1. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Production and Cost Analysis I Chapter 9

2. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve A woman hears from her doctor that she has only half a year to live. The doctor advises her to marry an economist and to move to South Dakota.

3. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve “Will this cure my illness?” she asked. No, but the half year will seem pretty long.”

4. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction n In the supply process, people first offer their factors of production to the market. n Then the factors are transformed by firms into goods that consumers want. l Production is the name given to that transformation of factors into goods.

5. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Role of the Firm n The firm is an economic institution that transforms factors of production into consumer goods – it: l Organizes factors of production. l Produces goods and services. l Sells produced goods and services.

6. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. l Virtual firms subcontract out all work. l More and more of the organizational structure of business is being separated from the business. The Role of the Firm n A virtual firm only organizes production.

7. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Firm and the Market n Firms operate within the market, while at the same time — n Firms replace the market with command and control.

8. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Firm and the Market n How an economy operates depends on: l Transaction costs – costs of undertaking trades through the market, and l The rent or command over resources that organizers can appropriate to themselves by organizing the market in a certain way.

9. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Firm and the Market n Firms are the production organizations that translate factors of production into consumer goods.

10. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Firms Maximize Profit n Profit is the difference between total revenue and total cost. Profit = total revenue – total cost

11. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Firms Maximize Profit n Economists and accountants measure profit differently. l Accountants focus on explicit costs and revenue. l Economist focus on both explicit and implicit costs and revenue.

12. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Firms Maximize Profit n For an economist, total cost is explicit payments to factors of production plus the opportunity cost of the factors provided by the owners of the firm.

13. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Firms Maximize Profit n Economists define total revenue as the amount a firm receives for selling its good or service plus any increase in the value of the assets owned by firms.

14. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Firms Maximize Profit n For economists: Economic profit = (explicit and implicit revenue) – (explicit and implicit cost)

15. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Production Process n The production process can be divided into the long run and the short run.

16. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Long Run and the Short Run n A long-run decision is a decision in which the firm can choose among all possible production techniques.

17. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Long Run and the Short Run n A short-run decision is one in which the firm is constrained in regard to what production decision it can make.

18. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Long Run and the Short Run n The terms long run and short run do not necessarily refer to specific periods of time. n They refer to the degree of flexibility the firm has in changing the level of output.

19. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Long Run and the Short Run n In the long run, all inputs are variable. n In the short run, some inputs are fixed.

20. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Production Tables and Production Functions n A production table shows the output resulting from various combinations of factors of production or inputs.

21. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Production Tables and Production Functions n Marginal product is the additional output that will be forthcoming from an additional worker, other inputs remaining constant.

22. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Production Tables and Production Functions n Average product is calculated by dividing total output by the quantity of the output.

23. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Production Tables and Production Functions n Production function – a curve that describes the relationship between the inputs (factors of production) and outputs.

24. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Production Tables and Production Functions n The production function tells the maximum amount of output that can be derived from a given number of inputs.

25. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Production Table Number of workers Total output Marginal product Average product 4 6 7 6 5 3 1 0 2 5 1 2 3 4 5 6 7 8 9 10 0 4 5 5.7 5.8 5.6 5.2 4.6 4.0 3.3 2.5 — 4 10 17 23 28 31 32 30 25 0

26. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Output 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 123456789 Number of workers TP Output per worker 123456789 10 Number of workers 7 6 5 4 3 2 1 0 MP (a) Total product(b) Marginal and average product AP A Production Function

27. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Law of Diminishing Marginal Productivity n Both marginal and average productivities initially increase, but eventually they both decrease.

28. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Law of Diminishing Marginal Productivity n This means that initially the production function exhibits increasing marginal productivity. n Then it exhibits diminishing marginal productivity. n Finally, it exhibits negative marginal productivity.

29. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Law of Diminishing Marginal Productivity n The most relevant part of the production function is that part exhibiting diminishing marginal productivity.

30. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Law of Diminishing Marginal Productivity n Law of diminishing marginal productivity – as more and more of a variable input is added to an existing fixed input, after some point the additional output one gets from the additional input will fall.

31. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Law of Diminishing Marginal Productivity Number of workers Total output Marginal product Average product Increasing marginal returns Diminishing marginal returns Diminishing absolute returns 4 6 7 6 5 3 1 0 2 5 1 2 3 4 5 6 7 8 9 10 0 4 5 5.7 5.8 5.6 5.2 4.6 4.0 3.3 2.5 — 4 10 17 23 28 31 32 30 25 0

32. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Output Diminishing marginal returns Diminishing absolute returns 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 123456789 Increasing marginal returns Number of workers TP Output per worker 123456789 10 Number of workers 7 6 5 4 3 2 1 0 MP Diminishing marginal returns Diminishing absolute returns (a) Total product(b) Marginal and average product AP The Law of Diminishing Marginal Productivity

33. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Law of Diminishing Marginal Productivity n This law is also called the flower pot law. n If it did not hold true, the world’s entire food supply could be grown in a single flower pot.

34. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Costs of Production n There are many different types of costs. n Invariably, firms believe costs are too high and try to lower them.

35. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Fixed Costs, Variable Costs, and Total Costs n Fixed costs are those that are spent and cannot be changed in the period of time under consideration. l In the long run there are no fixed costs since all costs are variable. l In the short run, a number of costs will be fixed.

36. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Fixed Costs, Variable Costs, and Total Costs n Workers represent variable costs – those that change as output changes.

37. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Fixed Costs, Variable Costs, and Total Costs n The sum of the variable and fixed costs are total costs. TC = FC + VC

38. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Costs n Much of the firm’s discussion is of average cost.

39. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Costs n Average total cost (often called average cost) equals total cost divided by the quantity produced. ATC = TC/Q

40. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Costs n Average fixed cost equals fixed cost divided by quantity produced. AFC = FC/Q

41. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Costs n Average variable cost equals variable cost divided by quantity produced. AVC = VC/Q

42. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Costs n Average total cost can also be thought of as the sum of average fixed cost and average variable cost. ATC = AFC + AVC

43. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Cost n Marginal cost is the increase (decrease) in total cost of increasing (or decreasing) the level of output by one unit. n In deciding how many units to produce, the most important variable is marginal cost.

44. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

45. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing Cost Curves n To gain a greater understanding of these concepts, it is a good idea to draw a graph. n Quantity is put on the horizontal axis and a dollar measure of various costs on the vertical axis.

46. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Total Cost Curves n The total variable cost curve has the same shape as the total cost curve—increasing output increases variable cost.

47. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Total cost $400 350 300 250 200 150 100 50 0 FC 24 M 68102030 Quantity of earrings VC TC L Total Cost Curves O TC = (VC + FC)

48. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Average and Marginal Cost Curves n The marginal cost curve goes through the minimum point of the average total cost curve and average variable cost curve. n Each of these curves is U-shaped.

49. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Average and Marginal Cost Curves n The average fixed cost curve slopes down continuously.

50. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Downward-Sloping Shape of the Average Fixed Cost Curve n The average fixed cost curve looks like a child’s slide – it starts out with a steep decline, then it becomes flatter and flatter. n It tells us that as output increases, the same fixed cost can be spread out over a wider range of output.

51. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The U Shape of the Average and Marginal Cost Curves n When output is increased in the short-run, it can only be done by increasing the variable input.

52. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The U Shape of the Average and Marginal Cost Curves n The law of diminishing marginal productivity sets in as more and more of a variable input is added to a fixed input. n Marginal and average productivities fall and marginal costs rise.

53. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The U Shape of the Average and Marginal Cost Curves n And when average productivity of the variable input falls, average variable cost rise.

54. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The U Shape of the Average and Marginal Cost Curves n The average total cost curve is the vertical summation of the average fixed cost curve and the average variable cost curve.

55. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The U Shape of the Average and Marginal Cost Curves n If the firm increased output enormously, the average variable cost curve and the average total cost curve would almost meet. n The firm’s eye is focused on average total cost—it wants to keep it low.

56. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost $30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 Quantity of earrings 246810121416182022 2426283032 Per Unit Output Cost Curves AFC AVC ATC MC

57. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Relationship Between Productivity and Costs n The shapes of the cost curves are mirror- image reflections of the shapes of the corresponding productivity curves.

58. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Relationship Between Productivity and Costs n When one is increasing, the other is decreasing. n When one is at a maximum, the other is at a minimum.

59. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Costs per unit Productivity of workers at this output $18 16 14 12 10 8 6 4 2 04812162024 9 8 7 6 5 4 3 2 1 04812162024 AVC MC Output A AP of workers MP of workers The Relationship Between Productivity and Costs

60. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Relationship Between Marginal and Average Costs n The marginal cost and average cost curves are related. l When marginal cost exceeds average cost, average cost must be rising. l When marginal cost is less than average cost, average cost must be falling.

61. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Relationship Between Marginal and Average Costs n Marginal cost curves always intersect average cost curves at the minimum of the average cost curve.

62. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Relationship Between Marginal and Average Costs n The position of the marginal cost relative to average total cost tells us whether average total cost is rising or falling.

63. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Relationship Between Marginal and Average Costs n To summarize: If MC > ATC, then ATC is rising. If MC = ATC, then ATC is at its low point. If MC < ATC, then ATC is falling.

64. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Relationship Between Marginal and Average Costs n Marginal and average total cost reflect a general relationship that also holds for marginal cost and average variable cost. If MC > AVC, then AVC is rising. If MC = AVC, then AVC is at its low point. If MC < AVC, then AVC is falling.

65. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Relationship Between Marginal and Average Costs n As long as average variable cost does not rise by more than average fixed cost falls, average total cost will fall when marginal cost is above average variable cost,

66. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Relationship Between Marginal and Average Costs Costs per unit $90 80 70 60 50 40 30 20 10 0 Quantity Area B Area AArea C MC ATC AVC 123456789 Q1Q1 B ATC MC Q0Q0 A

67. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Production and Cost Analysis I End of Chapter 9