Production and Cost

© 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e O’Sullivan/Sheffrin

Prepared by:

Fernando Quijano and Yvonn Quijano

C H A P T E R

8

Production and CostProduction and Cost


Economic Cost

• The key principle underlying the computation The key principle underlying the computation of economic cost is the principle of opportunity of economic cost is the principle of opportunity cost.cost.

• In economics, the notion of a firmIn economics, the notion of a firm’’s costs is s costs is based on the notion of economic cost.based on the notion of economic cost.

PRINCIPLEPRINCIPLE of Opportunity Costof Opportunity CostThe opportunity cost of something is what you The opportunity cost of something is what you sacrifice to get it.sacrifice to get it.


Accounting Versus Economic Cost

• An accountantAn accountant’’s notion of costs involves only s notion of costs involves only the firmthe firm’’s explicit costs.s explicit costs.• Explicit cost:Explicit cost: the firm the firm’’s actual cash payments for its s actual cash payments for its

inputs.inputs.

• An economist includes the firmAn economist includes the firm’’s implicit costs.s implicit costs.• Implicit cost:Implicit cost: the opportunity cost of nonpurchased the opportunity cost of nonpurchased

inputs.inputs.

• Economic cost:Economic cost: the sum of explicit cost plus the sum of explicit cost plus implicit cost.implicit cost.


Accounting Versus Economic Cost

Accounting Versus Economic CostAccounting Versus Economic Cost

AccountingAccounting

ApproachApproach

EconomicEconomic

ApproachApproach

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 Decisions

• Short run:Short run: a period of time during which at a period of time during which at least one factor of production remains fixed. least one factor of production remains fixed. In the short run, a firm decides how much In the short run, a firm decides how much output to produce in the current facility.output to produce in the current facility.

• Long run:Long run: the time it takes for a firm to build the time it takes for a firm to build a production facility and start producing a production facility and start producing output. In the long run, a firm decides what output. In the long run, a firm decides what size and type of facility to build.size and type of facility to build.


Production and Cost in the Short Run

• The key principle behind the firmThe key principle behind the firm’’s short-run s short-run cost curves is the principle of diminishing cost curves is the principle of diminishing returns, which states…?returns, which states…?

PRINCIPLEPRINCIPLE of Diminishing Returnsof Diminishing ReturnsSuppose output is produced with two or more inputs Suppose output is produced with two or more inputs and we increase one input while holding the other and we increase one input while holding the other input or inputs fixed. Beyond some point—called the input or inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a point of diminishing returns—output will increase at a decreasingdecreasing rate.rate.


Production and Marginal Product

• The The total product curvetotal product curve shows the relationship shows the relationship between the quantity of between the quantity of labor and the quantity of labor and the quantity of output produced.output produced.

Labor Input and OutputLabor Input and Output

Labor: Number of Workers

Output: Rakes per

Minute

0 0

8 1

12 2

15 3

20 4

27 5

36 6

48 7

65 8

90 9

130 10



Labor: Number of Workers

Output: Rakes per

Minute

Marginal Product of

labor

0 0

8 1 1/8

12 2 1/4

15 3 1/3

20 4 1/5

27 5 1/7

36 6 1/9

48 7 1/12

65 8 1/17

90 9 1/25

130 10 1/40



• The shape of the The shape of the production function is production function is explained by explained by diminishing returns.diminishing returns.

• Beyond 15 workers the Beyond 15 workers the marginal product of marginal product of labor decreases and labor decreases and the production function the production function becomes flatter.becomes flatter.


Marginal Product

• Why does the Why does the marginal product marginal product increase from c to d?increase from c to d?

• i.e. Why doesn’t the i.e. Why doesn’t the return diminish before return diminish before point d?point d?

= Task Specialization= Task Specialization


Short-Run Total Cost

There are two types of production cost in the There are two types of production cost in the short run:short run:

• Fixed cost (FC):Fixed cost (FC): cost that does not depend on the cost that does not depend on the quantity produced.quantity produced.

• Variable cost:Variable cost: a cost that varies with the quantity a cost that varies with the quantity produced. produced. Total variable cost (TVC)Total variable cost (TVC) is the cost that is the cost that varies as the firm changes its output.varies as the firm changes its output.

The The short-run total cost (STC)short-run total cost (STC) equals the sum equals the sum of fixed and variable costs.of fixed and variable costs.


Short-Run Total Cost

Total Cost ==

Total Fixed Cost

++Total Variable Cost

Short-Run Production CostsShort-Run Production Costs

Output: Rakes

per Minute

Fixed Cost

Total Variable

CostShort-Run Total Cost

(FC) (TVC) (STC)

0 36 0 36

1 36 8 44

2 36 12 48

3 36 15 51

4 36 20 56

5 36 27 63

6 36 36 72

7 36 48 84

8 36 65 101

9 36 90 126

10 36 130 166

STC FC TVC


Short-Run Marginal Cost

• Short-run marginal cost (SMC)Short-run marginal cost (SMC) is the is the change in total cost resulting from producing change in total cost resulting from producing one more unit of the good.one more unit of the good.

