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© 2005 Prentice Hall Business Publishing© 2005 Prentice Hall Business Publishing Survey of Economics, 2/eSurvey of Economics, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Prepared by: Jamal Husein
C H A P T E R
44
Production and Cost
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 2
Economic CostEconomic CostEconomic CostEconomic Cost
The key principle underlying the computation of economic cost is opportunity cost.
PRINCIPLE of Opportunity CostThe opportunity cost of something is what you sacrifice to get it.
PRINCIPLE of Opportunity CostThe opportunity cost of something is what you sacrifice to get it.
In economics, the notion of a firm’s costs is based on the notion of economic cost.
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 3
Accounting versus Economic CostAccounting versus Economic CostAccounting versus Economic CostAccounting versus Economic Cost
An accountant’s notion of costs involves only the firm’s explicit costs:
Explicit costs: the firm’s actual cash payments for its inputs.
An economist includes the firm’s implicit costs:
Implicit costs: the opportunity costs of nonpurchased inputs.
Economic Cost = Explicit Cost + Implicit CostEconomic Cost = Explicit Cost + Implicit Cost
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 4
Accounting versus Economic CostAccounting versus Economic CostAccounting versus Economic CostAccounting versus Economic Cost
Accounting versus Economic Cost
AccountingApproach
EconomicApproach
Explicit Cost (purchased inputs) $60,000 $60,000
Implicit: opportunity cost of entrepreneur’s time
30,000
Implicit: opportunity cost of funds 10,000
______ ______
Total Cost $60,000 $100,000
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 5
Short-run versus Long-run DecisionsShort-run versus Long-run DecisionsShort-run versus Long-run DecisionsShort-run versus Long-run Decisions
Short run (SR): a period of time over which one or more factors of production remains fixed.
In the short run, a firm decides how much output to produce in the current facility.
Long run (LR): a period of time long enough that a firm can change all factors pf production.
In the long run, a firm decides what size and type of facility to build.
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 6
Production and Cost in the Short RunProduction and Cost in the Short RunProduction and Cost in the Short RunProduction and Cost in the Short Run
The key principle behind the firm’s short-run cost curves is the principle of diminishing returns.
PRINCIPLE of Diminishing ReturnsSuppose that output is produced with two or more inputs and we increase one input while holding the other inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate.
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 7
The Firm’s Short-run Production FunctionThe Firm’s Short-run Production FunctionThe Firm’s Short-run Production FunctionThe Firm’s Short-run Production Function
The short-run production function, or total product curve, shows the relationship between the number of workers and the quantity of output produced.
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 8
Production and Marginal ProductProduction and Marginal ProductProduction and Marginal ProductProduction and Marginal ProductRakes
Per Minute
Number
of Workers
0 0
1 8
2 12
3 15
4 20
5 27
6 36
7 48
8 65
9 90
10 130
Total Product Curve: A curve showing the relationship between the quantity ofLabor and the quantity of outputproduced
0
1
2
3
4
5
6
7
8
9
10
Rakes p
er
min
ute
0 20 40 60 80 100 120 140 Labor: Number of workers
Short-run Production FunctionTotal product curve
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 9
Production and Marginal ProductProduction and Marginal ProductProduction and Marginal ProductProduction and Marginal Product
The shape of the total product curve between d & e is explained by diminishing returns.
Beyond 15 workers the total product curve becomes flatter, i.e., marginal product of labor decreases. In other words, output beyond 15 workers is increasing at a decreasing rate.
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Short-run Production CostsShort-run Production CostsShort-run Production CostsShort-run Production Costs
The short-run costs of production are a reflection of the relationship between labor and output in the short run under diminishing returns.
In the short run, the firm has two types of costs: Fixed cost (FC): the cost of the production
facility, which is independent of the amount of output produced in it.
Variable costs (VC): the costs of labor and materials associated with producing output.
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 11
Short-run Production CostsShort-run Production CostsShort-run Production CostsShort-run Production Costs
T C T FC T VC
Total Cost =
Total Fixed Cost
+Total Variable CostTotal Cost
Short-runCost
VariableTotal
CostFixed
MinuteRakes perOutput:
STCTVCFCQ
360360
448361
4812362
5115363
5620364
6327365
7236366
8448367
10165368
12690369
1661303610
0
50
100
150
Co
st
in $
0 1 2 3 4 5 6 7 8 9 10 11 Output: Rakes per minute
Total Costs SRTC
TVC
TFC
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 12
Short-run Average Cost CurvesShort-run Average Cost CurvesShort-run Average Cost CurvesShort-run Average Cost Curves
Fixed cost FCAFC= =
Quantity Q
Variable cost TVCAVC= =
Quantity Q
Total cost TCSRATC= =
Quantity Q
Change in Total cost TCSRMC= =
Change in Quantity Q
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 13
Short-run Average Total CostShort-run Average Total CostShort-run Average Total CostShort-run Average Total Cost
Short-run average total cost (SRATC) measures total cost per unit of output produced.
