The Costs of Production Chapter 6. In This Chapter… 6.1. The Production Process 6.2. How Much to...

The Costs of Production

Chapter 6

In This Chapter…

6.1. The Production Process6.2. How Much to Produce? 6.3. The Right Size: Large or Small?

6.1. The Production Process


Factors of Production(Inputs)

Final Goods and Services(Output)

Production Process

6.1.The Production Process

Factors of production – Resource inputs used to produce goods and

services. land, labor, capital, entrepreneurship.

It takes some or all factors of production to produce a good or service – no matter what the good; OUTPUT


Production function : is the technical relationship that expresses the

maximum quantity of a good that can be produced (attainable) from different combinations of factors (inputs).

The technical relationship between the quantities of inputs used in the production process and the maximum output that can be produced.

The purpose of a production function is to tell us how much output we can produce with varying amounts of factor inputs

Varying Input Levels During some time period the amount of some inputs

that can be employed are fixed or can’t be varied….Fixed Inputs (E.g. Land; Plant Size)

While the amount of some other inputs can be easily changed… Variable Input (E.g., Labor)


Short-Run …. The time period during which the quantity

(and quality) of some inputs cannot be changed.

When there are fixed inputs, we’re dealing with a short run production condition.


In the Long Run, however, all inputs can be varied Thus long run is a time period that allows us to

sufficiently vary the amount of inputs we can use in the production process.

When we vary the amounts of input we use in the production process it affects productivity


Productivity - Output per unit of input, for example, output per labor hour.

The productivity of any factor of production depends on the amount of other resources available to it.


6.1. The Production Process: In the Short Run

The Production Function

01 2 3 4 5 6 7 8Labor Input (machine operators per day)

Jean

s O

utpu

t (p

airs

per

day

)

510152025303540455055

Total output

A

B

C

DE F H

IG

Amount of Output depends on Input levels

Marginal Productivity

An important Concept

Marginal Productivity

Marginal physical product (MPP): is the change in total output that results from

employment of one additional unit of the variable input.

quantityinputinchangeoutputtotalinchange

(MPP)productphysicalMarginal

Number of

WorkersTotal

Output

Marginal Physical Product

A 0 0

B 1 15 15

C 2 34 19

D 3 44 10

E 4 48 4

F 5 50 2

G 6 51 1

H 7 51 0

I 8 47 -4

Marginal Physical Product

01 2 3 4 5 6 7 8

Labor Input (machine operators per day)

Jean

s O

utpu

t (p

airs

per

day

)

510152025303540455055 Total output

Bb

C

c

E

e

F

f

G

g

H

h

I

i

+ 10 jeans

Third worker

D

d

aA

MPP

MPP:…Important Feature…

When the MPP of labor (MPPL >0), then total output increases.

Improving the ratio of the variable input (labor) to other factors increases the MPP of the variable input (labor).

But there is a limit to which we can do this because the capacity of the fixed resources will be exhausted

This leads to eventual decline in the additional and total output we could produce

Diminishing Marginal Returns

I.e., as more labor is hired, each unit of labor will have less capital and land to work with.

Thus output begins to rise more and more slowly as more workers are hired and will eventually fall

Law of Diminishing Returns

According to the law of diminishing returns, the marginal physical product of a variable input declines as more of it is employed with a given quantity of other (fixed) inputs.

All types of production are subject to this natural law

Diminishing Marginal Returns

01 2 3 4 5 6 7 8

Labor Input (machine operators per day)

Jean

s O

utpu

t (p

airs

per

day

)

510152025303540455055 Total output

Bb

C

c

E

e

F

f

G

g

H

h

I

i

+ 10 jeans

Third worker

D

d

aA

MPP

Resource Costs

6.2. The Costs of Production (The components of the

Costs of Production)

Resource Costs

A production function tells us how much a firm can produce but not how much it should produce.

Goal of a firm: Maximizing profit Profit: The difference between Total Revenue

(PxQ) and Total Cost (TC) Requires every firm to decide on its most

desirable level of output

Explicit vs. Implicit Cost

Explicit costs: are the payments made for the use of a

resource.

Implicit costs : are the value of resources used, even when

no direct payment is made.

Economic vs. Accounting Profit

Accounting Profit Accountants typically count dollar costs only

and ignore any resource use that doesn’t result in an explicit dollar cost.

Economic Profit: Economists consider implicit costs as well as

explicit costs to be part of the total costs of production.

Economic vs. Accounting profit

I.e., Economic cost represents he value of all resources used to produce a good or service; opportunity cost.

Dollar Costs (Economic Costs)

The dollar costs of production are directly related to the underlying production function.

