can only move along its current ATC curve

• In the long run– A firm can move from one ATC curve to

another• By varying the size of its plant• Moving along its LRATC curve


Figure

Average-total cost curves ATC0, ATC1, ATC2, and ATC3 show average costs when the firm has zero, one, two, and three automated lines, respectively. The LRATC curve combines portions of all the firm’s ATC curves. In the long run, the firm will choose the lowest-cost ATC curve for each level of output.

Long-Run Average Total Cost


4

Use 0

automated

lines

90 1300 Units of Output

Dollars

$8.00

$6.00

$4.00

$2.00

30 175184

250 300

ATC1ATC0ATC2 ATC3

A

B

C

E

D

Use 1

automated

lines

Use 2

automated

lines

Use 3

automated

lines

LRATC

Production and Cost in the Long Run• The U-shape of the LRATC curve:

– As output increases, long-run average costs:

– First decline (economies of scale)– Then remain constant (constant returns to

scale)– And finally rise (diseconomies of scale)


Production and Cost in the Long Run• Economies of scale

– Long-run average total cost decreases as output increases

– LRATC curve slopes downward– Long-run total cost rises proportionately

less than output• Causes for economies of scale

– Gains from specialization– Spreading costs of lumpy inputs


Production and Cost in the Long Run• Lumpy input

– An input whose quantity cannot be increased gradually as output increases

– But must instead be adjusted in large jumps


Production and Cost in the Long Run• Diseconomies of scale

– Long-run average total cost increases as output increases

– LRATC curve slopes upward– Long-run total cost rises more than in

proportion to output


Production and Cost in the Long Run• Constant returns to scale

– Long-run average total cost is unchanged as output increases

– LRATC curve is flat– Both output and long-run total cost rise by

the same proportion


Figure

If long-run total cost rises proportionately less than output, production reflects economies of scale, and LRATC slopes downward. If cost rises proportionately more than output, there are diseconomies of scale, and LRATC slopes upward. Between those regions, cost and output rise proportionately, yielding constant returns to scale. The lowest output level at which the LRATC hits bottom is the firm’s minimum efficient scale.

The Shape of LRATC


5

Pizzas Served per Day

Dollars

200 250

$8.00

0

$6.00

$4.00

$2.00

LRATC

Economies of Scale

Diseconomies of Scale

Constant Returns to Scale

Minimum efficient scale (MES)

Production and Cost in the Long Run• Minimum efficient scale (MES)

– The lowest output level at which the firm’s LRATC curve hits bottom

– Tells us how large a firm must grow in order to fully exploit economies of scale

• Firms that grow to their MES– Have a cost advantage over other firms

that operate at smaller output levels


TableTypes of Costs


7

Term Symbol/Formula Definition

Costs in generalExplicit costImplicit costSunk cost

Lumpy input cost

Short-run costsTotal fixed cost

Total variable cost

Total costAverage fixed costAverage variable costAverage total cost Marginal cost

Long-run costsLong-run total costLong-run averagetotal cost

TFC

TVC

TC=TFC+TVCAFC = TFC/QAVC = TVC/QATC = TC/QMC=ΔTC/ΔQ

LRTCLRATC=LRTC/Q

An opportunity cost where an actual payment is madeAn opportunity cost, but no actual payment is madeAn irrelevant cost because it cannot be affectedby any current or future decisionThe cost of an input that can only be adjusted inlarge, indivisible amounts

The cost of all inputs that are fixed (cannot be adjusted) in the short runThe cost of all inputs that are variable (can be adjusted) in the short runThe cost of all inputs in the short runThe cost of all fixed inputs per unit of outputThe cost of all variable inputs per unit of outputThe cost of all inputs per unit of outputThe change in total cost for each one-unit rise in output

The cost of all inputs in the long runCost per unit in the long run

The Urge to Merge

• When there are significant, unexploited economies of scale– Because the market has too many firms

for each to operate near its minimum efficient scale

– Mergers often follow


Figure

With market quantity demanded fixed at 60,000, and six firms of equal market share, each operates at point A, producing 10,000 units at $200 per unit. 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). Other firms must match the first-mover’s price; otherwise they lose market share and end up at .a point like C, with higher cost per unit than originally. The result is a price war, with each firm ending up back at point A, only now—due to the lower price—they suffer losses. A series of mergers to create three large firms would enable each to operate at its MES (point B), with less likelihood of price wars and losses.

