Chapter 6 Production and Cost ECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western

Production Business firm – an organization Production Technology 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

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 Different Quantities of Output Production Function

Short-Run versus Long-Run Decisions 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

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

Total and Marginal Product Figure 2 Total and Marginal Product Units of Output Number of Workers 6 2 3 4 5 1 196 Total Product 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 increasing marginal returns diminishing marginal returns

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

Thinking About Costs Total cost Sunk 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

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

Costs in the Short Run Fixed costs Variable 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

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

Total Cost Curves Figure 3 The Firm’s Total Cost Curves Dollars 135 Dollars 135 195 255 315 375 $435 30 90 130 160 Units of Output 184 TC TVC TFC TFC

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

Marginal Cost Marginal Cost (MC) MC curve is U-shaped Increase in total cost from producing one more unit or output 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.

Average And Marginal Costs Figure 4 Average And Marginal Costs Units of Output Dollars $4 3 2 1 30 90 130 160 196 MC AFC ATC AVC

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

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

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 ≤ TC LRATC ≤ ATC

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

Graphing the LRATC Curve Figure 5 Long-Run Average Total Cost 196 184 Dollars 1.00 2.00 3.00 $4.00 Units of Output 30 90 130 160 250 300 ATC1 LRATC ATC3 ATC0 ATC2 C D B A E 175 Use 0 automated lines Use 1 automated lines Use 2 automated lines Use 3 automated lines

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

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

Constant Returns to Scale The Shape Of LRATC Figure 6 The Shape Of LRATC Dollars 1.00 2.00 3.00 $4.00 130 184 LRATC Economies of Scale Constant Returns to Scale Diseconomies of Scale Units of Output

The Urge to Merge Minimum efficient scale (MES) Mergers 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

The Urge to Merge Figure 7 LRATC for a Typical Firm in a Merger-Prone Industry 3. Other firms lose market share and end up at C Dollars Quantity per Month A B C LRATC $240 200 80 8,000 10,000 20,000 4.Price war - other firms must match the first-mover’s price; each firm ends up back at A - they suffer losses 1. With market quantity demanded fixed at 60,000, and six firms of equal market share, each operates at A 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) 5. Mergers to create three large firms would enable each to operate at its MES with less likelihood of price wars and losses

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

Appendix: An Isoquant Map Figure A.1 An Isoquant Map Labor (workers) Land (hectares) 11 3 5 F Q=6,000 Q=4,000 A B C Q=2,000

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

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

Appendix: Isocost Lines Figure A.2 Isocost Lines Labor (workers) Land (hectares) 10 3 9 5 7.5 20 15 TC=$10,000 TC=$7,500 C TC=$5,000

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

Appendix: Isocost Lines Figure A.3 The Least-Cost Input Combination for a Given Output Level Labor (workers) Land (hectares) 5 7.5 10 Labor (workers) 20 15 TC=$10,000 20 Q=4,000 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 TC=$5,000 5 C K TC=$7,500