1. Total Fixed Costs (TFC)

2. Total Variable Costs (TVC)

3. Total Costs (TC)

Costs of Production

Rate of Output

Fixed Cost(TFC)

Variable Cost(TVC)

Total Cost(TC) (FC + VC)

0 $120 $ 0 $120 10 120 85 205 15 120 125 245 20 120 150 270 30 120 240 360 40 120 350 470 50 120 550 670 51 120 633 753

Fixed Cost

Fixed costs are the costs of production that do not change when the rate of output is altered, such as the cost of basic plant and equipment.

0 15 30 45 60 75

100200300400500600700800900

1,0001,100

$1,200

Rate of Output (pairs of jeans per day)

Pro

duct

ion

Cos

ts (

dolla

rs p

er d

ay)

TFC=$120

Variable Cost

Variable costs are the costs of production that change when the rate of output is altered, such as labor and material costs.

0 15 30 45 60 75

100200300400500600700800900

1,0001,100

$1,200


Pro

duct

ion

Cos

ts (

dolla

rs p

er d

ay)

TVC

Total Cost

Total cost is the market value of all the resources used to produce a good or service.

0 15 30 45 60 75

100200300400500600700800900

1,0001,100

$1,200


Pro

duct

ion

Cos

ts (

dolla

rs p

er d

ay)

Total cost

G

BA

Fixed costs

Variable costs

Total Cost

How fast total costs rise depends on variable costs only.

Total cost is equal to the fixed costs when output is zero.

There is no way to avoid fixed costs in the short run.

The Cost of Jeans Production

0 15 30 45 60 75

100200300400500600700800900

1,0001,100

$1,200


Pro

duct

ion

Cos

ts (

dolla

rs p

er d

ay)

Total cost

G

BA

Fixed costs

Total cost include variable and fixed costs

Variable costs

Variable costs

Average Costs

One of the most common cost is average, or per-unit, cost.

4. Average Fixed Cost (AFC)

5. Average Variable Cost (AVC)

6. Average Total Cost (ATC)

Average Costs

Average fixed cost (AFC) is total fixed cost divided by the quantity produced in a given time period.

Average Costs

Average variable cost (AVC) is total variable cost divided by the quantity produced in a given time period.

Average Costs

Average total cost (ATC) is total cost divided by the quantity produced in a given time period.

Average Costs

Average total cost is the sum of average fixed and average variable cost.

ATC = AFC + AVC

Average Costs

Rate ofOutput

Total Cost AverageFixed Cost

AverageVariable

Cost

AverageTotal Cost

AFC + AVC0 $120 —10 205 $12.00 $ 8.50 $20.5015 245 8.00 8.33 16.3320 270 6.00 7.50 13.5030 360 4.00 8.00 12.0040 470 3.00 8.75 11.7550 670 2.40 11.00 13.4051 753 2.35 12.41 14.76

$24

20

16

12

8

4

0 10 20 30 40 50Rate of Output (pairs per day)

Cos

ts (

dolla

rs p

er p

air)

I

J

KL M N

O

ATC

AVC

AFC

Average Costs

Characteristic of Average Costs

Falling AFC As the rate of output increases, AFC

decreases as the fixed cost is spread over more output.

Any increase in output lowers average fixed cost.

Falling and then Rising AVC AVC will eventually rise as the rate of output

increases. AVC rises because of diminishing returns in

the production process.


U-Shaped ATC

The initial dominance of falling AFC, combined with the later resurgence of rising AVC, is what gives the ATC curve its characteristic U shape.


Minimum Point of the Average Total Cost The bottom of the U-shaped average total

cost curve represents the minimum average total costs.

It identifies the lowest possible opportunity costs to produce the product.

Note: Profit aren’t necessarily maximized where average total costs are minimized.

7. Marginal Cost (MC)

Marginal Cost

Marginal cost refers to the change in total costs associated with one more unit of output.

Marginal Cost

Marginal Cost

$35

30

25

20

15

10

5

10 20 30 40 50

pq

r

s t

u

v

Higher output level becomes increasingly expensive

Rate of Output (pairs per day)

Relationship between MPP and MC

Whenever MPP is increasing, the marginal cost of producing a good must be falling.

If marginal physical product declines, marginal cost increases.

Diminishing returns in production cause marginal costs to increase as the rate of output is expanded.

Falling MPP Implies Rising Marginal Cost

Diminishing marginal productivity implies . . . Rising marginal cost

Mar

gina

l Phy

sica

l Pro

duct

Labor Input

24

20

16

12

8

4

0 1 2 3 4 5 6 7 8

Add

ition

al L

abor

Cos

t

1.20

1.00

0.80

0.60

0.40

0.20

0 1 2 3 4 5 6 7Labor Input

Dim

inishing

marginal physical product

i

b

c

d

ef

g h1/b 1/c 1/d

1/e

1/f

1/g

Ris

ing

mar

gina

l cos

t

Summarizing the Relationship between different types of Costs of Production

and their Implication

Relationships

Output decision (how much to produce) has to be based not only on the capacity to produce (the production function) but also on the costs of production (the cost functions).

