1. Production and Cost Anybody can cut prices, but it takes
brains to produce a better article -P.D. Armour Slide 1 of 58
2. First, some notes This module is a critical part of this
class. The concepts we learn here are a foundation for material we
will discuss in each of the next three modulesand in your final
project! We are now turning our attention from the behavior of
consumers (Modules 4 and 6) to the behavior of producers (Modules
7-11). Slide 2 of 58
3. This module has been divided into three major parts Part 1:
Production Relationships Part 2: Short Run Production Costs Part 3:
Long Run Production Costs The relationship between the amount of
inputs used and the amount of output produced will be explored. One
input in particular, labor, will be emphasized. Short run costs are
a key part of determining how much a producer will produce. Several
short run costs will be discussed Long run costs are key in
examining how big your firm should be. Slide 3 of 58
4. Production relationships help show a key microeconomic
concept Total Product (TP) This is the total output or total
quantity of a particular good or service produced Marginal Product
(MP) This is the increase in output associated with adding one more
unit of a resource (for example one more unit of labor) Average
Product (AP) This is the output per unit of input (for example the
amount of output each unit of labor produces) In reference to
labor, this is productivity Part 1: Production Relationships Three
production relationships will be explored: TP MP AP Slide 4 of
58
5. Total product (TP) describes how much can be produced by a
firm In this example, well talk about bricklayers. With no
employees, your firm will not produce any brick walls. With the
hire of your first employee, your firm may be able to produce 10
feet of brick wall per day. With the hire of your second employee,
your firm may be able to produce 25 feet of brick wall per day.
Note how two employees are more productive then twice one employee.
They are working together and are more efficient. With the hire of
your third employee, your firm may be able to produce 45 feet of
brick wall per day. Note how three employees are more productive
then three times one employee. They are working together and again
they are more efficient. Eventually these gains from efficiency
start to wear off. If you keep adding employees to the same job,
eventually they become increasingly unproductive. In the extreme,
production can decline with added employees as the worksite becomes
crowded and confused. Part 1: Production Relationships TP Slide 5
of 58
6. Total product, seen graphically This line is referred to as
the production function. A producer may produce anywhere up to and
including points on this line. But note how the line eventually
declines as an increasing number of inputs are added! With one
employee, your firm will produce 10 feet of product With two
employees, your firm will produce 25 feet of product With three
employees, your firm will produce 45 feet of product With four
employees, your firm will produce 60 feet of product With five
employees, your firm will produce 70 feet of product With six
employees, your firm will produce 75 feet of product With seven
employees, your firm will still produce 75 feet of product Part 1:
Production Relationships TP This is the key lesson in this section:
Beyond some point, as extra variable resources are added (in this
case, labor), product that can be attributed to each additional
unit will decline. With eight employees, your firm will only
produce 70 feet of product Slide 6 of 58
7. Marginal product (MP) shows how much can be produced given
one more input When we are discussing Marginal Product, we are
asking, How much more output will I get if I hire another worker?
The technical definition: Marginal product is the extra output
associated with adding an extra unit of input such as labor. Part
1: Production Relationships MP Slide 7 of 58
8. Calculating marginal product The first worker produces 10
units. MP =10 The 2nd worker produces 15 units. MP =15 The 3rd
worker produces 20 units. MP =20 The 4th worker produces 15 units.
MP =15 The 5th worker produces 10 units. MP =10 The 6th worker
produces 5 units. MP =5 The 7th worker produces 0 units. MP =0 The
8th worker actually hurts production. The workplace is too crowded.