LRATC for a Typical Firm in a Merger-Prone Industry


6

Quantity

per Month

Dollars

8,000 10,000 20,000

80

200

$240

LRATC

Original Output Level

MES

A

B

C

Isoquant Analysis: Finding the Least-Cost Input Mix

• Every point on an isoquant– Input mix that produces the same quantity

of output– An increase in one input requires a

decrease in the other input to keep total production unchanged

• Isoquants – Always slope downward


Isoquant Analysis

• Higher isoquants – Greater levels of output than lower

isoquants • Marginal rate of technical substitution

– The (absolute value of the) slope of an isoquant

– Measures the rate at which a firm can substitute one input for another while keeping output constant


Isoquant Analysis

• Move rightward along any given isoquant– Marginal rate of technical substitution

(MRTS) decreases• Slope of the isoquant (MRTSL,N)

• With land measured horizontally• And labor measured vertically

– MRTSL,N is the ratio of the marginal products, MPN/MPL


Isoquant Analysis

• An isoquant– Becomes flatter as we move rightward– The MPN decreases, while the MPL

increases– The ratio (MPN/MPL) decreases


TableProduction Technology for an Artichoke Farm


A.1

Figure

Each of the curves in the figure is an isoquant, showing all combinations of labor and land that can produce a given output level. The middle curve, for example, shows that 4,000 units of output can be produced with 11 workers and 3 hectares of land (point B), with 5 workers and 5 hectares of land (point C), as well as other combinations of labor and land. Each isoquant is drawn for a different level of output. The higher the isoquant line, the greater the level of output.

An Isoquant Map


A.1

10

8

Land

(hectares)

Labor (workers)

2 4 6 80 10 12 14 16 18

2

4

6

12

14

16

18

20

22

Q=2,000

Q=6,000

F

Q=4,000

C

B

A

Isocost Lines

• Isocost lines always slope downward– If you use more of one input, you must use

less of the other input in order to keep your total cost unchanged

• Slope of an isocost line: - PN /PL • With land (N) on the horizontal axis and labor

(L) on the vertical axis• Remains constant as we move along the line

• Higher isocost lines – Greater total costs for the firm


Figure

Each of the lines in the figure is an isocost line, showing all combinations of labor and land that have the same total cost. The middle line, for example, shows that total cost will be $7,500 if 9 workers and 3 hectares of land are used (point C). All other combinations of land and labor on the middle line have the same total cost of $7,500. Each isocost line is drawn for a different value of total cost. The higher the isocost line, the greater is total cost.

Isocost Lines


A.2

109

Land

(hectares)

Labor (workers)

3 5 7.5 10

12

15

20

TC=$10,000

TC=$7,500

TC=$5,000

C

The Least-Cost Input Combination

• Least-cost input combination – Of two inputs (L, N) for producing any level

of output• Is found at the point where an isocost line is

tangent to the isoquant for that output level• The firm’s MRTS between the two inputs

(MPN/MPL) will equal the ratio of input prices (PN /PL)

• The marginal product per dollar of land (MPN/PN) must equal the marginal product per dollar of labor (MPL/PL)


Figure

To produce any given level of output at the least possible cost, the firm should use the input combination where the isoquant for that output level is tangent to an isocost line. In the figure, the input combinations at points J, C, and K can all be used to produce 4,000 units of output. But the combination at point C (5 workers and 5 hectares of land), where the isoquant is tangent to the isocost line, is the least expensive input combination for that output level.

The Least-Cost Input Combination for a Given Output Level


A.3

10

5

Land

(hectares)

Labor (workers)

3 5 7.5 10

15

20

TC=$10,000

TC=$5,000

Q=4,000

TC=$7,500

J

K

C

The Least-Cost Input Combination

• Least-cost input mix with many variable inputs– Marginal product per dollar of any input is

equal to marginal product per dollar of any other input


Chapter 7

Economy & Finance

Transcript of Chapter 7