The relationship between the different cost components is thus important

Basic Cost Curves-relationships

$32

28

24

20

16

12

8

4

0 1 2 3 4 5 6 7 8

Co

st (

dol

lars

per

uni

t)

Rate of Output (units per time period)9

ATC

n

mAVC

AFC

MC

Relationships…

The marginal cost curve always intersects the ATC curve at its lowest point.

If MC > ATC, ATC is increasing

If MC < ATC, ATC is decreasing

If MC = ATC, ATC at minimum

Number of Employees

(L)

Output(Bottles

per Day); Q

Fixed Cost(TFC)

Variable cost

(TVC)

Total Cost(TC)

Average Fixed Cost

(AFC)

Average Variable

Cost(AVC)

Average Total Cost

(ATC)

Marginal Cost (MC)

A 0 0 $40

B 1 80

C 2 200

D 3 260 $36

E 4 300 $48

F 5 330

G 6 350

H 7 362 $84

Complete the Table Below

Number of Employees

(L)

Output(Bottles per Day)

Total Cost(TC)

Total Revenue TR=P x Q

ProfitTR-TC

A 0 0

B 1 80

C 2 200

D 3 260

E 4 300

F 5 330

G 6 350

H 7 362

Bottles sell for 35 cents each. Complete the table below

Long-Run Costs

The short-run is characterized by some costs that cannot be changed (fixed costs).

In the long run, there are no fixed costs.

The long run is a period of time long enough for all inputs to be varied (no fixed costs).

Long-Run Average Costs

The long-run cost curve is a summary of our best short-run cost possibilities.

Long-Run Average Costs

ATC1

ATC2

ATC3

Long-run average total cost (LATC)

Cos

ts (

dolla

rs p

er p

air)

0 40 a 60 b cRate of Output (pairs of jeans per day)

Long-Run Marginal Costs

The long-run marginal costs curve intersects our long-run cost curve at its lowest point.

0 q2

Rate of Output (jeans per day)

Cos

ts (

dolla

rs p

er p

air)

LMC

LATC

ATC2

m2

What is the appropriate Size?

In the long run, there are many optional plant sizes available to the firm. Decision as to which size is appropriate has to be made.

A firm can decide to use one large plant or several smaller plants to produce a given amount of output.

What guides the firm on such a decision?

Economies of Scale

Three Types: Constant returns to scale

are increases in plant size do not affect minimum average cost – minimum per-unit costs are identical for small plants and large plants.

Economies of scale: are reductions in minimum average costs that

come about through increases in the size (scale) of plant and equipment.

Diseconomies of scale: occur when an increase in plant size results in

reducing operating efficiency.

Economies of Scale

QM0

Economies of scale

c

ATC2

m2

ATCS

RATE OF OUTPUT (units per period)

QM0

Diseconomies of scale

c

ATC3

m3ATCS

RATE OF OUTPUT (units per period) QM

0

CO

ST

(do

llars

per

uni

t)Constant returns to scale

c

ATC1

m1


ATCS

Economies of Scale

QM0


c

ATC3

m3ATCS


QM0

Economies of scale

c

ATC2

m2

ATCS


QM0

CO

ST

(do

llars

per

uni

t)

Constant returns to scale

c

ATC1

m1


ATCS

Economies of Scale

QM0

CO

ST

(do

llars

per

uni

t)

Constant returns to scale

c

ATC1

m1


ATCS

QM0

Economies of scale

c

ATC2

m2

ATCS


QM0


c

ATC3

m3ATCS


Global Competitiveness: Low Wages and Advances in Productivity Global competitiveness ultimately depends on

the costs of production.

Low wages are not a reliable measure of global competitiveness.

A worker’s productivity (MPP) depends on the quantity and quality of other resources in the production process.

Global Competitiveness: Low Wages and Advances in Productivity What should American Firms do to remain

globally competitive?

American productivity must increase as fast as other nations in order for America to stay competitive in global markets.

Unit Labor Costs

Both factor costs and productivity are taken into account to measure competitiveness.

Unit labor cost a true measure of global competitiveness.

MPP

rate wagecost labor Unit

Improvements in Productivity Reduce Costs

TO

TA

L O

UT

PU

T(u

nits

per

tim

e pe

riod)

When the production function shifts up

Resource Inputs (dollars per unit)

Cost curves shift down

Rate of Output(units per time period)

CO

ST

(do

llars

per

uni

t)

ATC1

ATC2

MC1

MC2

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