MP =-5 Part 1: Production Relationships MP Slide 8 of 58
9. Note: Increasing MP as a second worker is added Note: MP is
increasing at a decreasing rate as more workers are added Note: MP
is negative as workers get in each others way This highlights the
Law of Diminishing Marginal Returns (see next slide) Marginal
product, seen graphically Marginal product is increasing. People
are working together and specializing. Added employees are still
productive (MP>0) but not as much as the first few. Perhaps they
have to wait in line for tools. Part 1: Production Relationships MP
Slide 9 of 58
10. Eventually the MP curve turns downward and becomes negative
This idea is embodied in the Law of Diminishing Marginal Return: As
successive units of variable resources (such as labor) are added to
a fixed resource (such as a factory), beyond some point, the added
product (i.e. marginal product) that can be attributed to each
additional unit of the variable resource will decline Part 1:
Production Relationships In common language: As you continually
hire more employees without increasing your factory size,
eventually each one will produce less than the last. MP Slide 10 of
58
11. There is a relationship between the production function and
MP Early in production, we observe increasing marginal returns At
some point, diminishing marginal returns sets in
Eventually,negative marginalreturnsoccurs Part 1: Production
Relationships MP Slide 11 of 58
12. To make sure you understand, try this exercise At what
point does diminishing marginal returns set in? ____________ At
what point does negative MP occur? ____________ Please fill in the
blank cells and answer the questions below. Click to see the
answers. 4th employee 7th employee Part 1: Production Relationships
MP Slide 12 of 58
13. Average product (AP) describes output per unit of labor
When we are discussing Marginal Product, we are asking, How much
does the average employee produce? The technical definition:
Average product is the total output produced per unit of resource
employed. Part 1: Production Relationships AP Slide 13 of 58
14. Calculating average product The first worker produces 10
units. AP =10 The first 2 workers produce 25 units. AP =12.5 The
first 3 workers produce 45 units. AP =15 The first 4 workers
produce 60 units. AP =15 The first 5 workers produce 70 units.
AP=14 The first 6 workers produce 75 units. AP =12.5 The first 7
workers produce 75 units. AP =10.7 The first 8 workers produce 70
units. AP =8.8 Part 1: Production Relationships AP Slide 14 of
58
15. AP and MP, seen graphically Diminishing Marginal Returns is
evident in both these measures: Eventually, the curves slope
downward. When does diminishing marginal returns set in? Part 1:
Production Relationships AP When does diminishing marginal returns
set in? With the fourth worker. Slide 15 of 58
16. Part 2: Short run costs of production Lets turn our
attention from production to producer costs Well use the
shipbuilding industry as an example. Part 2: Short Run Production
Costs Slide 16 of 58
17. First, a clarification about time When analyzing production
costs, we must first differentiate between the short run and the
long run. In the short run, the plant is fixed plant capacity cant
be altered, but the intensity with which that plant is used can be
altered. For example, you can hire a night shift. In the long run,
the plant is variable In the long run, the producer can alter plant
capacity and any other resource. For example, you can add another
dry dock. But you cant do that in the short run. Part 2: Short Run
Production Costs Slide 17 of 58
18. Opportunities to change production differ in the short run
versus the long run Part 2: Short Run Production Costs Assume you
own a farm and decided to plant corn last spring. It is time to
harvest. You are now reading in the paper that corn prices are
falling and soybean prices are rising. In the long run, you can
change your crop to soybean (i.e. next year). In the short run, you
are going to harvest corn. Slide 18 of 58
19. Short run costs are a major factor in deciding how much to
produce Total Costs (TC) It is the sum of all producers costs It
includes fixed and variable costs Average Total Costs (ATC) It is
the average cost per unit of production Includes average fixed and
average variable costs Marginal Costs (MC) It is change in costs
associated with a one unit change in production Remember: marginal
means additional Part 2: Short Run Production Costs Three short run
producer costs will be explored: TC ATC MC Slide 19 of 58
20. Producer cost concept #1: Total Costs (TC) Total costs of
production include the value of all resources used in the
production process Total costs include: Fixed costs Variable costs
TC Part 2: Short Run Production Costs Slide 20 of 58 These (and
other) relationships are a key learning outcome. Each cost has a
special, but different relationship with output. Understanding the
producer costs outlined from here forward will be critical in your
success in this class.
