Download Chapter 7

Product Curves
q
AP is slope of line from
origin to point on TP
curve
q/L
112
TP
C
60
30
20
B
AP
10
MP
0 1 2 3 4 5 6 7 8 9 10
Labor
©2005 Pearson Education, Inc.
Chapter 7
0 1 2 3 4 5 6 7 8 9 10
Labor
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Practice
 Bridget's Brewery production function is given
by y  K , L   2 KL ,
 where K is the number of vats she uses and L is
the number of labor hours. Does this
production process exhibit increasing, constant
or decreasing returns to scale? Holding the
number of vats constant at 4, is the marginal
product of labor increasing, constant or
decreasing as more labor is used?
©2005 Pearson Education, Inc.
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Solution
 Multiplying the K and L by 2 yields:
 we know the production process exhibits
constant returns to scale. Holding the
number of vats constant at 4 will still
result in a downward sloping marginal
product of labor curve. That is the
marginal product of labor decreases as
more labor is used.
©2005 Pearson Education, Inc.
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Chapter 7
The Cost of Production
Measuring Cost:
Which Costs Matter?
 Accountants tend to take a retrospective
view of firms’ costs, whereas economists
tend to take a forward-looking view
 Accounting Cost
Actual expenses plus depreciation charges
for capital equipment
 Economic Cost
Cost to a firm of utilizing economic resources
in production, including opportunity cost
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Measuring Cost:
Which Costs Matter?
 Economic costs distinguish between
costs the firm can control and those it
cannot
Concept of opportunity cost plays an
important role
 Opportunity cost
Cost associated with opportunities that are
foregone or the value of the next best
alternative use of a resource
©2005 Pearson Education, Inc.
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Opportunity Cost
 An Example
A firm owns its own building and pays no rent
for office space
Does this mean the cost of office space is
zero?
The building could have been rented instead
Foregone rent is the opportunity cost of
using the building for production and should
be included in the economic costs of doing
business
©2005 Pearson Education, Inc.
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Opportunity Cost
 A person starting their own business
must take into account the opportunity
cost of their time
Could have worked elsewhere making a
competitive salary
 Accountants and economists often treat
depreciation differently as well
©2005 Pearson Education, Inc.
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Measuring Cost:
Which Costs Matter?
 Although opportunity costs are hidden
and should be taken into account, sunk
costs should not
 Sunk Cost
Expenditure that has been made and cannot
be recovered
Should not influence a firm’s future economic
decisions
©2005 Pearson Education, Inc.
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Sunk Cost
 Firm buys a piece of equipment that
cannot be converted to another use
 Expenditure on the equipment is a sunk
cost
Has no alternative use so cost cannot be
recovered – opportunity cost is zero
Decision to buy the equipment might have
been good or bad, but now does not matter
©2005 Pearson Education, Inc.
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Prospective Sunk Cost
 An Example
Firm is considering moving its headquarters
A firm paid $500,000 for an option to buy a
building
The cost of the building is $5 million for a
total of $5.5 million
The firm finds another building for $5.25
million
Which building should the firm buy?
©2005 Pearson Education, Inc.
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Prospective Sunk Cost
 Example (cont.)
 The first building should be purchased
 The $500,000 is a sunk cost and should
not be considered in the decision to buy
 What should be considered is
Spending an additional $5,250,000 or
Spending an additional $5,000,000
©2005 Pearson Education, Inc.
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Measuring Cost:
Which Costs Matter?
 Some costs vary with output, while
some remain the same no matter the
amount of output
 Total cost can be divided into:
1. Fixed Cost
 Does not vary with the level of output
2. Variable Cost
 Cost that varies as output varies
©2005 Pearson Education, Inc.
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Fixed and Variable Costs
 Total cost of production equals the fixed
cost (the cost of the fixed inputs) plus the
variable cost (the cost of the variable
inputs), or…
TC  FC  VC
 Short time horizon – most costs are fixed
 Long time horizon – many costs become
variable
©2005 Pearson Education, Inc.
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Fixed Cost Versus Sunk Cost
 Fixed cost and sunk cost are often
confused
 Fixed Cost
Cost paid by a firm that is in business
regardless of the level of output
 Sunk Cost
Cost that has been incurred and cannot be
recovered
©2005 Pearson Education, Inc.
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Measuring Costs
 Marginal Cost (MC):
The cost of expanding output by one unit
Fixed costs have no impact on marginal cost,
so it can be written as:
ΔVC ΔTC
MC 

