Download aggregate demand, aggregate supply, and modern macroeconomics

Chapter 10
PRODUCTION
AND COST
ANALYSIS II
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-2
Today’s lecture will:
• Distinguish technical efficiency from economic
•
•
•
•
efficiency.
Explain how economies and diseconomies of
scale influence the shape of long-run cost
curves.
State the envelope relationship between shortrun cost curves and long-run cost curves.
Explain the role of the entrepreneur in
translating cost of production to supply.
Discuss some of the problems of using cost
analysis in the real world.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-3
Making Long-run
Production Decisions
• To make their long-run decisions:
 Firms look at costs of various inputs
and the technologies available for
combining these inputs.
 They choose the combination which
offers the lowest cost.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-4
Technical Efficiency and
Economic Efficiency
• Technical efficiency – as few inputs
•
as possible are used to produce a
given output.
Economically efficient – the method
that produces a given level of output
at the lowest possible cost.
 It is the least-cost technically efficient
process.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-5
Determinants of the Shape of
the Long-Run Cost Curve
• The law of diminishing marginal
•
•
productivity does not apply in the
long run.
All inputs are variable in the long
run.
The shape of the long-run cost curve
is due to the existence of economies
and diseconomies of scale.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-6
A Typical Long-Run
Average Cost Table
Total Costs
Quantity of Labor
11
12
13
14
15
16
17
18
19
20
McGraw-Hill/Irwin
$381
390
402
420
450
480
510
549
600
666
Total Cost
of
Machines
$254
260
268
280
300
320
340
366
400
444
Total Costs Average Total
= TCL + TCM Costs = TC/Q
$635
650
670
700
750
800
850
915
1,000
1,110
$58
54
52
50
50
50
50
51
53
56
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-7
Costs per unit
A Typical Long-Run Average
Total Cost Curve
$64
62
60
58
56
54
52
50
48
Economies
of scale
A
Constant
returns to
scale
B
C
ATC
Minimum efficient
level of production
11 12 13 14 15
McGraw-Hill/Irwin
Diseconomies
of scale
16 17 18 19 20
Q
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-8
Economies of Scale
• Economies of scale – long run
•
average total costs decrease as
output increases.
In the longer run all inputs are
variable, so only economies of scale
can influence the shape of the longrun cost curve.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-9
Economies of Scale
• An indivisible setup cost is the cost of
•
an indivisible input for which a certain
amount of production must be
undertaken before the input becomes
economically feasible to use.
The cost of a blast furnace or an oil
refinery is an example of an indivisible
setup cost.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-10
Economies of Scale
• The minimum efficient level of production
•
is the amount of production that spreads
setup costs out sufficiently for firms to
undertake production profitably.
The minimum efficient level of production
is reached once the size of the market
expands to a size large enough so that
firms can take advantage of all
economies of scale.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-11
Diseconomies of Scale
• Diminishing marginal productivity -the
•
decline in productivity caused by
increasing units of a variable input being
added to a fixed input.
Diseconomies of scale – decreases in
productivity and increases in average
costs which occur when there are
increases in all inputs (no input is fixed).
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-12
Diseconomies of Scale
• Monitoring costs – those incurred by
•
the organizer of production in seeing
to it that the employees do what they
are supposed to do.
Team spirit – the feelings of
friendship and being part of a team
that brings out peoples’ best effort.
 As the size of the firm increases,
monitoring costs increase, and team
spirit and morale decrease.
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10-13
Constant Returns to Scale
• Constant returns to scale – where
•
average total costs do not change as
output increases.
Constant returns to scale are shown
by the flat portion of the long-run
average total cost curve.
McGraw-Hill/Irwin
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10-14
Long-Run and
Short-Run Cost Curves
• The long-run and short-run average cost
•
•
curves have the same U-shape, but the
underlying causes of these shapes differ.
Economies and diseconomies of scale account
for the shape of the long-run average cost
curve.
Initially increasing and eventually diminishing
marginal productivity accounts for the shape of
the short-run average cost curves.
McGraw-Hill/Irwin
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10-15
The Envelope Relationship
• Long-run costs are always less than
or equal to short-run costs because:
 In the long run, all inputs are flexible.
 In the short run, some inputs are fixed.
• In the short run all expansion must
proceed by increasing only the
variable input.
 This constraint increases cost.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-16
The Envelope Relationship
• The envelope relationship explains
that:
 At the planned output level, short-run
average total cost equals long-run
average total cost.
