Prepared by: Jamal Husein C H A P T E R 4 © 2005 Prentice Hall Business PublishingSurvey of...

© 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

© 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.


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


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


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.


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.


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.


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


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.


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.


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


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


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


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


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.


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


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


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.


Short-run Average Total Cost (SATC)Short-run Average Total Cost (SATC)Short-run Average Total Cost (SATC)Short-run Average Total Cost (SATC)


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


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


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


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.


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.


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.


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


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.


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.


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.


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.


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


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).


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.


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.


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


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


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

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Prepared by: Jamal Husein C H A P T E R 4 © 2005 Prentice Hall Business PublishingSurvey of...

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