© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 8: Production and Cost Analysis I Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 2 Introduction In the supply process, people first offer their factors of production to the market. Then the factors are transformed by firms into goods that consumers want. Production is the name given to that transformation of factors into goods.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 3 Role of the Firm The firm is an economic institution that transforms factors of production into consumer goods.  Organizes factors of production.  Produces goods and services.  Sells produced goods and services.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 4 Forms of Business There are three major types of businesses:  sole proprietorships  partnerships  corporations.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 5 Sole Proprietorship Businesses that have only one owner. Advantages:  Minimum bureaucratic hassle.  Direct control by owner. Disadvantages:  Limited ability to get funds.  Unlimited personal liability.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 6 Partnership Businesses with two or more owners. Advantages:  Ability to share work and risks.  Relatively easy to form. Disadvantages:  Unlimited personal liability (even for partner's blunder).  Limited ability to get funds.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 7 Corporation Businesses that are treated as a person and are legally owned by their stockholders who are not liable for the actions of the corporate "person."

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 8 Corporation Advantages:  No personal liability.  Increased ability to get funds.  Ability to shed personal income and gain added expenses.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 9 Corporation Disadvantages:  Legal hassle to organize.  Possible double taxation of income.  Monitoring problems.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 10 Forms of Business

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 11 The Firm and the Market A firm operates within the market and, simultaneously, it abandons the market in the sense that it replaces the market with command and control.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 12 The Firm and the Market How an economy operates depends on transaction costs — the costs of undertaking trades through the market.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 13 The Firm and the Market Firms are the production organizations that translate factors of production into consumer goods. A firm’s goal is to maximize profits.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 14 Firms Maximize Profit Profit is the difference between total revenue and total cost. Profit = total revenue – total cost

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 15 Firms Maximize Profit For an economist,the measure of profit is revenues minus both implicit costs and explicit costs. An accountant will calculate profit by subtracting explicit costs from the revenue.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 16 Firms Maximize Profit 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, which is an implicit cost.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 17 Firms Maximize Profit For economists: Economic Profit = total revenue – (implicit and explicit cost)

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 18 Production Process The production process generally divided into the long run planning decision and the short run adjustment decision.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 19 The Long Run and the Short Run A long-run decision is a decision in which the firm can choose the least expensive method of producing from among all possible production techniques.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 20 The Long Run and the Short Run A short-run decision is one in which the firm is constrained by past choices in regard to what production decision it can make.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 21 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 degree of flexibility the firm has in changing the level of output.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 22 The Long Run and the Short Run In the long run, all inputs are variable. In the short run:  Flexibility is limited.  Some factors of production cannot be changed.  Generally, the production facility (“the plant”) is fixed.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 23 Production Table A production table shows the output resulting from various combinations of factors of production, or inputs.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 24 Production Table Most of the production decisions firms make are short run decisions involving changes in output at a given production facility. The firm can increase or decrease production by adjusting the amount of variable inputs, such as labour or materials.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 25 Production Table Total product is the number of units of the good or service produced by different numbers of workers.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 26 Production Marginal product is the additional output that will be forthcoming from an additional worker, other inputs remaining constant. Average product is calculated by dividing total output by the number of workers who produced it.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 27 Production Functions Production function – a curve that describes the relationship between the inputs (factors of production) and output.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 28 Production Functions The production function tells the maximum amount of output that can be derived from a given number of inputs.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 29 Production Table Number of workers Total output Marginal product Average product —

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 30 Output Number of workers TP Output per worker Number of workers MP (a) Total product(b) Marginal and average product AP Production Function

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 31 Diminishing Marginal Productivity Both marginal and average productivities initially increase, but eventually they both decrease.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 32 Diminishing Marginal Productivity This means that initially the production function exhibits increasing marginal productivity. Then it exhibits diminishing marginal productivity. Finally, it exhibits negative marginal productivity.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 33 Diminishing Marginal Productivity The most relevant part of the production function is that part exhibiting diminishing marginal productivity.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 34 Diminishing Marginal Productivity 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.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 35 Diminishing Marginal Productivity Number of workers Total output Marginal product Average product Increasing marginal returns Diminishing marginal returns Diminishing absolute returns —

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 36 Output Diminishing marginal returns Diminishing absolute returns Increasing marginal returns Number of workers TP Output per worker Number of workers MP Diminishing marginal returns Diminishing absolute returns (a) Total product(b) Marginal and average product AP Diminishing Marginal Productivity Increasing marginal returns

