Download Production and Cost

Chapter 6
Production and Cost
ECONOMICS: Principles and Applications, 4e
HALL & LIEBERMAN, © 2008 Thomson South-Western
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
2
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
Production
Function
Different
Quantities
of Output
3
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
4
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
5
Total and Marginal Product
• Figure 2 Total and Marginal Product
Units of Output
Total Product
196
184
160
DQ from hiring fourth worker = 30
130
DQ from hiring third worker = 40
90
DQ from hiring second worker = 60
30
DQ from hiring first worker = 30
1
increasing
marginal returns
2
3
4
5
diminishing
marginal returns
6
Number of Workers
6
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
7
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
8
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
9
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
10
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
11
Total Cost Curves
• Figure 3 The Firm’s Total Cost Curves
Dollars
TC
$435
375
TVC
TFC
315
255
195
135
TFC
0
30
90
130
160
184
Units of Output
12
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
13
Marginal Cost
• Marginal Cost (MC)
–Increase in total cost from producing one
more unit or output
ΔTC
MC 
ΔQ
• 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.
14
Average And Marginal Costs
• Figure 4 Average And Marginal Costs
Dollars
MC
$4
3
AFC
ATC
AVC
2
1
0
30
90
130
160
196
Units of Output
15
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
16
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
17
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
LRTC
LRATC 
Q
• LRTC ≤ TC
• LRATC ≤ ATC
18
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
19
Graphing the LRATC Curve
• Figure 5 Long-Run Average Total Cost
Dollars
ATC1
$4.00
ATC0
ATC2
3.00
C
D
B
A
2.00
LRATC
ATC3
E
1.00
0
30
Use 0
automated
lines
90
130
160 184
175 196
Use 1
automated
lines
250
Use 2
automated
lines
300
Use 3
automated
lines
Units of Output
20
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
21
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
22
The Shape Of LRATC
• Figure 6 The Shape Of LRATC
Dollars
$4.00
3.00
LRATC
2.00
1.00
130
0
Economies of Scale
184
Constant
Returns to
Scale
Diseconomies of Scale
Units of Output
23
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
24
The Urge to Merge
• Figure 7 LRATC for a Typical Firm in a Merger-Prone Industry
Dollars
$240
200
3. Other firms lose market share and end up at C
C
4.Price war - other firms must match the first-mover’s
price; each firm ends up back at A - they suffer losses
A
1. With market quantity demanded fixed at 60,000,
and six firms of equal market share, each
operates at A
B
LRATC
80
5. Mergers to create three large firms would enable each
to operate at its MES with less likelihood of price wars and losses
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)
8,000
10,000
20,000
Quantity
per Month
25
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
26
Appendix: An Isoquant Map
• Figure A.1 An Isoquant Map
Labor
(workers)
A
F
11
B
C
5
Q=6,000
Q=4,000
Q=2,000
3
5
Land (hectares)
27
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
28
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
29
Appendix: Isocost Lines
• Figure A.2 Isocost Lines
Labor
(workers)
20
TC=$10,000
15
TC=$7,500
10
9
C
TC=$5,000
3
5
7.5
10 Land
(hectares)
30
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
31
Appendix: Isocost Lines
Figure A.3 The Least-Cost Input Combination for a Given Output Level
Labor
(workers)
20
TC=$10,000
The input combinations at
J, C, and K can all be used
to produce 4,000 units of output.
15
J
The input combination at
C - where the isoquant is
tangent to the isocost line,
is the least expensive
10
5
C
K
Q=4,000
TC=$7,500
TC=$5,000
5
7.5
10 Land
(hectares)
32