SA T CT FC
Q
T VC
Q
SA T C A FC SA VC
Short-run Average Total Cost
=Fixed Cost per Unit
+Variable Cost per Unit
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 14
Short-run Marginal CostShort-run Marginal CostShort-run Marginal CostShort-run Marginal Cost
Short-run marginal cost (SRMC) is the change in total cost resulting from a 1-unit increase in the output of an existing production facility.
M CT C
Q
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 15
The Relationship between Marginal & The Relationship between Marginal & Average CurvesAverage CurvesThe Relationship between Marginal & The Relationship between Marginal & Average CurvesAverage Curves
The marginal cost of production is the amount of money necessary to buy the additional labor and materials necessary to produce one more unit of output.
The marginal cost of production increases because output increases at a decreasing rate with additional labor hours.
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Short-run Average and Marginal Short-run Average and Marginal Costs: An ExampleCosts: An ExampleShort-run Average and Marginal Short-run Average and Marginal Costs: An ExampleCosts: An Example
OUTPUT FIXEDCost
TOTALVARIABLE
COST
SR TOTALCOST
SRMARGINAL
COST
AVERAGEFIXEDCOST
SR AVERAGEVARIABLE
COST
SR AVERAGE
TOTALCOST
Q FC TVC STC SMC AFC SAVC SATC0 $36 $0 36 $ - $ - $ - $ -
1 36 8 44 8 362 $8 44
2 36 12 48 4 183 6 24
3 36 15 51 3 12 5 17
4* 36 20 56 5* 9 5* 14
5 36 27 63 7 7 5.4 12.6
6 36 36 72 9 6 6 12
7* 36 48 84 12* 5.14 6.86 12*
8 36 65 101 17 4.5 8.13 12.63
9 36 90 126 25 4 10 14
10 36 130 166 40 3.6 13 16.6
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 17
Short-run Average and Marginal Short-run Average and Marginal Costs: An ExampleCosts: An ExampleShort-run Average and Marginal Short-run Average and Marginal Costs: An ExampleCosts: An Example
0
5
10
15
20
25
30
35
40
Co
st
in $
0 1 2 3 4 5 6 7 8 9 10 11 Output: Rakes per minute
MC ATC AFC AVC
Per-unit costsSMC
SAVC
SATC
AFC
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 18
A Closer Look at SR Production CostsA Closer Look at SR Production CostsA Closer Look at SR Production CostsA Closer Look at SR Production Costs
To study the relationship between the components of short-run production costs, consider the following example concerning a producer of computer chips facing diminishing returns.
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Short-run Average Total Cost (SATC)Short-run Average Total Cost (SATC)Short-run Average Total Cost (SATC)Short-run Average Total Cost (SATC)
Short-run Average Total Cost
Quantity of Chips
Fixed Cost per Chip
Labor Hours
Labor Cost
Labor Cost per Chip
Material Cost per Chip
Average Total Cost
Small: 100 $72 100 $800 $8 $10 $90
Medium: 300 24 900 7,200 24 10 58
Large: 400 18 2,000 16,000 40 10 68
Assumptions: Total fixed cost: $7,200 Hourly wage: $8.00
$7,200/100
100 x $8
$7,200+800 100 $72+$8+$10
Short-run Average Total Cost
Quantity of Chips
Fixed Cost per Chip
Labor Hours
Labor Cost
Labor Cost per Chip
Material Cost per Chip
Average Total Cost
Small: 100 $72 100 $800 $8 $10 $90
Medium: 300 24 900 7,200 24 10 58
Large: 400 18 2,000 16,000 40 10 68
Assumptions: Total fixed cost: $7,200 Hourly wage: $8.00
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 20
Average Variable Cost ($)
Average Fixed
Cost ($)
Average Total
Cost ($)
Quantity Produced
Short-run Average Total Cost (SATCShort-run Average Total Cost (SATCShort-run Average Total Cost (SATCShort-run Average Total Cost (SATC
The gap between SATC and SAVC decreases as output increases.
AFC continuously decreases as total fixed cost is spread over more units of output produced.
187290100
342458300
501868400
Average Total Cost is the Sum of Average Variableand Average Fixed Cost
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Short-run Average Total Cost (SATC)Short-run Average Total Cost (SATC)Short-run Average Total Cost (SATC)Short-run Average Total Cost (SATC)
The SATC curve is U-shaped because of the behavior of its two components as output produced increases.
AFC decreases as output increases.
SAVC increases as output increases.
