Production and Cost Analysis I 12 Production and Cost Analysis I Production is not the application of tools to materials, but logic to work. — Peter Drucker CHAPTER 12 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Production and Cost Analysis I 12 Chapter Goals Differentiate economic profit from accounting profit Calculate fixed costs, variable costs, marginal costs, total costs, average fixed costs, average variable costs, and average total costs Introduce the law of diminishing marginal productivity Distinguish between long-run and short-run production Distinguish the various kinds of cost curves and describe the relationships among them Explain why the average cost curves are U-shaped 12-2

Production and Cost Analysis I 12 The Role of the Firm Firms transform the factors into goods for consumers Production is the transformation of factors into goods In the supply process, people offer their factors of production, such as land, labor, and capital, to the market Ultimately, all supply comes from individuals because control the factors of production (land, labor, capital, and entrepreneurial ability) 12-3

Production and Cost Analysis I 12 The Role of the Firm 1.Organize factors of production and/or 2.Produce goods and services and/or 3.Sell produced goods and services A virtual firm organizes production and subcontracts out all work A firm is an economic institution that transforms factors of production into goods and services Many of the organizational structures of business are being separated from the production process Firms 12-4

Production and Cost Analysis I 12 Firms Maximize Profit For economists, total cost is explicit payments to the factors of production plus the opportunity cost of the factors provided by the owners of the firm For economists, total revenue is the amount a firm receives for selling its product or service plus any increase in the value of the assets owned by the firm Profit = total revenue – total cost The goal of a firm is to maximize profits 12-5

Production and Cost Analysis I 12 Explicit Revenue - $ amount of sales (P X Q) Implicit Revenue – Increase in the value of assets (I’ll never ask you this on a test, nor include it in any problem) TOTAL REVENUE = EXPLICIT REVENUE + IMPLICIT REVENUE Explicit Cost – payments to the factors of production, government, etc. – typically a paper trail Implicit Cost – the value of resources owned and employed by the firm, measured by the opportunity cost concept NOTE: A normal profit is an implicit cost in decision- making TOTAL COST = EXPLICIT COST + IMPLICIT COST McGraw-Hill/Irwin Colander, Economics 6

Production and Cost Analysis I 12 Firms Maximize Profit Accountants focus on explicit costs and revenues Accounting profit = explicit revenue – explicit cost Economists and accountants measure profit differently Economists focus on both explicit and implicit costs and revenue Economic profit = (explicit and implicit revenue) – (explicit and implicit cost) 12-7 Both definitions are correct – they focus on different tasks

Production and Cost Analysis I 12 The Production Process A firm chooses from all possible production techniques All inputs are variable New firms may enter, existing firms leave The production process can be divided into the long run and the short run The terms long run and short run do not necessarily refer to specific periods of time, but to the flexibility the firm has in changing the level of output Short runLong run A firm is constrained in regard to what production decisions it can make Some inputs are fixed No entry or exit 12-8

Production and Cost Analysis I 12 Production Tables and Production Functions A production table is a table showing the output resulting from various combinations of factors of production or inputs This analysis will concentrate on short run production when in which one of the factors (capital) is fixed and one factor (labor) is variable Firms combine factors of production to produce goods and services Real-world production tables are complicated 12-9

Production and Cost Analysis I 12 A Production Table # of workers Total Output Marginal Product Average Product Marginal product is the additional output that will be forthcoming from an additional worker, other inputs constant Average product is the output per worker 12-10

Production and Cost Analysis I 12 Graphing a Production Function Q Increasing marginal productivity Diminishing marginal productivity Diminishing Absolute productivity (Negative Marginal Productivity) Number of workers TP A production function is the relationship between then inputs and the outputs

Production and Cost Analysis I 12 Graphing Marginal and Average Productivity Increasing marginal productivity Diminishing marginal productivity Diminishing Absolute productivity (Negative Marginal Productivity Number of workers AP MP Q Marginal productivity first increases Then marginal productivity declines Eventually marginal productivity is negative

Production and Cost Analysis I 12 Law of Diminishing Marginal Productivity # of workers Total Output Marginal Product Average Product Law of diminishing marginal productivity states as more of a variable input is added to an existing fixed input, after some point the additional output from the additional input will fall Increasing marginal productivity Diminishing marginal productivity Diminishing Absolute productivity (Negative Marginal Productivity) 12-13

