1. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. PRODUCTION AND COST ANALYSIS I PRODUCTION AND COST ANALYSIS I Chapter 9

2. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-2 Today’s lecture will: Differentiate economic profit from accounting profit. Distinguish between long-run and short- run production. Introduce the law of diminishing marginal productivity. Calculate fixed costs, variable costs, marginal costs, total costs, average fixed costs average variable costs, and average total costs.

3. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-3 Today’s lecture will: Distinguish the various kinds of cost curves and describe the relationships among them. Explain why the marginal and average cost curves are U-shaped. Explain why the marginal cost curve always goes through the minimum point of an average cost curve.

4. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-4 The Supply Process In the supply process, people first offer their factors of production to the market. Firms transform the factors into goods that consumers want. Production is the transformation of factors into goods.

5. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-5 The Role of the Firm The firm is an economic institution that transforms factors of production into consumer goods. It:  Organizes factors of production.  Produces and sells goods and services. A virtual firm only organizes production and subcontracts out all work.

6. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-6 Firms Maximize Profit Profit = total revenue – total cost Economists and accountants measure profit differently.  Accountants focus on explicit costs and revenues.  Economists focus on both explicit and implicit costs and revenue.

7. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-7 Firms Maximize Profit Economic profit = (explicit and implicit revenue) – (explicit and implicit costs) Total revenue is the amount a firm receives for selling its good or service plus any increase in the value of its assets. Total cost is explicit payments to resources plus the opportunity cost of resources provided by the owners of the firm.

8. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-8 The Production Process The production process can be divided into the long run and the short run. The terms long run and short run do not necessarily refer to specific periods of time. They refer to the flexibility the firm has in changing the level of output.

9. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-9 The Long Run and the Short Run A long-run decision is a decision in which the firm can choose among all possible production techniques.  In the long run, all inputs are variable. A short-run decision is one in which the firm is constrained in regard to what production decision it can make.  In the short run, some inputs are fixed.

10. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-10 Production Functions Production function – a curve that describes the relationship between the inputs (factors of production) and outputs. It tells the maximum amount of output that can be derived from a given number of inputs. Marginal product is the additional output that will be produced by an additional worker, other factors remaining constant. Average product is total output divided by the number of workers.

11. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-11 A Production Function Table Number of workers Total output Marginal product Average product Increasing marginal productivity Diminishing marginal productivity Diminishing absolute productivity 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

12. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-12 A Production Function Both average and marginal productivities initially increase, but eventually they both decrease. The production function exhibits:  Increasing marginal productivity  Then diminishing marginal productivity  Finally negative marginal productivity 5671238910 Number of workers Diminishing marginal productivity Diminishing absolute productivity 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 Increasing marginal productivity TP Output Number of workers 123456789 10 7 6 5 4 3 2 1 0 AP MP 4 Output

13. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-13 The Law of Diminishing Marginal Productivity Law of diminishing marginal productivity – as more of a variable input is added to an existing fixed input, after some point the additional output from the additional input will fall. This law is also called the flower pot law. If it did not hold true, the world’s entire food supply could be grown in a single flower pot.

14. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-14 Fixed Costs, Variable Costs, and Total Costs Fixed costs are those that are spent and cannot be changed in the period of time under consideration.  In the long run, there are no fixed costs since all inputs (and therefore their costs) are variable.  In the short run, a number of inputs and their costs will be fixed.

15. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-15 Fixed Costs, Variable Costs, and Total Costs Workers represent variable costs – costs that change as output changes. The sum of the variable and fixed costs are total costs. TC = FC + VC

16. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-16 Average Costs Average fixed costs AFC = FC/Q Average variable cost AVC = VC/Q Average total cost ATC = TC/Q or ATC = AFC + AVC Marginal cost is the increase in total cost of increasing output by one unit.

17. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-17 Costs of Production

18. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-18 Total Cost Curves Total cost $400 350 300 250 200 150 100 50 0 FC 24 M 68102030 Quantity of earrings VC TC L O TC = VC + FC

19. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-19 Per Unit Output Cost Curves Cost $30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 Quantity of earrings 246810121416182022 2426283032 AFC AVC ATC MC

20. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-20 Average and Marginal Cost Curves The marginal cost curve goes through the minimum point of the average total cost curve and average variable cost curve. The average fixed cost curve slopes down continuously because as output increases, the same fixed cost is spread out over more output.

21. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-21 The U Shape of the Average and Marginal Cost Curves When output is increased in the short run, it can only be done by increasing the variable input. The law of diminishing productivity causes marginal and average productivities to fall. As average and marginal productivities fall, average and marginal costs rise.

22. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-22 Productivity and Costs Are Mirror Images The shapes of the cost curves are mirror-image reflections of the corresponding productivity curves. When one is increasing, the other is decreasing. When one is at a maximum, the other is at a minimum.

23. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-23 The Relationship Between Productivity and Costs Costs per unit 14 12 10 8 6 4 2 04812162024 AVC MC Output Output per worker 7 6 5 4 3 2 1 04812162024 Output A AP of workers MP of workers

24. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-24 Relationship Between Marginal and Average Costs If MC > ATC, then ATC is rising If MC > AVC, then AVC is rising If MC < ATC, then ATC is falling If MC < AVC, then AVC is falling MC = AVC and MC = ATC at their minimum points.

25. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-25 Relationship Between Average and Marginal Costs Costs per unit 60 50 40 30 20 10 0 Quantity Area B Area AArea C MC ATC AVC 123456789 Q1Q1 B Q0Q0 A

26. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-26Summary Accounting profit is explicit revenue less explicit cost. Economists include implicit revenue and cost in determining economic profit. Implicit revenue includes the increases in the value of assets owned by the firm. Implicit costs include opportunity cost of time and capital provided by owners of the firm.

27. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-27Summary In the long run a firm can choose among all possible production techniques; in the short run it is constrained in its choices because at least one input is fixed. The law of diminishing marginal productivity states that as more of a variable input is added to a fixed input, the additional output will eventually be decreasing.

28. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-28Summary Costs are generally divided into fixed costs, variable costs, and marginal costs. TC = FC + VC MC = change in TC AFC = FC/Q AVC = VC/Q ATC = AFC + AVC

29. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-29Summary AVC and MC are mirror images of the average and marginal products. The law of diminishing marginal productivity causes marginal and average costs to rise. MC goes through the minimum points of the AVC and ATC.  If MC > ATC, then ATC is rising.  If MC = ATC, then ATC is constant.  If MC < ATC, then ATC is falling.

30. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-30 Review Question 9-1 Given the following production function, find marginal product. NumberTotalMarginal of WorkersOutputProduct 0 _____ 1 5 _____ 2 11 _____ 3 15 _____ 4 17 Where does diminishing marginal productivity begin? 2 4 6 5 Diminishing marginal productivity begins after the 2 nd worker is hired.

31. McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9-31 Review Question 9-2 Assuming that fixed costs are $100, complete the following table. Output VariableTotalMarginalAverageAverage CostsCosts CostsVariable Total Costs Costs 0 $ 0_____ _____ 1 200_____ ______ ______ _____ 2 360_____ ______ ______ _____ 3 500_____ ______ ______ _____ 4 750_____ ______ ______ _____ 5 1,050_____ ______ ______ $100 $200 $300$200 300 160 210 1,150 850 600 460 300 140 230 213188 167200 230180 250