21. Fixed costs include costs that dont change Costs that do
not vary with changes in output are fixed costs Examples include:
Rental payments Interest on a firms debt Depreciation on equipment
Insurance premiums TC Part 2: Short Run Production Costs Rent is a
great example. It doesnt matter how many units of output you
produce your rent is the same. Interest on debt is another example.
Do you think these guys care how much output you produced? Slide 21
of 58
22. An example of fixed costs Which of these costs are fixed?
Note: Many other costs such as taxes, insurance, pensions, energy,
fuel, and others are ignored. TC Part 2: Short Run Production Costs
Hypothetical Costs for a Shipbuilder Slide 22 of 58
23. Variable costs include costs that do change Costs that do
vary with changes in output are variable costs Other examples
include: Materials Fuel Power Transportation services TC Part 2:
Short Run Production Costs Labor is a great example. As your output
increases, you have to hire more people and labor costs go up.
Slide 23 of 58
24. An example of variable costs Which of these costs are
variable? Note: Many other costs such as taxes, insurance,
pensions, energy, fuel, and others are ignored TC Part 2: Short Run
Production Costs Hypothetical Costs for a Shipbuilder Slide 24 of
58
25. Fixed costs, shown in tabular form TC Part 2: Short Run
Production Costs Note: fixed costs dont change with increases in
output. Slide 25 of 58
26. Fixed costs, shown graphically Note: There is no
relationship between fixed costs and output What is the
relationship between fixed costs and output? (positive, negative or
no relationship) TC Part 2: Short Run Production Costs Slide 26 of
58
27. Variable costs, shown in tabular form TC Part 2: Short Run
Production Costs Note: fixed costs DO change with increases in
output. Slide 27 of 58
28. Variable costs, shown graphically The relationship is
positive. As output increases, variable costs go up. TC Part 2:
Short Run Production Costs Note: The Law of Diminishing Marginal
Returns is evident in the shape of this curve! It increases at an
increasing rate as added employees become less productive. What is
the relationship between variable costs and output? (positive,
negative or no relationship) Slide 28 of 58
29. Total costs Please keep in mind that fixed costs plus
variable costs equal total costs TC Part 2: Short Run Production
Costs Slide 29 of 58
30. Total cost, variable cost, and fixed costs shown
graphically TC Part 2: Short Run Production Costs Notice: the
vertical distance between variable costs and total costs is
constant. Why? Because the difference between them is fixed costs,
which doesnt change as production changes! Slide 30 of 58
31. Try this total cost exercise Fill in the empty cells on the
table then graph TFC, TVC, and total costs TC Part 2: Short Run
Production Costs Slide 31 of 58
32. Producer cost concept #2: Average Total Costs (ATC) When we
are discussing the ATC, we are asking," How much, on average, does
each unit of production cost? The technical definition: A firms
total cost divided by its output. Average total costs include:
Average fixed costs Average variable costs ATC Part 2: Short Run
Production Costs Slide 32 of 58
33. Calculation of Average Total Costs (ATC) ATC Part 2: Short
Run Production Costs The first cell cannot be filled out, You cant
divide by zero! For the first unit, the ATC is $650. (Total Cost/
Total Output = $650/1) For the second unit, the ATC is $413. (Total
Cost/ Total Output = $825/2) Costs for a Hypothetical Shipbuilder,
in MillionsCosts for a Hypothetical Shipbuilder, in Millions Slide
33 of 58
34. Average total costs, seen graphically Note the U-Shape of
the ATC! At lower levels of production, fixed costs are spread over
only a few units making ATC high As production increases, fixed
costs are spread over more units and ATC declines Eventually,
Diminishing Marginal Returns sets in and ATC begins to rise ATC
Part 2: Short Run Production Costs Slide 34 of 58
35. Average total costs, seen graphically Note the U-Shape of
the ATC! Examine the data: At lower levels of production, fixed
costs are spread over only a few units making ATC high ATC Part 2:
Short Run Production Costs Slide 35 of 58
36. Average total costs, seen graphically Note the U-Shape of
the ATC! Examine the data: At high levels of production,
