Production and Cost CH 7, 8

Outline Production Costs Output Decisions Pricing Market Environment and Consumer Demand Firm’s Objectives

Production and Cost Purpose and motivation Profit = Revenue - Cost = P x Q d - AC x Q s Managers make the most efficient use of inputs of production in the short run and make prudent and farsighted capital investment decisions in the long run.

A: Production Analysis a)It examines the efficient use of inputs to produce outputs b)It applies to a wide range of settings (e.g., factories, offices, and stores) where production in the general sense takes place c)It is the basis for understanding cost analysis because: Cost = f(Q), and Q = f( physical inputs and technology)

Production is a technical relationship between a set of inputs or resources and a set of outputs or goods. Q X = f( inputs [land, labour, capital], technology,. ) ltural institutions influence the pon function.] Cost functions are the pecuniary relationships between outputs and the costs of production; Cost = f(Q X, prices of inputs,... ) Cost functions are determined by input prices and production relationships. It is necessary to understand production functions if you are to interpret cost data.

Production is an activity where resources are altered or changed and there is an increase in the ability of these resources to satisfy wants. change in physical characteristics – change in location – change in time – change in ownership

The Production Function The production function is a convenient way of expressing the physical relationship between inputs and output. For example, Q = f(X, Y), where Q = quantity of output X = quantity of variable inputs such as labor (L)and raw materials Y = quantity of fixed input (physical or capital input(K)

Production in the short run (Firms operate in the short run) Q = f(X, Y = constant) With fixed capacity, the relationship between X and Q in the short run is best described by the law of diminishing returns As the quantity of a variable input (such as labor) increases, the resulting rate of output increase eventually diminishes.

Production in the long run  The return to scale concept - How will an expansion of capacity (use of a bigger piece of equipment) affect total output?  There are three possible outcomes : Increasing return to scale Constant return to scale Decreasing return to scale

Reasons For Increasing Returns to Scale Specialization in the use of capital and labor Appropriate technology changes with scale

Reasons for Decreasing Returns To Scale Coordination, communication and control become more difficult at larger scale - causing a disproportionate requirement for more staff functions. Bureaucracy, red tapes, and X- inefficiencies (inefficiency in operation due to a lack of market competition, e.g., municipal utility companies)

B: Cost Analysis Three useful principles that guide managers in understanding business costs: 1.The principle of relevance 2.Economies of scale and scope and their impact on production costs 3.Sliding down the learning curve

Costs are incurred as a result of production. The important concept of cost is opportunity cost [marginal cost]. These are the costs associated with an activity. When inputs or resources are used to produce one good, the other goods they could have been used to produce are sacrificed. Costs may be in real or monetary terms; implicit costs explicit costs

Cost Relationship C=f(Q)  Short-term costs TC = TFC + TVC TFC = a constant TVC = f(Q) ATC = (TFC/Q)+(TVC/Q) MC = dTVC/dQ  Long-term costs

Short-Run Cost Curves - Total Costs TC(Q): Minimum total cost of producing alternative levels of output: TC(Q) = TVC + TFC TVC: Costs that vary with output TFC: Costs that do not vary with output $ Q TC (Q) = TVC + TFC TVC(Q) FC

Short-Run Costs: Average and Marginal Costs $ Q ATC AVC AFC MC

Significance of Marginal Cost Only rarely do we make “all or nothing” decisions. Most decisions are made at the margin Marginal costs influence operating decisions while average costs are the results of production decisions.

Learning Curves When knowledge gained from experience is used to improve production methods so that output is produced with increasing efficiency, the resulting decline in unit costs is said to reflect the effects of the firm’s learning curve. Executives have 2 main jobs: (1) to make new and better things, and (2) to make existing products faster, cheaper, and of higher quality. Learning curves are invaluable for the latter.

Learning Curves (cont.) The “learning curve effect” drives down the AV cost Lower costs => lower prices => new customers Learning curve effects enable Japanese firms to compete competitively in international markets Personal computers, surgical procedures, etc.