# Lecture 3 Production and Costs. Outline Production Theory: Basics Production Theory: Basics Cost Theory: Basics Cost Theory: Basics Economies and Diseconomies.

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Lecture 3 Production and Costs

Outline Production Theory: Basics Production Theory: Basics Cost Theory: Basics Cost Theory: Basics Economies and Diseconomies of Scale Economies and Diseconomies of Scale Production With Multiple Inputs Production With Multiple Inputs Time and Costs: Observations on Fixed Costs Time and Costs: Observations on Fixed Costs Ideas That Matter Ideas That Matter Complications Complications

Production Theory: Basics Production Function: The relationship describing the most output possible with a given quantity of an input. Production Function: The relationship describing the most output possible with a given quantity of an input. (Or the least amount inputs necessary to produce some given level of output.) (Or the least amount inputs necessary to produce some given level of output.) Marginal Product: The change in total product when one of the inputs is changed. Marginal Product: The change in total product when one of the inputs is changed. Approximation: MPx =Change in output/change in input Approximation: MPx =Change in output/change in input Exact (calculus): MPx =dq/dx Exact (calculus): MPx =dq/dx Average Product: Output per unit of input Average Product: Output per unit of input APx =Q/X

Example Hours of LaborQuantity of OutputMarginal ProductAverage Product 00 1111 2321.5 3632 4822 5911.8 EXTRA Q PER EXTRA L

The Graph MP increase and then decreases Max AC occurs when MC=AC

Useful Stuff MP increases and then decreases MP increases and then decreases Think about what an odd world it would be if MP did not decrease. Think about what an odd world it would be if MP did not decrease. (This is commonly defined as diminishing marginal returns). (This is commonly defined as diminishing marginal returns). AP begins to decrease only when MP { "@context": "http://schema.org", "@type": "ImageObject", "contentUrl": "http://images.slideplayer.com/13/4133456/slides/slide_6.jpg", "name": "Useful Stuff MP increases and then decreases MP increases and then decreases Think about what an odd world it would be if MP did not decrease.", "description": "Think about what an odd world it would be if MP did not decrease. (This is commonly defined as diminishing marginal returns). (This is commonly defined as diminishing marginal returns). AP begins to decrease only when MP

Application: Optimal Choice of Input Hours of LaborQuantity of OutputMarginal Product 00 155 294 3123 4142 5151

Suppose that the output is worth \$10 per unit and labor costs \$15 per hour. Total value (value of output – cost of inputs) is as follows. Hours of Labor Quantity of Output Marginal Product Total Value 00 \$ - 155\$35 294\$60 3123\$75 4142\$80 5151\$75

More Marginals Marginal revenue product: the revenue obtained from the extra output produced when another unit of the input is employed. Formally, Marginal revenue product: the revenue obtained from the extra output produced when another unit of the input is employed. Formally, MRP = Marginal Product x Price of output MRP = Marginal Product x Price of output

Output price=\$10 Input price =\$15 Hours of Labor Quantity of Output Marginal Product MRP 00 155\$50 294\$40 3123\$30 4142\$20 5151\$10 MRP=10*MP If MRP > Input price, buy more input

Cost Function: Basics Cost Function: The relationship describing the least expensive way producing a given quantity of output. (Or, equivalently, the most output that can be produced for a given level of expenditure.) Cost Function: The relationship describing the least expensive way producing a given quantity of output. (Or, equivalently, the most output that can be produced for a given level of expenditure.) “Costs” are simply of way of expressing economically important information about what the firm does. As such, when we describe costs, we are really summarizing two kinds of things “Costs” are simply of way of expressing economically important information about what the firm does. As such, when we describe costs, we are really summarizing two kinds of things The production technology (e.g., what sorts of inputs are able to produce what sorts of outputs) The production technology (e.g., what sorts of inputs are able to produce what sorts of outputs) The cost of the inputs The cost of the inputs Thus, if we have described the technology by writing out the production function, we need only to know the price of the inputs before we can describe costs. Thus, if we have described the technology by writing out the production function, we need only to know the price of the inputs before we can describe costs.

Example: Given the production function suppose that cost of the fixed input=\$10 and wage rate=\$5) Cost Function Hours of Labor Quantity of OutputTotal CostMCAC 00 \$ 10 11 \$ 15515 23 \$ 202.56.7 36 \$ 251.674.17 48 \$ 302.53.75 59 \$ 355.03.89

Economies and diseconomies of scale Economies of scale the tendency for AC to decrease when output increases Economies of scale the tendency for AC to decrease when output increases MCAC MC>AC

Why Economies of Scale? Learning by doing/gains from specialization Learning by doing/gains from specialization The presence of fixed costs The presence of fixed costs Pure technological factors Pure technological factors Pecuniary Economies: Reduction in input prices by purchasing in volume. Pecuniary Economies: Reduction in input prices by purchasing in volume.

