1. 1 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 ECONOMICS FOR MANAGERS University of Management and Technology 1901 North Fort Myer Drive Arlington, VA 22209 Voice: (703) 516-0035 Fax: (703) 516-0985 Website: www.umtweb.edu

2. 2 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 CHAPTER 8 Production and Cost

3. 3 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Economic Cost In economics, the notion of a firm’s costs is based on the notion of economic cost. The key principle underlying the computation of economic cost is the principle of opportunity cost. PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it.

4. 4 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Accounting Versus Economic Cost An accountant’s notion of costs involves only the firm’s explicit costs. Explicit cost: the firm’s actual cash payments for its inputs. An economist includes the firm’s implicit costs. Implicit cost: the opportunity cost of nonpurchased inputs. Economic cost: the sum of explicit cost plus implicit cost.

5. 5 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Accounting Versus Economic Cost Accounting Approach Economic Approach 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

6. 6 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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. 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.

7. 7 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Production and Cost in the Short Run The key principle behind the firm’s short-run cost curves is the principle of diminishing returns. 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.

8. 8 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Production and Marginal Product 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 00 81 122 153 204 275 366 487 658 909 13010

9. 9 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Production and Marginal Product Labor: Number of Workers Output: Rakes per Minute Marginal Product of labor 00 811/8 1221/4 1531/3 2041/5 2751/7 3661/9 4871/12 6581/17 9091/25 130101/40 Labor Input and Output Labor: Number of Workers Output: Rakes per Minute 00 81 122 153 204 275 366 487 658 909 13010

10. 10 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Production and Marginal Product 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.

11. 11 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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. 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.

12. 12 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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) 0360 1 844 2361248 3361551 4362056 5362763 636 72 7364884 83665101 93690126 1036130166

13. 13 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Short-Run Marginal Cost Short-run marginal cost (SMC) is the change in total cost resulting from producing one more unit of the good.

14. 14 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Short-Run Average Cost There are three types of short run average cost: 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 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.

15. 15 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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 –––– 18.0036.008.0044.00 24.0018.006.0024.00 33.0012.005.0017.00 45.009.005.0014.00 57.007.205.4012.60 69.006.00 12.00 7 5.146.8612.00 817.004.508.1312.63 925.004.0010.0014.00 1040/003.6013.0016.60

16. 16 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 The Relationship Between Marginal and Average Cost Curves Throughout the range of output where average cost decreases, marginal cost lies below average cost (points b and c). When the marginal contribution is greater than the average contribution, the marginal rises above the average (points f and h). At point m, average cost is minimum and equal to marginal cost.

17. 17 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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.

18. 18 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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. Diminishing returns occur because workers share a fixed facility. In the long run the firm can expand its production facility as its workforce grows.

19. 19 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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 average cost of production (LAC) is the long-run total cost divided by the quantity of output produced.

20. 20 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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. Long-Run Costs: Total and Average Cost Output: Rakes per minuteLong-Run Total CostLong-Run Average Cost 3.5$ 70$20 7$ 84$12 14$168$12 28$336$12

21. 21 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Decrease in Output and Indivisible Inputs 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. In general, if there are indivisible inputs, the long-run average total cost curve will be negatively sloped.

22. 22 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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). Output: Rakes per minute Long-Run Average Cost 3.5$20 7$12 14$12 28$12

23. 23 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Examples of Indivisible Inputs 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 steel producer uses a large blast furnace. A hospital uses imaging machines (for X-rays, CAT scans, and MRIs). A pizzeria uses a pizza oven.

24. 24 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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 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.

25. 25 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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 refer to cost savings associated with spreading the cost of indivisible inputs and the benefits of input specialization.

26. 26 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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. Small Turbine (150 kilowatt) Large Turbine (600 kilowatt) Purchase price of turbine$150,000$420,000 Installation cost$100,000 Operating and maintenance cost$75,000$126,000 Total cost$325,000$646,000 Electricity generated (kilowatt hours)5 million20 million Average cost (per kilowatt hour)$0.065$0.032 Danish Wind Turbine Manufacturers Association. Guided Tour of Wind Energy (http://www.windpower.dk)

27. 27 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Minimum Efficient Scale 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.

28. 28 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Actual Long-Run Average Cost Curves LAC Curve for Electricity Generation LAC Curve for Aluminum Production

29. 29 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 Actual Long-Run Average Cost Curves LAC Curve for Truck Freight LAC Curve for Hospital Services

30. 30 of 30Visit UMT online at www.umtweb.edu© Prentice Hall 2003 Economics: Principles and Tools, 3/eChapter 8, ECON125 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. Diseconomies of scale may arise for two reasons: Coordination problems Increasing input costs