diminishing Marginal Returns sets in and the ATC begins to rise ATC
Part 2: Short Run Production Costs Slide 36 of 58
37. Average total, variable, and fixed costs, seen graphically
ATC Part 2: Short Run Production Costs This side of the ATC is held
up by high fixed costs per unit (The orange line) This side of the
ATC is held up by high variable costs per unit (The green line)
Among these curves, this is the most important one. We will
continue to discuss the ATC for the next several weeks. Slide 37 of
58
38. Try this average total cost exercise ATC Part 2: Short Run
Production Costs Fill in the empty cells on the table then graph
ATC Slide 38 of 58
39. Producer cost concept #3: Marginal Costs (MC) When
discussing the MC, we are asking the question, " How much would it
cost to produce one more unit? The technical definition: A firms
total cost divided by its output. Part 2: Short Run Production
Costs MC Slide 39 of 58
40. Marginal cost (MC) Note: When adding the 1st unit of
production, costs go up by $250 MC Part 2: Short Run Production
Costs MC for the first unit = ($650- $400)/(1-0) Costs for a
Hypothetical Shipbuilder, in MillionsCosts for a Hypothetical
Shipbuilder, in Millions Note: When adding the 2nd unit of
production, costs go up by $175 MC for the second unit =
($825-$650)/(2-1) Slide 40 of 58
41. Marginal cost, seen graphically Note the J-Curve Shape. MC
decreases as efficiency is improved (Increasing Marginal Product)
MC slowly rises as Diminishing Marginal Returns sets in (Decreasing
Marginal Product) MC increases rapidly as Marginal Product
approaches (and falls below) zero (Negative Marginal Product) MC
Part 2: Short Run Production Costs Slide 41 of 58
42. Try this marginal cost exercise MC Part 2: Short Run
Production Costs Fill in the empty cells on the table then graph MC
Slide 42 of 58
43. Long run producer costs impact the size of the company Part
3: Long Run Production Costs In the long run, a shipbuilder can add
another dry dock In the long run, a farmer can farm additional land
Slide 43 of 58
44. In the long run, if a firm is successful it will likely
expand The question is, what happens to its average total costs
(ATC) as it expands? Part 3: Long Run Production Costs Slide 44 of
58
45. As a firm expands, economies of scale may occur Please
note: scale is a fancy word for size The issue: can this big
factory produce a good at a lower average cost than this little
factory? Part 3: Long Run Production Costs The technical definition
of economies of scale: Reductions in the average total cost of
producing a product as the firm expands the size of its plant Slide
45 of 58
46. Recall: in the long run an industry (and the individual
firms it includes) can adjust all resources Farmers can add to
farmed land Manufacturers can add an assembly line Shipbuilders can
add a dry dock Part 3: Long Run Production Costs Slide 46 of
58
47. As an example: assume that you run a transportation company
moving containers Your current fleet is comprised of containers
measuring 10X10 X 30 10 10 30 3,000 ft3 Total costs to transport
one container (fuel, driver, taxes, tariffs, storage) = $1,500
Average total costs (ATC) are $0.50 per cubic foot i.e. $1,500 /
3,000 ft3 Part 3: Long Run Production Costs Slide 47 of 58
48. One of your competitors is operating with larger containers
10 12 60 7,200 ft3 Total costs to transport one container (fuel,
driver, taxes, tariffs, storage) = $2,600 Average total costs (ATC)
are $0.36 per cubic foot Clearly, your competitor has a cost
advantage on you ! i.e. $2,600 / 7,200 ft3 Part 3: Long Run
Production Costs Your ATC = $0.50/sf His ATC=$0.36/sf Slide 48 of
58
49. Long run versus short run In the long run, you could
upgrade your fleet to include the larger containers. You realize
that you should probably adjust your fleet to compete, but you look
at the number of containers you have and sigh In the short run, you
are stuck with the containers you have. Part 3: Long Run Production
Costs Slide 49 of 58
50. Short run ATC for individual firms $0.50 200 $0.50 $0.36
200 500 Your ATC Your Competitors ATC ATC3 Perhaps there is another
firm with even bigger containers ATC4 Eventually, however,
containers may become so big, that it takes specialized equipment
to pick them up, overwhelming any cost savings. ATC5 Here average