MCTC

Q


Marginal Product

= Task Specialization= Task Specialization


Short-Run Average Cost

There are three types of There are three types of short run average cost:short run average cost:

• Average fixed cost Average fixed cost (AFC):(AFC): fixed cost divided fixed cost divided by the quantity produced.by the quantity produced.

• Short-run average Short-run average variable cost (SAVC):variable cost (SAVC): total variable cost divided total variable cost divided by the quantity produced.by the quantity produced.

SATCFC

Q

TVC

Q

SATC AFC SAVC

Short-run Short-run Average Average Total CostTotal Cost

==Average Average fixed fixed costcost

++

Short run Short run average average variable variable costcost

• Short-run average total Short-run average total cost (SATC):cost (SATC): short-run short-run total cost divided by the total cost divided by the quantity of output.quantity of output.


Short-run Average and Marginal Costs: An Example

Short-Run Production CostsShort-Run Production Costs

Output: Rakes

per Minute

Short-Run

Marginal Cost

Average Fixed Cost

Short-Run

Average Variable

Cost

Short-Run

Average Total Cost

(SMC) (AFC) (SAVC) (SATC)

0 – – – –

1 8.00 36.00 8.00 44.00

2 4.00 18.00 6.00 24.00

3 3.00 12.00 5.00 17.00

4 5.00 9.00 5.00 14.00

5 7.00 7.20 5.40 12.60

6 9.00 6.00 6.00 12.00

7 12.00 5.14 6.86 12.00

8 17.00 4.50 8.13 12.63

9 25.00 4.00 10.00 14.00

10 40/00 3.60 13.00 16.60


Short-run Average and Marginal Costs


The Relationship Between Marginal and Average Cost Curves

• When the marginal When the marginal contribution is greater than contribution is greater than the average contribution, the average contribution, the marginal rises above the marginal rises above the average (points the average (points ff and and hh).).

• Throughout the range of Throughout the range of output where average cost output where average cost decreases, marginal cost decreases, marginal cost lies below average cost lies below average cost (points (points bb and and cc).).

• At point At point mm, average cost is , average cost is minimum and equal to minimum and equal to marginal cost.marginal cost.


Why is the SATC Curve U-Shaped?

• Initially high due to spreading fixed Initially high due to spreading fixed cost over only a few unitscost over only a few units

• Begins to decrease due to labor Begins to decrease due to labor specialization and spreading fixed specialization and spreading fixed costs over more unitscosts over more units

• Begins to increase due to increasing Begins to increase due to increasing variable costs (labor) and no variable costs (labor) and no additional benefit from labor additional benefit from labor specialization (diminishing returns)specialization (diminishing returns)

• But costs are still being pulled down by But costs are still being pulled down by spreading the fixed costs spreading the fixed costs


The Cost Mystery

• Because the short-Because the short-run average total cost run average total cost curve is U-shaped, it curve is U-shaped, it is possible to have is possible to have the same short-run the same short-run average cost at twoaverage cost at two—but not three——but not three—different quantities of different quantities of output.output.


Production and Cost in the Long Run

• The key difference between the short run and The key difference between the short run and the long run is that there are no diminishing the long run is that there are no diminishing returns in the long run.returns in the long run.

• Diminishing returns occur because workers Diminishing returns occur because workers share a fixed facility. In the long run the firm share a fixed facility. In the long run the firm can expand its production facility as its can expand its production facility as its workforce grows.workforce grows.


Expansion and Replication

• The firmThe firm’’s s long-run total costlong-run total cost is the total cost is the total cost of production in the long run when a firm is of production in the long run when a firm is perfectly flexible in its choice of inputs and can perfectly flexible in its choice of inputs and can choose a production facility of any size.choose a production facility of any size.

• The firmThe firm’’s s long-run average cost of long-run average cost of production (LAC)production (LAC) is the long-run total cost is the long-run total cost divided by the quantity of output produced.divided by the quantity of output produced.


Expansion and Replication

• The replication process—i.e. doubling the output The replication process—i.e. doubling the output produced in the original operation—means that long-run produced in the original operation—means that long-run total cost increases proportionately with the quantity total cost increases proportionately with the quantity produced.produced.

Long-Run Costs: Total and Average CostLong-Run Costs: Total and Average CostOutput: Rakes per minuteOutput: Rakes per minute Long-Run Total CostLong-Run Total Cost Long-Run Average CostLong-Run Average Cost

3.53.5 $ 70$ 70 $20$20

77 $ 84$ 84 $12$12

1414 $168$168 $12$12

2828 $336$336 $12$12


Decrease in Outputand Indivisible Inputs

• An input is An input is indivisibleindivisible if it cannot be if it cannot be scaled down to produce a smaller quantity scaled down to produce a smaller quantity of output.of output.

