© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 8 Production and Cost

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Economic Cost The key principle underlying the computation of economic cost is the principle of opportunity cost.The key principle underlying the computation of economic cost is the principle of opportunity cost. In economics, the notion of a firm’s costs is based on the notion of economic cost.In economics, the notion of a firm’s costs is based on the notion of economic cost. PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Accounting Versus Economic Cost An accountant’s notion of costs involves only the firm’s explicit costs.An accountant’s notion of costs involves only the firm’s explicit costs. Explicit cost: the firm’s actual cash payments for its inputs. Explicit cost: the firm’s actual cash payments for its inputs. An economist includes the firm’s implicit costs.An economist includes the firm’s implicit costs. Implicit cost: the opportunity cost of nonpurchased inputs. Implicit cost: the opportunity cost of nonpurchased inputs. Economic cost: the sum of explicit cost plus implicit cost.Economic cost: the sum of explicit cost plus implicit cost.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Accounting Versus Economic Cost AccountingApproachEconomicApproach Explicit Cost (purchased inputs)$60,000 Implicit: opportunity cost of entrepreneur’s time 30,000 Implicit: opportunity cost of funds 10,000 _______________ Total Cost$60,000$100,000

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Short-Run Versus Long-Run Decisions Short run: a period of time during which at least one factor of production remains fixed. In the short run, a firm decides how much output to produce in the current facility.Short run: a period of time during which at least one factor of production remains fixed. In the short run, a firm decides how much output to produce in the current facility. Long run: the time it takes for a firm to build a production facility and start producing output. In the long run, a firm decides what size and type of facility to build.Long run: the time it takes for a firm to build a production facility and start producing output. In the long run, a firm decides what size and type of facility to build.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Production and Cost in the Short Run The key principle behind the firm’s short-run cost curves is the principle of diminishing returns, which states…?The key principle behind the firm’s short-run cost curves is the principle of diminishing returns, which states…? PRINCIPLE of Diminishing Returns Suppose output is produced with two or more inputs and we increase one input while holding the other input or inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Production and Marginal Product The total product curve shows the relationship between the quantity of labor and the quantity of output produced.The total product curve shows the relationship between the quantity of labor and the quantity of output produced. Labor Input and Output Labor: Number of Workers Output: Rakes per Minute

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Production and Marginal Product Labor: Number of Workers Output: Rakes per Minute Marginal Product of labor /8 1221/4 1531/3 2041/5 2751/7 3661/9 4871/ / / /40

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Production and Marginal Product The shape of the production function is explained by diminishing returns.The shape of the production function is explained by diminishing returns. Beyond 15 workers the marginal product of labor decreases and the production function becomes flatter.Beyond 15 workers the marginal product of labor decreases and the production function becomes flatter.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Marginal Product Why does the marginal product increase from c to d?Why does the marginal product increase from c to d? i.e. Why doesn’t the return diminish before point d? i.e. Why doesn’t the return diminish before point d? = Task Specialization

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Short-Run Total Cost There are two types of production cost in the short run: Fixed cost (FC): cost that does not depend on the quantity produced. Fixed cost (FC): cost that does not depend on the quantity produced. Variable cost: a cost that varies with the quantity produced. Total variable cost (TVC) is the cost that varies as the firm changes its output. Variable cost: a cost that varies with the quantity produced. Total variable cost (TVC) is the cost that varies as the firm changes its output. The short-run total cost (STC) equals the sum of fixed and variable costs.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Short-Run Total Cost Total Cost = Total Fixed Cost+ Total Variable Cost Short-Run Production Costs Output: Rakes per Minute Fixed Cost Total Variable Cost Short-Run Total Cost (FC)(TVC)(STC)

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Short-Run Marginal Cost Short-run marginal cost (SMC) is the change in total cost resulting from producing one more unit of the good.Short-run marginal cost (SMC) is the change in total cost resulting from producing one more unit of the good.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Marginal Product = Task Specialization

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Short-Run Average Cost There are three types of short run average cost: Average fixed cost (AFC): fixed cost divided by the quantity produced.Average fixed cost (AFC): fixed cost divided by the quantity produced. Short-run average variable cost (SAVC): total variable cost divided by the quantity produced.Short-run average variable cost (SAVC): total variable cost divided by the quantity produced. Short-run Average Total Cost = Average fixed cost + Short run average variable cost Short-run average total cost (SATC): short-run total cost divided by the quantity of output.Short-run average total cost (SATC): short-run total cost divided by the quantity of output.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Short-run Average and Marginal Costs: An Example Short-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 –––– /

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Short-run Average and Marginal Costs

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Relationship Between Marginal and Average Cost Curves When the marginal contribution is greater than the average contribution, the marginal rises above the average (points f and h).When the marginal contribution is greater than the average contribution, the marginal rises above the average (points f and h). Throughout the range of output where average cost decreases, marginal cost lies below average cost (points b and c).Throughout the range of output where average cost decreases, marginal cost lies below average cost (points b and c). At point m, average cost is minimum and equal to marginal cost.At point m, average cost is minimum and equal to marginal cost.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Why is the SATC Curve U-Shaped? Initially high due to spreading fixed cost over only a few unitsInitially high due to spreading fixed cost over only a few units Begins to decrease due to labor specialization and spreading fixed costs over more unitsBegins to decrease due to labor specialization and spreading fixed costs over more units Begins to increase due to increasing variable costs (labor) and no additional benefit from labor specialization (diminishing returns)Begins to increase due to increasing variable costs (labor) and no additional benefit from labor specialization (diminishing returns) But costs are still being pulled down by spreading the fixed costs But costs are still being pulled down by spreading the fixed costs

