1. Production and Cost Analysis II
Chapter 10

2. Laugher Curve
Economists have forecasted nine out of the last 15 recessions.

3. Making Long-Run Production Decisions
To make their long-run decisions:
Firms look at costs of various inputs and the technologies available for combining these inputs.
Then decide which combination offers the lowest cost.

4. Making Long-Run Production Decisions
The firm makes long-run decisions on the basis of the expected costs and expected usefulness of inputs.

5. Technical Efficiency and Economic Efficiency
Technical efficiency – as few inputs as possible are used to produce a given output.
Technical efficiency is efficiency that does not consider cost of inputs.

6. Technical Efficiency and Economic Efficiency
Economically efficient – the method that produces a given level of output at the lowest possible cost.
It is the least-cost technically efficient process.

7. Determinants of the Shape of the Long-Run Cost Curve
The law of diminishing marginal productivity does not hold in the long run.
All inputs are variable in the long run.

8. Determinants of the Shape of the Long-Run Cost Curve
The shape of the long-run cost curve is due to the existence of economies and diseconomies of scale.

9. A Typical Long-Run Average Total Cost Table
Quantity
Total Costs of Labor
Total Cost of Machines
Total Costs = TCL + TCM
Average Total Costs = TC/Q 11 12 13 14 15 16 17 18 19 20
$381
390
402
420
450
480
510
549
600
666
$254
260
268
280
300
320
340
366
400
444
$635
650
670
700
750
800
850
915
1,000
1,110
$58 54 52 50 51 53 56
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

10. A Typical Long-Run Average Total Cost Curve
Costs per unit
$64 62 60 58 56 54 52 50 48 1 12 13 14 15 16 17 18 19 20
Quantity
Average total cost
Minimum efficient level of production
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

11. Economies of Scale
Economies of scale – long run average total costs decrease as output increases.
In real-world production processes, economies of scale are extremely important at low levels of production.

12. Economies of Scale
An indivisible setup cost is the cost of an indivisible input for which a certain minimum amount of production must be undertaken before the input becomes economically feasible to use.

13. Economies of Scale
Indivisible setup costs create many real-world economies of scale.
The cost of a blast furnace or an oil refinery is an example of an indivisible setup cost.

14. Economies of Scale
In the longer run all inputs are variable, so only economies of scale can influence the shape of the long-run cost curve.

15. Economies of Scale
Because of the importance of economies of scale, business people often talk of a minimum efficient level of production.

16. Economies of Scale
The minimum efficient level of production is the amount of production that spreads setup costs out sufficiently for firms to undertake production profitably.

17. Economies of Scale
The minimum efficient level of production is reached once the size of the market expands to a size large enough so that firms can take advantage of all economies of scale.

18. Diseconomies of Scale
Diminishing marginal productivity refers to the decline in productivity caused by increasing units of a variable input being added to a fixed input.

19. Diseconomies of Scale
Diseconomies of scale refer to decreases in productivity which occur when there are equal increases of all inputs (no input is fixed).
Diseconomies of scale occur on the right side of the long-run average cost curve where it is upward sloping, meaning that average cost is increasing.

20. Diseconomies of Scale
As the size of the firm increases, monitoring costs generally increase.
Monitoring costs are those incurred by the organizer of production in seeing to it that the employees do what they are supposed to do.

21. Diseconomies of Scale
As the size of the firm increases, team spirit or morale generally decreases.
Team spirit is the feelings of friendship and being part of a team that brings out peoples’ best effort

22. Constant Returns to Scale
Constant returns to scale is where long-run average total costs do not change as output increases.
It is shown by the flat portion of the LRATC curve.

23. Economies and Diseconomies of Scale
Costs per unit
$64 62 60 58 56 54 52 50 48 1 12 13 14 15 16 17 18 19 20
Quantity
Economies of Scale
Constant returns to Scale
Diseconomies of Scale
Average total cost

24. Importance of Economies and Diseconomies of Scale
Economies and diseconomies of scale play important roles in real-world long-run production decisions.

25. Importance of Economies and Diseconomies of Scale
The long-run and the short-run average cost curves have the same U-shape, but the underlying causes of these shapes differ.

26. Importance of Economies and Diseconomies of Scale
Economies and diseconomies of scale account for the shape of the long-run total cost curve.