• Most production processes have at least Most production processes have at least one indivisible input.one indivisible input.

• In general, if there are indivisible inputs, In general, if there are indivisible inputs, the long-run average total cost curve will the long-run average total cost curve will be negatively sloped.be negatively sloped.


Decrease in Outputand Indivisible Inputs

• When inputs cannot be When inputs cannot be scaled down to scaled down to produce a smaller produce a smaller quantity of output, the quantity of output, the long-run average cost long-run average cost of production will rise of production will rise (from point (from point ff to point to point ee).).

Output: Rakes per Output: Rakes per minuteminute

Long-Run Long-Run Average CostAverage Cost

3.53.5 $20$20

77 $12$12

1414 $12$12

2828 $12$12


Examples of Indivisible Inputs

• A cable-TV firm uses a cable running throughout its A cable-TV firm uses a cable running throughout its territory.territory.

• A shipping firm uses a large ship to carry TV sets from A shipping firm uses a large ship to carry TV sets from Japan to the United States.Japan to the United States.

• A steel producer uses a large blast furnace.A steel producer uses a large blast furnace.

• A hospital uses imaging machines (for X-rays, CAT A hospital uses imaging machines (for X-rays, CAT scans, and MRIs).scans, and MRIs).

• A pizzeria uses a pizza oven.A pizzeria uses a pizza oven.


Decrease in Outputand Labor Specialization

• A second reason for higher average long-run A second reason for higher average long-run costs in a smaller operation is that labor will be costs in a smaller operation is that labor will be less specialized in the small operation.less specialized in the small operation.

• A jack of all trades is a master of none.A jack of all trades is a master of none.

• In a large operation, each worker specializes In a large operation, each worker specializes in fewer tasks, thus, is more productive than in fewer tasks, thus, is more productive than his or her counterpart in a small operation.his or her counterpart in a small operation.


Economies of Scale

• Economies of scaleEconomies of scale is a is a situation in which an situation in which an increase in the quantity increase in the quantity produced decreases the produced decreases the long-run average cost of long-run average cost of production (or during the production (or during the trajectory from trajectory from ee to to ff).).

• Economies of scale refer to Economies of scale refer to cost savings associated cost savings associated with spreading the cost of with spreading the cost of indivisible inputs and the indivisible inputs and the benefits of input benefits of input specialization.specialization.


Scale Economies in Wind Power

• The average cost per kilowatt hour is $0.032 for the large The average cost per kilowatt hour is $0.032 for the large turbine, compared to $0.065 for the smaller turbine.turbine, compared to $0.065 for the smaller turbine.

Small Turbine Small Turbine (150 kilowatt)(150 kilowatt)

Large Turbine Large Turbine (600 kilowatt)(600 kilowatt)

Purchase price of turbinePurchase price of turbine $150,000$150,000 $420,000$420,000

Installation costInstallation cost $100,000$100,000 $100,000$100,000

Operating and maintenance costOperating and maintenance cost $75,000$75,000 $126,000$126,000

Total costTotal cost $325,000$325,000 $646,000$646,000

Electricity generated (kilowatt hours)Electricity generated (kilowatt hours) 5 million5 million 20 million20 million

Average cost (per kilowatt hour)Average cost (per kilowatt hour) $0.065$0.065 $0.032$0.032Danish Wind Turbine Manufacturers Association. Guided Tour of Wind Energy (http://www.windpower.dk)Danish Wind Turbine Manufacturers Association. Guided Tour of Wind Energy (http://www.windpower.dk)


Minimum Efficient Scale

• The The minimum efficient scaleminimum efficient scale describes the describes the output at which the long-run average cost output at which the long-run average cost curve becomes horizontal.curve becomes horizontal.

• Once the minimum efficient scale has been Once the minimum efficient scale has been reached, an increase in output no longer reached, an increase in output no longer decreases the long-run average cost.decreases the long-run average cost.


Actual Long-Run Average Cost Curves

LAC Curve for Electricity LAC Curve for Electricity GenerationGeneration

LAC Curve for Aluminum LAC Curve for Aluminum ProductionProduction


Actual Long-Run Average Cost Curves

LAC Curve for Truck FreightLAC Curve for Truck Freight LAC Curve for Hospital ServicesLAC Curve for Hospital Services


Diseconomies of Scale

• A firm experiences A firm experiences diseconomies of scalediseconomies of scale when an increase in output leads to an when an increase in output leads to an increase in long-run average cost—the LAC increase in long-run average cost—the LAC curve becomes positively sloped.curve becomes positively sloped.

• Diseconomies of scale may arise for two Diseconomies of scale may arise for two reasons:reasons:

• Coordination problemsCoordination problems

• Increasing input costsIncreasing input costs

Production and Cost

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