Δq
Δq
©2005 Pearson Education, Inc.
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Measuring Costs
 Average Total Cost (ATC)
Cost per unit of output
Also equals average fixed cost (AFC) plus
average variable cost (AVC)
TC
ATC 
 AFC  AVC
q
TC TFC TVC
ATC 


q
q
q
©2005 Pearson Education, Inc.
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A Firm’s Short Run Costs
©2005 Pearson Education, Inc.
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Determinants of Short Run
Costs – An Example
 Assume the wage rate (w) is fixed
relative to the number of workers hired
 Variable costs is the per unit cost of extra
labor times the amount of extra labor: wL
VC wL
MC 

q
q
©2005 Pearson Education, Inc.
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Determinants of Short Run
Costs – An Example
 Remembering that
Q
MPL 
L
 And rearranging
L
1
L for a 1 unit Q 

Q MPL
©2005 Pearson Education, Inc.
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Determinants of Short Run
Costs – An Example
 We can conclude:
w
MC 
MPL
 …and a low marginal product (MPL) leads
to a high marginal cost (MC) and vice
versa
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Determinants of Short Run Costs
 Consequently (from the table):
MC decreases initially with increasing returns
0
through 4 units of output
MC increases with decreasing returns
5
through 11 units of output
©2005 Pearson Education, Inc.
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Cost Curves for a Firm
TC
Cost 400
($ per
year)
Total cost
is the vertical
sum of FC
and VC.
300
VC
Variable cost
increases with
production and
the rate varies with
increasing and
decreasing returns.
200
Fixed cost does not
vary with output
100
FC
50
0
1
2
©2005 Pearson Education, Inc.
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Output
23
Cost Curves
120
Cost ($/unit)
100
MC
80
60
ATC
40
AVC
20
AFC
0
0
2
4
6
8
10
12
Output (units/yr)
©2005 Pearson Education, Inc.
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Cost Curves for a Firm
 The line drawn from
the origin to the
variable cost curve:
TC
P
400
VC
 Its slope equals AVC
 The slope of a point 300
on VC or TC equals
MC
200
 Therefore, MC = AVC
at 7 units of output
100
(point A)
A
FC
1
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Output
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Cost in the Long Run
 In the long run a firm can change all of its
inputs
 In making cost minimizing choices, must
look at the cost of using capital and labor
in production decisions
 Now: The firms’ long-run cost minimizing
decision
©2005 Pearson Education, Inc.
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Cost in the Long Run
 Capital is either rented/leased or purchased
 Assume Delta is considering purchasing an
airplane for $150 million
 Plane lasts for 30 years – economic depreciation for
the plane = $5 million per year
 If the firm had not purchased the plane, it would
have earned interest on the $150 million (of
10%)
 Forgone interest is an opportunity cost that
must be considered also
©2005 Pearson Education, Inc.
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Cost in the Long Run
 User cost of capital, then, can be
described as:
r = Depreciation Rate + Interest Rate
 In our example, depreciation rate was
3.33% and interest was 10%, so
r = 3.33% + 10% = 13.33%
©2005 Pearson Education, Inc.
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Cost Minimizing Input Choice
 How does a firm select inputs to produce a
given output at minimum cost?
 Assumptions
 Two Inputs: Labor (L) and capital (K)
 Price of labor: wage rate (w)
 The price of capital
r
= depreciation rate + interest rate
©2005 Pearson Education, Inc.
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Cost in the Long Run
 The Isocost Line
A line showing all combinations of L & K that
can be purchased for the same cost
Total cost of production is sum of firm’s labor
cost, wL, and its capital cost, rK:
C = wL + rK
For each different level of cost, the equation
shows another isocost line
©2005 Pearson Education, Inc.
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Cost in the Long Run
 Rewriting C as an equation for a straight
line:
K = C/r - (w/r)L
Slope of the isocost: K L   w r
 