 At all other levels of output, short-run
average total cost is higher than longrun average total cost.
McGraw-Hill/Irwin
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10-17
Costs per unit
Envelope of Short-Run Average
Total Cost Curves
0
McGraw-Hill/Irwin
LRATC
SRMC1
SRATC4
SRATC1
SRMC2
SRMC4
SRATC2 SRATC3
SRMC3
Q2
Q3
Quantity
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-18
Entrepreneurial Activity and
the Supply Decision
• Supplier’s expected economic profit per unit –
•
•
the difference between the expected price of a
good and the expected average total cost of
producing it.
Profit underlies the dynamics of production in
a market economy.
The expected price must exceed the
opportunity cost of supplying the good for a
good to be supplied.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-19
Entrepreneurial Activity and
the Supply Decision
• An entrepreneur is an individual who sees
•
•
an opportunity to sell an item at a price
higher than the average cost of producing
it.
Entrepreneurs organize production.
They visualize the demand and convince
the owners of the factors of production
that they want to produce those goods.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-20
Using Cost Analysis
in the Real World
• Some of the problems of using cost
analysis in the real world include the
following:
 Economies of scope
 Learning by doing and technological
change
 Many dimensions
 Unmeasured costs
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-21
Economies of Scope
• There are economies of scope when the
•
•
costs of producing goods are
interdependent so that it is less costly for
a firm to produce one good when it is
already producing another.
Firms look for both economies of scope
and economies of scale.
Globalization has made economies of
scope even more important to firms in
their production decisions.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-22
Learning by Doing and
Technological Change
• Learning by doing – as we do something, we
•
•
learn what works and what doesn’t, and over
time we become more proficient at it.
Technological change – an increase in the
range of production techniques that leads to
more efficient ways of producing goods and the
production of new and better goods.
These changes occur over time and cannot be
predicted accurately.
McGraw-Hill/Irwin
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10-23
Many Dimensions
• Most decisions that firms make
involve more than one dimension,
including:
 Quality
 Packaging
 Shipping
• The level of output is the only
dimension in the standard model.
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10-24
Unmeasured Costs
• Economists include opportunity
•
costs while accountants use explicit
costs that can be measured.
Economists include the owner’s
opportunity cost – the forgone
income that the owner could have
earned in another job.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-25
Economic Versus
Accounting Depreciation
• In measuring the costs of
•
depreciable assets, accountant use
historical costs – what a depreciable
item costs in terms of money actually
spent for it – as the cost basis.
If the depreciable asset increased in
value, an economist would count its
increased value as revenue.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-26
Summary
• An economically efficient production
•
process must be technically efficient, but
a technically efficient process may not be
economically efficient.
The long-run average total cost curve is Ushaped because economies of scale
cause average total cost to decrease;
diseconomies of scale eventually cause
average total cost to increase.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-27
Summary
• Marginal cost and short-run average cost
•
•
curves slope upward because of
diminishing marginal productivity.
The long-run average cost curve slopes
upward because of diseconomies of scale.
The envelope relationship between shortrun and long-run average cost curves
shows that the short-run average cost
curves are always above the long-run
average cost curve.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-28
Summary
• An entrepreneur is an individual who sees an
•
opportunity to sell an item at a price higher
than the average cost of producing it.
Costs in the real world are affected by:
 Economies of scope
 Learning by doing and technological change
 Many dimensions to output
 Unmeasured costs, such as opportunity costs
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
10-29
Review Question 10-1 Why are short-run and long-run average cost
curves U-shaped?
The short-run average cost curves are U-shaped because of
diminishing marginal productivity. The long-run average cost curves
are U-shaped because of economies and diseconomies of scale.
Review Question 10-2 Suppose that capital and labor both cost $5 per
unit. Currently the firm is using 4 workers and 4 machines to produce
an output of 40 units. If the firm wants to produce 100 units of output,
it can be done using the 4 machines and 25 workers or with 10
machines and 10 workers.
a. In the short run, how much capital and how much labor will the firm
use? What is the total cost and the average cost of the 100 units?
In the short run, the firm can not change capital, the fixed input, so it
must use 4 machines and 25 workers. Total cost = $5x4 + $5x25 =
$145. Average cost = $145/100 = $1.45 In the long run, both inputs are
variable, so the firm will minimize costs with 10 workers and 10
machines. Total cost = $5x10 + $5x10 = $100 and long-run average
cost = $100/100 = $1.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.