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 37 Diminishing Marginal Productivity This law is sometimes called the flowerpot law. If it did not hold true, the world’s entire food supply could be grown in a single flower pot.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 38 Costs of Production Costs of production in the short run are:  Fixed Costs,  Variable Costs, and  Total Costs.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 39 Fixed Costs Fixed costs are those that cannot be changed in the period of time under consideration regardless of output.  In the long run there are no fixed costs since all costs are variable.  In the short run, a number of costs will be fixed.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 40 Variable Costs Variable costs are costs that change as output changes, such as the costs of labour and materials.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 41 Fixed Costs, Variable Costs, and Total Costs The sum of the fixed costs and variable costs are total costs. TC = FC + VC

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 42 Average Costs Besides total costs, firms are concerned with their costs per unit of output. Per unit costs are  Average Total Cost,  Average Fixed Cost, and  Average Variable Cost

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 43 Average Costs Average total cost (often called average cost) equals total cost divided by the quantity produced. ATC = TC/Q

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 44 Average Costs Average fixed cost equals fixed cost divided by quantity produced. AFC = FC/Q

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 45 Average Costs Average variable cost equals variable cost divided by quantity produced. AVC = VC/Q

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 46 Average Costs Average total cost can also be thought of as the sum of average fixed cost and average variable cost. ATC = AFC + AVC

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 47 Marginal Cost Marginal cost is the increase in total cost of increasing the level of output by one unit, MC =  TC/  Q In deciding how many units to produce, the most important variable is marginal cost.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 48

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 49 Graphing Cost Curves To gain a greater understanding of these concepts, it is a good idea to draw a graph. Quantity is plotted on the horizontal axis and a dollar measure of various costs on the vertical axis.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 50 Total Cost Curves Total cost rises with output. The total variable cost curve has the same shape as the total cost curve—increasing output increases variable cost.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 51 Total cost $ FC 24 M Quantity of earrings VC TC L Total Cost Curves O TC = (VC + FC)

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 52 Average Fixed Cost Curve The average fixed cost curve slopes down continuously.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 53 Average Fixed Cost Curve The average fixed cost curve looks like a child’s slide – it starts out with a steep decline, then it becomes flatter and flatter. It tells us that as output increases, the same fixed cost can be spread out over a wider range of output.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 54 Increasing Output in the Short Run In the short run, output can only be increased by increasing the variable input.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 55 U-Shaped Cost Curves The law of diminishing marginal productivity sets in as more and more of a variable input is added to a fixed input. Marginal and average productivities fall and marginal costs rise.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 56 U-Shaped Cost Curves And when average productivity of the variable input falls, average variable cost rises.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 57 U-Shaped Cost Curves The average total cost curve is the vertical summation of the average fixed cost curve and the average variable cost curve.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 58 U-Shaped Cost Curves If the firm increased output enormously, the average variable cost curve and the average total cost curve would almost meet.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 59 Cost $ Quantity of earrings Per Unit Cost Curves AFC AVC ATC MC

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 60 Relationship Between Productivity and Costs The shapes of the cost curves are mirror- image reflections of the shapes of the corresponding productivity curves.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 61 Relationship Between Productivity and Costs When one is increasing, the other is decreasing. When one is at a maximum, the other is at a minimum.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 62 Relationship Between Productivity and Costs 21 Output per worker Costs per unit

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 63 Relationship Between Marginal and Average Costs The marginal cost and average cost curves are related.  When marginal cost exceeds average cost, average cost must be rising.  When marginal cost is less than average cost, average cost must be falling.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 64 Relationship Between Marginal and Average Costs This relationship explains why marginal cost curves always intersect average cost curves at the minimum of the average cost curve.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 65 Relationship Between Marginal and Average Costs The position of the marginal cost relative to average total cost tells us whether average total cost is rising or falling.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 66 Relationship Between Marginal and Average Costs To summarize: If MC > ATC, then ATC is rising. If MC = ATC, then ATC is at its minimum. If MC < ATC, then ATC is falling.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 67 Relationship Between Marginal and Average Costs 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 minimum. If MC < AVC, then AVC is falling.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 68 Relationship Between Marginal and Average Costs 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.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 69 Relationship Between Marginal and Average Costs Costs per unit $ Quantity Area B Area AArea C MC ATC AVC Q1Q1 B Q0Q0 A

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.70 Production and Cost Analysis I End of Chapter 8