27. Importance of Economies and Diseconomies of Scale
Initially increasing and then eventually diminishing marginal productivity (as a variable input is added to a fixed input) accounts for the shape of the short-run cost curve.

28. The Envelope Relationship
In the long run all inputs are flexible, while in the short run some inputs are not flexible.
As a result, long-run cost will always be less than or equal to short-run cost.

29. The Envelope Relationship
In the short run the firm faces an additional constraint – all expansion must proceed using only the variable input.
These additional constraints increase cost.

30. The Envelope Relationship
The envelope relationship explains that:
At the planned output level, short-run average total cost equals long-run average total cost.
At all other levels of output, short-run average total cost is higher than long-run average total cost.

31. Envelope of Short-Run Average Total Cost Curves
Costs per unit
Quantity
LRATC
SRATC4
SRATC1
SRMC1
SRATC2
SRMC2
SRMC4
SRATC3 Q2
SRMC3 Q3

32. Entrepreneurial Activity and the Supply Decision
Profit is what underlies the dynamics of production in a market economy.
The expected price must exceed the opportunity cost of supplying the good for a good to be supplied.

33. Entrepreneurial Activity and the Supply Decision
Supplier’s expected economic profit per unit – the difference between the expected price of a good and the expected average total cost of producing it.

34. Entrepreneurial Activity and the Supply Decision
An entrepreneur is an individual who see an opportunity to sell an item at a price higher than the average cost of producing it.

35. Entrepreneurial Activity and the Supply Decision
Entrepreneurs organize production.
They visualize the demand and convince the individuals who own the factors of production that they want to produce those goods.

36. Using Cost Analysis in the Real World
Some of the problems of using cost analysis in the real world include the following:
Economies of scope.
Learning by doing and technological change.
Many dimensions.
Unmeasured costs.

37. Economies of Scope
The cost of production of one product often depends on what other products a firm is producing.

38. Economies of Scope
There are economies of scope when the costs of producing goods are interdependent so that it is less costly for a firm to produce one good when it is already producing another.

39. Economies of Scope
Firms look for both economies of scope and economies of scale.
Economies of scope play an important role in firms’ decisions of what combination of goods to produce.

40. Economies of Scope
Globalization has made economies of scope even more important to firms in their production decisions.

41. Learning by Doing and Technological Change
Production techniques available to real-world firms are constantly changing because of learning by doing and technological change.
These changes occur over time and cannot be accurately predicted.

42. Learning by Doing and Technological Change
Learning by doing means that as we do something, we learn what works and doesn’t, and over time we become more proficient at it.

43. Learning by Doing and Technological Change
Many firms estimate worker productivity to grow 1 to 2 percent a year because of learning by doing.

44. Learning by Doing and Technological Change
Technological change is an increase in the range of production techniques that provides new ways to producing goods.

45. Learning by Doing and Technological Change
Technological change can fundamentally alter the nature of production costs.

46. Learning by Doing and Technological Change
Technological change occurs in all industries, not only high-tech industries.

47. Learning by Doing and Technological Change
In many businesses, the effect of learning by doing and technological change on prices is built into the firm's pricing structure.

48. Learning by Doing and Technological Change
Technological change and learning by doing are intricately related.

49. Many Dimensions
Most decisions that firms make involve more than one dimension.
The only dimension in the standard model is the level of output.
Good economic decisions take all relevant marginal costs and benefits into account.

50. Many Dimensions
The important thing to remember in using the standard model is the reasoning, not the specific model.

51. Unmeasured Costs
The relevant costs as defined by economists are not the costs found in a firm’s books.
Economists include opportunity costs while accountants use explicit costs that can be measured.

52. Economists Include Opportunity Cost
Economists insists on including the business owner’s opportunity cost.
The business owner’s opportunity cost includes forgone income that the owner could have earned by spending his or her time in another job.

53. Economic Versus Accounting Depreciation
Economic depreciation differs from accounting depreciation.

54. Economic Versus Accounting Depreciation
In measuring the costs of depreciable assets, accountants insist on using historical costs—what a depreciable item costs in terms of money actually spent for it—as the cost basis.

55. Economic Versus Accounting Depreciation
If the depreciable asset increased in value, accountants would still use the historical cost basis while an economist would count its increased value as revenue.

56. The Standard Model as a Framework
Despite its limitations, the standard model provides a good framework for cost analysis.
It can be expanded to include real-world complications.

57. Production and Cost Analysis II
End of Chapter 10