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.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Objectives 1. Summarize briefly the advantages and disadvantages of three types of businesses. 2. Differentiate between economic profit and accounting profit. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Objectives 3a. Distinguish between long-run and short-run production. 3b. State the law of diminishing marginal productivity. 4. Calculate fixed costs, variable costs, total costs, average fixed costs, average variable costs, and average total costs, given the appropriate information. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Objectives 5a. Distinguish the various kinds of cost curves and describe the relationships among them. 5b. Explain why the marginal and average cost curves are U-shaped. 5c. Explain why the marginal cost curve always goes through the minimum point of the average cost curve. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

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

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

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

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

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

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

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.

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.

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.

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

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

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

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Production Table Number of workers Total output Marginal product Average product 4 6 7 5 3 1 2 8 9 10 5.7 5.8 5.6 5.2 4.6 4.0 3.3 2.5 — 17 23 28 31 32 30 25 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Production Function 32 7 30 28 26 6 24 22 TP 5 20 18 4 Output 16 14 Output per worker 3 12 10 2 8 AP 6 4 1 2 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 Number of workers Number of workers MP (a) Total product (b) Marginal and average product © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

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.

Diminishing Marginal Productivity Diminishing marginal returns Diminishing absolute returns Diminishing marginal returns Diminishing absolute returns 32 7 30 28 26 6 24 22 TP 5 20 Increasing marginal returns 18 4 Output 16 14 Output per worker 3 12 10 2 8 Increasing marginal returns AP 6 4 1 2 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 Number of workers Number of workers MP (a) Total product (b) Marginal and average product © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

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

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

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.

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

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

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

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

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

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

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Total Cost Curves TC $400 VC 350 300 TC = (VC + FC) 250 Total cost 200 L 150 O 100 M 50 FC 2 4 6 8 10 20 30 Quantity of earrings © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Per Unit Cost Curves Cost $30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 Quantity of earrings 30 32 ATC MC AFC AVC © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

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.

Relationship Between Productivity and Costs Costs per unit Output per worker $18 16 14 12 10 8 6 4 2 18 9 7 5 3 1 21/2 AVC MC Output Labour AP MP 21 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

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.

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.

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.

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.

Relationship Between Marginal and Average Costs $90 Area B MC ATC AVC 80 Area A Area C 70 60 50 40 Costs per unit 30 Q1 B 20 Q0 A 10 1 2 3 4 5 6 7 8 9 Quantity © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

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