Why Diseconomies of Scale? Managerial complexities Managerial complexities Pecuniary diseconomies Pecuniary diseconomies

Production with multiple inputs There is more than one way to do most things. (Think of examples where this is and isn’t the case.) Thus, the essential problem is how to find the optimal mix of inputs. This can be stated formally in either of two ways. There is more than one way to do most things. (Think of examples where this is and isn’t the case.) Thus, the essential problem is how to find the optimal mix of inputs. This can be stated formally in either of two ways. Minimize the cost of producing a given quantity of output Minimize the cost of producing a given quantity of output Maximize the output from a given level of expenditures. Maximize the output from a given level of expenditures.

Isoquant: various combinations of inputs that will produce a given level of output. (equivalent to an indifference curve) Ways of Producing Q=5 MethodCapitalLabor A111 B72 C43 D24 E15

Marginal Rate of Technical Substitution: The rate at which one input can be substituted for another without any change in output CapitalLaborCapitalMRTS 111 727-4 434-3 242-2 151

Optimal Input Mix (Price of labor = \$10, Price of Labor =\$25) Q=5 CapitalLaborTCMRTS 111135 72120-4 43115-3 24120-2 15135 What is the Marginal Condition That Makes This Optimal

MRTS measures the relative productivity of the two inputs MRTS measures the relative productivity of the two inputs The ratio of their prices measures their relative costs The ratio of their prices measures their relative costs If an input’s relative productivity is greater than its relative cost, buy more of that input and less of the other If an input’s relative productivity is greater than its relative cost, buy more of that input and less of the other

Time and Costs: Observations on Fixed Costs “Long run”, “short run” and fixed costs “Long run”, “short run” and fixed costs Long Run: Period of time sufficiently long to vary all costs. Long Run: Period of time sufficiently long to vary all costs. Short Run: Any period less than the long run. Short Run: Any period less than the long run. Fixed Costs: Those costs that cannot be varied in the short run. Fixed Costs: Those costs that cannot be varied in the short run.

Distinguishing fixed and sunk costs Fixed costs: Costs that don’t vary with output Fixed costs: Costs that don’t vary with output an airplane an airplane Sunk costs: Costs that can’t be recovered Sunk costs: Costs that can’t be recovered a railroad track a railroad track

Opportunity Cost: The total value of what must be given up to get something (which is often more than the measured monetary cost) Economic profit: Revenues-Opportunity Cost Economic profit: Revenues-Opportunity Cost As distinguished from accounting cost: The dollars that must be given up to get something else. and accounting profit: Revenues-accounting cost As distinguished from accounting cost: The dollars that must be given up to get something else. and accounting profit: Revenues-accounting cost Examples of Opportunity Cost Examples of Opportunity Cost Retained earnings (was Coca Cola’s great cash flow free?) Retained earnings (was Coca Cola’s great cash flow free?) Make vs buy (Was Valuejet really wrong to outsource maintenance?) Make vs buy (Was Valuejet really wrong to outsource maintenance?) Time (Who gets the keys to the company jet?) Time (Who gets the keys to the company jet?)

Ideas That Matter: Relevant Costs When do fixed costs matter? As we’ve already seen, certainly not in any decision involving production levels, or pricing. Consider these examples When do fixed costs matter? As we’ve already seen, certainly not in any decision involving production levels, or pricing. Consider these examples R&D: “We’ve come too far to stop now. R&D: “We’ve come too far to stop now. Buildings: “We built in the wrong location, but we’re there now Buildings: “We built in the wrong location, but we’re there now Eternal problem: Managers who are given the power to make fixed investments need to be held accountable for those decisions. But how do you get them to ignore the investment once it’s made? Eternal problem: Managers who are given the power to make fixed investments need to be held accountable for those decisions. But how do you get them to ignore the investment once it’s made?

Ideas That Matter: Defining and measuring efficiency Pure Waste: not obtaining maximum output from a given amount of inputs Pure Waste: not obtaining maximum output from a given amount of inputs Allocative Efficiency: Employing the wrong mix of inputs Allocative Efficiency: Employing the wrong mix of inputs Caution: Is waste really waste if it would cost more to eliminate than would be saved by eliminating Caution: Is waste really waste if it would cost more to eliminate than would be saved by eliminating