 -(w/r)
is the ratio of the wage rate to rental cost
of capital.
 This shows the rate at which capital can be
substituted for labor with no change in cost
©2005 Pearson Education, Inc.
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Choosing Inputs
 We will address how to minimize cost for
a given level of output by combining
isocosts with isoquants
 We choose the output we wish to
produce and then determine how to do
that at minimum cost
Isoquant is the quantity we wish to produce
Isocost is the combination of K and L that
gives a set cost
©2005 Pearson Education, Inc.
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Producing a Given Output at
Minimum Cost
Capital
per
year
Q1 is an isoquant for output Q1.
There are three isocost lines, of
which 2 are possible choices in
which to produce Q1.
K2
Isocost C2 shows quantity
Q1 can be produced with
combination K2,L2 or K3,L3.
However, both of these
are higher cost combinations
than K1,L1.
A
K1
Q1
K3
C0
L2
©2005 Pearson Education, Inc.
C1
L3
L1
Chapter 7
C2
Labor per year
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Input Substitution When an
Input Price Change
 If the price of labor changes, then the
slope of the isocost line changes, -(w/r)
 It now takes a new quantity of labor and
capital to produce the output
 If price of labor increases relative to price
of capital, then capital is substituted for
labor
©2005 Pearson Education, Inc.
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Input Substitution When an
Input Price Change
Capital
per
year
If the price of labor
rises, the isocost curve
becomes steeper due to
the change in the slope -(w/L).
The new combination of K
and L is used to produce Q1.
Combination B is used in
place of combination A.
B
K2
A
K1
Q1
C2
©2005 Pearson Education, Inc.
L2
L1
Chapter 7
C1
Labor per year
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Cost in the Long Run
 How does the isocost line relate to the
firm’s production process?
MRTS  - K
L
  MPL
Slope of isocost line  K
MPL
MPK
©2005 Pearson Education, Inc.
w
r
MPK
L
 w
r
when firm minimizes cost
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Cost in the Long Run
 The minimum cost combination can then
be written as:
MPL
w