Production and Cost Analysis I 12 The Costs of Production (Short Run) Fixed costs (FC) are those that are spent and cannot be changed in the period of time under consideration In the long run, there are no fixed costs since all inputs (and therefore their costs) are variable In the short run, a number of inputs and their costs will be fixed Workers are an example of variable costs (VC) which are costs that change as output changes The sum of the variable and fixed costs are total costs (TC) TC = FC + VC 12-14

Production and Cost Analysis I 12 The Costs of Production Average fixed costs (AFC) equals fixed cost divided by quantity produced, AFC = FC/Q Marginal cost (MC) is the increase in total cost when output increases by one unit, MC = ΔTC/ΔQ Average variable costs (AVC) equals variable cost divided by quantity produced, AVC = VC/Q Average total costs (ATC) equals total cost divided by quantity produced, ATC = TC/Q or ATC = AFC + AVC 12-15

Production and Cost Analysis I 12 Costs of Production Table OutputFC ($)VC ($)TC ($)MC ($)AFC ($)AVC ($)ATC ($)

Production and Cost Analysis I 12 Graphing Total Cost Curves TFC Total Cost TFC curve is constant TC and TVC curves increase as Q increases Q TVC TC NOTE: Vertical difference between TC and TVC is TFC.

Production and Cost Analysis I 12 Graphing Per Unit Output Cost Curves AVC MC ATC AFC Q Cost AFC curve decreases MC, ATC, and AVC curves are U-shaped NOTE: Vertical difference between ATC and AVC is AFC.

Production and Cost Analysis I 12 The Shapes of Cost Curves The variable and total cost curves have the same shape Increasing output increases VC and TC The average fixed cost curve is downward sloping Increasing output decreases AFC The fixed cost curve is always constant Increasing output doesn’t change FC The marginal cost, average variable cost, and average total cost curves are U-shaped Increasing output initially leads to a decrease in MC, AVC, and ATC but eventually they increase 12-19

Production and Cost Analysis I 12 The Shapes of Cost Curves The marginal cost curve MUST go through the minimum points of the ATC and AVC curves The U-shape of ATC and AVC curves is due to: When output is increased in the short run, it can only be done by increasing the variable input The law of diminishing productivity causes marginal and average productivities to fall As average and marginal productivities fall, average and marginal costs rise 12-20

Production and Cost Analysis I 12 The Relationship Between Marginal Productivity and Marginal Costs AVC Q MC Q Output per worker Costs per unit If marginal productivity is rising, marginal costs are falling If average productivity is falling, average costs are rising MP of workers AP of workers 12-21

Production and Cost Analysis I 12 If MC > ATC, then ATC is rising If MC > AVC, then AVC is rising If MC < ATC, then ATC is falling If MC < AVC, then AVC is falling If MC = AVC and MC = ATC, then AVC and ATC are at their minimum points The Relationship Between Marginal Cost and Average Cost 12-22

Production and Cost Analysis I 12 The Relationship Between Marginal Cost and Average Cost AVC MC Q Costs per unit ATC The marginal cost curve goes through the minimum point of both the ATC and AVC curves 12-23

Production and Cost Analysis I 12 Chapter Summary Accounting profit is explicit revenue less explicit cost Economists include implicit revenue and cost in determining economic profit Implicit revenue includes the increases in the value of assets owned by the firm Implicit costs include opportunity cost of time and capital provided by owners of the firm In the long run a firm can choose among all possible production techniques; in the short run it is constrained in its choices because at least one input is fixed 12-24

Production and Cost Analysis I 12 Chapter Summary The law of diminishing marginal productivity states that as more of a variable input is added to a fixed input, the additional output will eventually be decreasing Costs are generally divided into fixed costs, variable costs, and marginal costs TC = FC + VC MC = ΔTC/ΔQ AFC = FC/Q AVC = VC/Q ATC = AFC + AVC 12-25

Production and Cost Analysis I 12 Chapter Summary AVC and MC are mirror images of the average and marginal products The law of diminishing marginal productivity causes marginal and average costs to rise MC goes through the minimum points of the AVC and ATC If MC > ATC, then ATC is rising If MC = ATC, then ATC is constant If MC < ATC, then ATC is falling 12-26

Production and Cost Analysis I 12 Preview of Chapter 13: Production and Cost Analysis II Distinguish technical efficiency from economic efficiency State the envelope relationship between short run cost curves and long run cost curves Explain how economies and diseconomies of scale influence the shape of long-run cost curves Explain the role of the entrepreneur in translating cost of production to supply Discuss some of the problems of using cost analysis in the real-world 12-27