Ideas That Matter: Comparative Advantage Suppose: Suppose: Attilla can produce 4 units of clean room or 2 units of clean dog per hour Attilla can produce 4 units of clean room or 2 units of clean dog per hour Godzilla can produce 1 unit of clean room or 1 unit of clean dog per hour. Godzilla can produce 1 unit of clean room or 1 unit of clean dog per hour. Note: Godzilla is, by one measure, less productive. Note: Godzilla is, by one measure, less productive. Can It Ever Be Efficient to Use a Less Productive Asset? Sure : Can It Ever Be Efficient to Use a Less Productive Asset? Sure : Suppose both kids spent 1 hour on each chore (4 hours of total work), producing 5 units of clean room and 3 units of clean dog. Suppose both kids spent 1 hour on each chore (4 hours of total work), producing 5 units of clean room and 3 units of clean dog. They could produce the same output with less effort. Godzilla could spend 2 hours on dog (producing 2 units of clean dog). Attilla could spend 1.25 hours on room (producing 5 units of clean room) and 0.5 hours on dog (producing 1 unit of clean dog). They get the same output with only 3.75 hours of labor They could produce the same output with less effort. Godzilla could spend 2 hours on dog (producing 2 units of clean dog). Attilla could spend 1.25 hours on room (producing 5 units of clean room) and 0.5 hours on dog (producing 1 unit of clean dog). They get the same output with only 3.75 hours of labor

Complications:Multiple Outputs Most production processes produce more than one output Most production processes produce more than one output Cars and SUV’s. Consulting services and audits. Finance majors and marketing majors Cars and SUV’s. Consulting services and audits. Finance majors and marketing majors Economies of Scope are said to exist when it is less expensive to produce more than one output jointly than separately. Economies of Scope are said to exist when it is less expensive to produce more than one output jointly than separately. Why economies of scope? Why economies of scope? The most likely source of economies of scope is common overhead The most likely source of economies of scope is common overhead

Complications: Multiple Plants : Some firms have several plants that produce the same output. This raises two kinds of issues. : Some firms have several plants that produce the same output. This raises two kinds of issues. Why? Why? If it is efficient to have more than one plant, how much output should be assigned to each plant If it is efficient to have more than one plant, how much output should be assigned to each plant

Transfer Pricing Many firms use a separate division to produce some intermediate input. What “price’ should the division charge for its input.? Many firms use a separate division to produce some intermediate input. What “price’ should the division charge for its input.? The “customer” would like to have a low price (zero is nice) but this creates incentives to produce too much. The “customer” would like to have a low price (zero is nice) but this creates incentives to produce too much. The “seller” would like to have a high price (it is in the position of being a monopolist with a captive customer) but this creates incentives to produce too little The “seller” would like to have a high price (it is in the position of being a monopolist with a captive customer) but this creates incentives to produce too little Principle: transferring at marginal cost requires the end user to recognize the true cost of the good. Complications How do you measure marginal cost (especially when the manager of the intermediate division has incentives to inflate costs). What if marginal costs are below average costs meaning that the intermediate division operates at a loss (Certainly a possibility and if so, how do you assure the manager of the intermediate division that its good to run a losing operation.) What if the intermediate good can also be sold on an open market Actually a blessing since the cost of transfering the intermediate good to the final producer is really just the price at which it could be sold on the market But this may create real hard feelings if the outside customers of the intermediate good compete with the final manufacturer. Principle: transferring at marginal cost requires the end user to recognize the true cost of the good. Complications How do you measure marginal cost (especially when the manager of the intermediate division has incentives to inflate costs). What if marginal costs are below average costs meaning that the intermediate division operates at a loss (Certainly a possibility and if so, how do you assure the manager of the intermediate division that its good to run a losing operation.) What if the intermediate good can also be sold on an open market Actually a blessing since the cost of transfering the intermediate good to the final producer is really just the price at which it could be sold on the market But this may create real hard feelings if the outside customers of the intermediate good compete with the final manufacturer.

Complications How do you measure marginal cost (especially when the manager of the intermediate division has incentives to inflate costs). How do you measure marginal cost (especially when the manager of the intermediate division has incentives to inflate costs). What if marginal costs are below average costs meaning that the intermediate division operates at a loss (Certainly a possibility and if so, how do you assure the manager of the intermediate division that its good to run a losing operation.) What if marginal costs are below average costs meaning that the intermediate division operates at a loss (Certainly a possibility and if so, how do you assure the manager of the intermediate division that its good to run a losing operation.) What if the intermediate good can also be sold on an open market What if the intermediate good can also be sold on an open market Actually a blessing since the cost of transfering the intermediate good to the final producer is really just the price at which it could be sold on the market Actually a blessing since the cost of transfering the intermediate good to the final producer is really just the price at which it could be sold on the market But this may create real hard feelings if the outside customers of the intermediate good compete with the final manufacturer. But this may create real hard feelings if the outside customers of the intermediate good compete with the final manufacturer.

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