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Cost Mystery Because the short- run average total cost curve is U-shaped, it is possible to have the same short-run average cost at two—but not three— different quantities of output.Because the short- run average total cost curve is U-shaped, it is possible to have the same short-run average cost at two—but not three— different quantities of output.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Production and Cost in the Long Run The key difference between the short run and the long run is that there are no diminishing returns in the long run.The key difference between the short run and the long run is that there are no diminishing returns in the long run. Diminishing returns occur because workers share a fixed facility. In the long run the firm can expand its production facility as its workforce grows.Diminishing returns occur because workers share a fixed facility. In the long run the firm can expand its production facility as its workforce grows.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Expansion and Replication The firm’s long-run total cost is the total cost of production in the long run when a firm is perfectly flexible in its choice of inputs and can choose a production facility of any size.The firm’s long-run total cost is the total cost of production in the long run when a firm is perfectly flexible in its choice of inputs and can choose a production facility of any size. The firm’s long-run average cost of production (LAC) is the long-run total cost divided by the quantity of output produced.The firm’s long-run average cost of production (LAC) is the long-run total cost divided by the quantity of output produced.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Expansion and Replication The replication process—i.e. doubling the output produced in the original operation—means that long-run total cost increases proportionately with the quantity produced.The replication process—i.e. doubling the output produced in the original operation—means that long-run total cost increases proportionately with the quantity produced. Long-Run Costs: Total and Average Cost Output: Rakes per minute Long-Run Total Cost Long-Run Average Cost 3.5 $ 70 $20 7 $ 84 $12 14$168$12 28$336$12

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Decrease in Output and Indivisible Inputs An input is indivisible if it cannot be scaled down to produce a smaller quantity of output.An input is indivisible if it cannot be scaled down to produce a smaller quantity of output. Most production processes have at least one indivisible input.Most production processes have at least one indivisible input. In general, if there are indivisible inputs, the long-run average total cost curve will be negatively sloped.In general, if there are indivisible inputs, the long-run average total cost curve will be negatively sloped.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Decrease in Output and Indivisible Inputs When inputs cannot be scaled down to produce a smaller quantity of output, the long-run average cost of production will rise (from point f to point e).When inputs cannot be scaled down to produce a smaller quantity of output, the long-run average cost of production will rise (from point f to point e). Output: Rakes per minute Long-Run Average Cost 3.5$20 7$12 14$12 28$12

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Examples of Indivisible Inputs A cable-TV firm uses a cable running throughout its territory.A cable-TV firm uses a cable running throughout its territory. A shipping firm uses a large ship to carry TV sets from Japan to the United States.A shipping firm uses a large ship to carry TV sets from 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 scans, and MRIs).A hospital uses imaging machines (for X-rays, CAT scans, and MRIs). A pizzeria uses a pizza oven.A pizzeria uses a pizza oven.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Decrease in Output and Labor Specialization A second reason for higher average long-run costs in a smaller operation is that labor will be less specialized in the small operation.A second reason for higher average long-run costs in a smaller operation is that labor will be 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 fewer tasks, thus, is more productive than his or her counterpart in a small operation.In a large operation, each worker specializes in fewer tasks, thus, is more productive than his or her counterpart in a small operation.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Economies of Scale Economies of scale is a situation in which an increase in the quantity produced decreases the long-run average cost of production (or during the trajectory from e to f).Economies of scale is a situation in which an increase in the quantity produced decreases the long-run average cost of production (or during the trajectory from e to f). Economies of scale refer to cost savings associated with spreading the cost of indivisible inputs and the benefits of input specialization.Economies of scale refer to cost savings associated with spreading the cost of indivisible inputs and the benefits of input specialization.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Scale Economies in Wind Power The average cost per kilowatt hour is $0.032 for the large turbine, compared to $0.065 for the smaller turbine.The average cost per kilowatt hour is $0.032 for the large turbine, compared to $0.065 for the smaller turbine. Small Turbine (150 kilowatt) Large Turbine (600 kilowatt) Purchase price of turbine $150,000$420,000 Installation cost $100,000$100,000 Operating and maintenance cost $75,000$126,000 Total cost $325,000$646,000 Electricity generated (kilowatt hours) 5 million 20 million Average cost (per kilowatt hour) $0.065$0.032 Danish Wind Turbine Manufacturers Association. Guided Tour of Wind Energy (

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Minimum Efficient Scale The minimum efficient scale describes the output at which the long-run average cost curve becomes horizontal.The minimum efficient scale describes the output at which the long-run average cost curve becomes horizontal. Once the minimum efficient scale has been reached, an increase in output no longer decreases the long-run average cost.Once the minimum efficient scale has been reached, an increase in output no longer decreases the long-run average cost.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Actual Long-Run Average Cost Curves LAC Curve for Electricity Generation LAC Curve for Aluminum Production

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Actual Long-Run Average Cost Curves LAC Curve for Truck Freight LAC Curve for Hospital Services

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Diseconomies of Scale A firm experiences diseconomies of scale when an increase in output leads to an increase in long-run average cost—the LAC curve becomes positively sloped.A firm experiences diseconomies of scale when an increase in output leads to an increase in long-run average cost—the LAC curve becomes positively sloped. Diseconomies of scale may arise for two reasons:Diseconomies of scale may arise for two reasons: Coordination problems Coordination problems Increasing input costs Increasing input costs