costs per unit have increased again as containers become even
bigger! Part 3: Long Run Production Costs Slide 50 of 58
51. Short run ATC for individual firms and long run ATC for
industry $0.50 200 $0.50 $0.36 200 500 Your ATC Your Competitors
ATC ATC3 ATC4 ATC5 These are the short run ATC curves for
individual firms. In the long run, any firm could move to any other
curve with an investment in new containers. Therefore, in the long
run, the Long Run Average Total Cost curve (LRATC) curve is
determined by connecting all the short run ATC curves. LR ATC Part
3: Long Run Production Costs Slide 51 of 58
52. Lets return to the original question This questions refers
to economies of scale and is asking about the shape of an industrys
Long Run Average Total Cost Curves (LRATC). The issue: can this big
factory produce a good at a lower average cost than this little
factory? Part 3: Long Run Production Costs Slide 52 of 58
53. Assume we are discussing a hypothetical industry and this
is that industrys LRATC Each industry has its own unique LRATC
Companies operating at this point on the LRATC are relatively small
as can be seen by their low output Eventually, costs start to
increase. Companies here are getting very big. There are numerous
layers of management and changes are implemented only very slowly.
Part 3: Long Run Production Costs Average costs per unit for these
firms are here. Smaller companies have relatively higher costs
Companies on this portion of the LRATC are relatively small.
Perhaps these small companies do not have the largest most
efficient equipment available. As output increases, the LRATC
declines Companies here are getting bigger as can be seen by their
output. Perhaps labor specialization occurs or capital is used more
efficiently. Average costs per unit for these firms are here. At
some point, average costs per unit stop decreasing Companies here
are bigger still. Perhaps there are a few layers of management and
making big decisions becomes more difficult. Average costs per unit
for these firms are here. Average costs per unit for these firms
are here. Slide 53 of 58
54. Costs behave differently along different portions of the
LRATC Part 3: Long Run Production Costs Along this portion of the
LRATC, average total costs are falling. As a firms size gets bigger
costs per unit fall. This is referred to as Economies of scale.
Along this portion of the LRATC, average total costs are constant.
As a firms size gets bigger costs per unit dont change. This is
referred to as Constant returns to scale. Along this portion of the
LRATC, average total costs increase. As a firms size gets bigger
costs per unit increase. This is referred to as Diseconomies of
scale. Remember that scale means size! Slide 54 of 58
55. Some industries have flat LRATCs Part 3: Long Run
Production Costs In this industry, a long constant returns to scale
segment exists In an industry with an ATC like this, large and
small firms may coexist. Neither would have a cost advantage on the
other. Examples could include food or apparel. For example, Toms
Two Table Tacos can operate right next to Jimmys Giant Buffet.
Average costs per unit are the same for these different sized
firms. Output for Firm #1 Output for Firm #2 Slide 55 of 58
56. Some industries have downward sloped LRATCs Part 3: Long
Run Production Costs In this industry, economies of scale prevail
through a wide range of outputs Large firms will dominate this
industry. Firms must Get big or go home. Auto makers are huge. You
cannot produce one or two cars per year and coexist with them. Your
costs would be outrageous and youd have to sell cars at
ridiculously high prices. Examples include: Auto Industry Steel
Industry Shipbuilding Farm Equipment Slide 56 of 58
57. Industrial examples Part 3: Long Run Production Costs In
this industry, economies of scale are quickly exhausted Small firms
will dominate this industry. Why isnt there one large concrete
production plant in the center of the U.S? Transportation costs
would be extreme. It is more efficient to have many plants all over
the country. Examples include: Concrete production Pizza delivery
Slide 57 of 58
58. Individual exercise Try to think of an industry that would
fit each of these LRATCs Industry:_____________
Industry:_____________ Industry:_____________ Part 3: Long Run
Production Costs Slide 58 of 58