MPK
r
 Minimum
cost for a given output will occur
when each dollar of input added to the
production process will add an equivalent
amount of output.
©2005 Pearson Education, Inc.
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Cost in the Long Run
 If w = $10, r = $2, and MPL = MPK, which
input would the producer use more of?
©2005 Pearson Education, Inc.
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Example
 If MPL = 10, MPK = 5 and w= r = $10
 Which input should the firm
increase/decrease usage?
 What if w increased to $20?
©2005 Pearson Education, Inc.
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Long Run Versus
Short Run Cost Curves
 Long-Run Average Cost (LAC)
 Most important determinant of the shape of
the LR AC and MC curves is relationship
between scale of the firm’s operation and
inputs required to minimize cost
1. Constant Returns to Scale
 If input is doubled, output will double
 AC cost is constant at all levels of output
©2005 Pearson Education, Inc.
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Long Run Versus Short Run
Cost Curves
2. Increasing Returns to Scale
 If input is doubled, output will more than
double
 AC decreases at all levels of output
3. Decreasing Returns to Scale
 If input is doubled, output will less than
double
 AC increases at all levels of output
©2005 Pearson Education, Inc.
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Long Run Versus Short Run
Cost Curves
 In the long run:
Firms experience increasing and decreasing
returns to scale and therefore long-run
average cost is “U” shaped.
Source of U-shape is due to returns to scale
instead of diminishing returns to a factor of
production (labor) like the short-run curve
Long-run marginal cost curve measures the
change in long-run total costs as output is
increased by 1 unit
©2005 Pearson Education, Inc.
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Economies and Diseconomies
of Scale
 Economies of Scale
Can double output for less than double the
original cost
 Diseconomies of Scale
Doubling the output costs more than twice
the original cost
 U-shaped LAC shows economies of
scale for relatively low output levels and
diseconomies of scale for higher levels
©2005 Pearson Education, Inc.
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Long Run Costs
 Increasing Returns to Scale
Output more than doubles when the
quantities of all inputs are doubled
 Economies of Scale
Doubling of output requires less than a
doubling of cost
 Why the difference: can have constant
returns to scale but still have economies
of scale:
©2005 Pearson Education, Inc.
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Long Run Versus Short Run
Cost Curves
 We will use short and long run costs to
determine the optimal plant size
 We can show the short run average costs
for 3 different plant sizes
 This decision is important because once
built, the firm may not be able to change
plant size for a while
©2005 Pearson Education, Inc.
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Long Run Cost with Economies
and Diseconomies of Scale
©2005 Pearson Education, Inc.
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Long Run Cost with
Constant Returns to Scale
 What is the firm’s long run cost curve?
Firms can change scale to change output in
the long run
The long run cost curve is the dark blue
portion of the SAC curve which represents
the minimum cost for any level of output
Firm will always choose plant that minimizes
the average cost of production
©2005 Pearson Education, Inc.
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Long Run Cost with
Constant Returns to Scale
 The long-run average cost curve
envelops the short-run average cost
curves
 The LAC curve exhibits economies of
scale initially but exhibits diseconomies
at higher output levels
©2005 Pearson Education, Inc.
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Production with Two Outputs –
Economies of Scope
 Many firms produce more than one
product and those products are closely
linked
 Examples:
Chicken farm--poultry and eggs
Automobile company--cars and trucks
University--teaching and research
©2005 Pearson Education, Inc.
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Production with Two Outputs –
Economies of Scope

1.
2.
3.
Advantages
Both use capital and labor
The firms share management resources
Both use the same labor skills and
types of machinery
©2005 Pearson Education, Inc.
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Production with Two Outputs –
Economies of Scope
 Firms must choose how much of each to
produce
 The alternative quantities can be
illustrated using product transformation
curves
Curves showing the various combinations of
two different outputs (products) that can be
produced with a given set of inputs
©2005 Pearson Education, Inc.
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Product Transformation Curve
Number
of tractors
Each curve shows
combinations of output
with a given combination
of L & K.
O2
O1
O1 illustrates a low level
of output. O2 illustrates
a higher level of output with
two times as much labor
and capital.
Number of cars
©2005 Pearson Education, Inc.
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Product Transformation Curve
 Product transformation curves are
negatively sloped
To get more of one output, must give up
some of the other output
 Constant returns exist in this example
Second curve lies twice as far from origin as
the first curve
 Curve is concave/bowed-outward
Joint production has advantages
©2005 Pearson Education, Inc.
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Production with Two Outputs –
Economies of Scope
 There is no direct relationship between
economies of scope and economies of
scale
May experience economies of scope and
diseconomies of scale
May have economies of scale and not have
economies of scope
©2005 Pearson Education, Inc.
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Production with Two Outputs –
Economies of Scope
 The degree of economies of scope (SC) can
be measured by percentage of cost saved
producing two or more products jointly:
C(q1 )  C(q2 )  C(q1 ,q2 )
SC 
C(q1 ,q2 )
 C(q1) is the cost of producing q1
 C(q2) is the cost of producing q2
 C(q1,q2) is the joint cost of producing both products
©2005 Pearson Education, Inc.
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Production with Two Outputs –
Economies of Scope
 With economies of scope, the joint cost is
less than the sum of the individual costs
 Interpretation:
If SC > 0  Economies of scope
If SC < 0  Diseconomies of scope
The greater the value of SC, the greater the
economies of scope
©2005 Pearson Education, Inc.
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