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Diminishing Returns and Increasing Diminishing Returns and Increasing Marginal CostMarginal CostDiminishing Returns and Increasing Diminishing Returns and Increasing Marginal CostMarginal Cost
Diminishing Returns and Increasing Marginal Cost
Quantity of ChipsAdditional Labor Hours
Additional Labor Cost
Additional Material Cost
Marginal Cost
Small: 100 2 $16 $10 $26
Medium: 300 6 48 10 58
Large: 400 10 80 10 90
Initially, it takes 4 additional labor hours to increase the quantity of chips by 200, from 100 to 300. Then, it takes another 4 hours of labor to increase output by only 100 more chips, from 300 to 400. Marginal cost increases because output increases at a decreasing rate with additional labor hours.
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 23
Relationship between Short-run MC Relationship between Short-run MC and AC Curvesand AC CurvesRelationship between Short-run MC Relationship between Short-run MC and AC Curvesand AC Curves
As long as SATC is declining, marginal cost lies below it.
When SATC rises, SMC is greater than SATC.
At point m, SATC=SMC.
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Relationship between Short-run MC Relationship between Short-run MC and AC Curvesand AC CurvesRelationship between Short-run MC Relationship between Short-run MC and AC Curvesand AC Curves
9026100
5858300
6890400
The marginal cost curve (SMC) intersects the average cost curve (SATC) when average cost is minimum.
Average Total Cost
($)
Marginal Cost($)
Quantity Produced
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Production and Cost in the Long RunProduction and Cost in the Long RunProduction and Cost in the Long RunProduction and Cost in the Long Run
The key difference between the short run and the long run is that there are no diminishing returns in the long run.
Diminishing returns occur because workers share a fixed facility. In the long run the firm can expand its production facility as its workforce grows.
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Long-run Average CostLong-run Average CostLong-run Average CostLong-run Average Cost
Long-run average cost (LAC) is total cost divided by the quantity of output when the firm can choose a production facility of any size.
The LAC curve describes the behavior of average cost as the plant size expands. Initially, the curve is negatively sloped, then beyond some point, it becomes horizontal.
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Indivisible InputsIndivisible InputsIndivisible InputsIndivisible Inputs
Because of indivisible inputs, the long-run average cost curve will be negatively sloped.
Indivisible input: an input that cannot be scaled down to produce a small quantity of output.
Most production processes have at least one indivisible input.
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Examples of Indivisible InputsExamples of Indivisible InputsExamples of Indivisible InputsExamples of Indivisible Inputs
A computer factory uses sophisticated machines and testing equipment.
A transatlantic shipper uses a large ship to carry TV sets from Japan to the United States.
A cable-TV firm uses a cable running throughout its territory.
A steel mill uses a large furnace. A freight hauler uses a freight truck. A pizzeria uses a pizza oven.
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Long-run Average CostLong-run Average CostLong-run Average CostLong-run Average Cost When long-run total cost is proportionate to
the quantity produced, long-run average cost does not change as output increases.
The long-run average cost curve is horizontal for 7 or more rakes per hour.
0
12
Avera
ge c
ost:
$ p
er
rake
0 7 14 21 28 Output: Rakes per minute
Long-run Average Cost Curve
CostAverage
Long-run
Total CostLong-run
MinuteRakes perOutput:
LAC
$20.00$703.5
$12.00$847
$12.00$16814
$12.00$33628
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Labor SpecializationLabor SpecializationLabor SpecializationLabor Specialization In a large operation, each worker
specializes in fewer tasks thus is more productive than his or her counterpart in a small operation.
Higher productivity (more output per worker) means lower labor costs per unit of output, thus lower production costs (ever-decreasing average cost).
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Economies of ScaleEconomies of ScaleEconomies of ScaleEconomies of Scale Economies of scale: a situation in which
an increase in the quantity produced decreases the long-run average cost of production.
Economies of scale refer to cost savings associated with spreading the cost of indivisible inputs and input specialization.
When economies of scale are present, the LAC curve will be negatively sloped.
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 32
Minimum Efficient ScaleMinimum Efficient ScaleMinimum Efficient ScaleMinimum Efficient Scale
The minimum efficient scale describes the output at which scale economies are exhausted;
The long-run average cost curve becomes horizontal.
Once the minimum efficient scale has been reached, an increase in output no longer decreases the long-run average cost.
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© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 33
Diseconomies of ScaleDiseconomies of ScaleDiseconomies of ScaleDiseconomies of Scale
A firm experiences diseconomies of scale when an increase in output leads to an increase in long-run average cost—the LAC curve becomes positively sloped.
Diseconomies of scale may arise for two reasons:
Coordination problems Increasing input costs
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Examples of Economies of ScaleExamples of Economies of ScaleExamples of Economies of ScaleExamples of Economies of Scale
LAC Curve for Aluminum Production
LAC Curve for Aluminum Production
LAC Curve for Electricity Generation
LAC Curve for Electricity Generation
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Examples of Economies of ScaleExamples of Economies of ScaleExamples of Economies of ScaleExamples of Economies of Scale
LAC Curve for Truck Freight
LAC Curve for Truck Freight
LAC Curve for Hospital Services
LAC Curve for Hospital Services