McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Costs of Production Chapter 6

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Production Function It takes factors of production to produce a good or service – no matter what the good is. –Factors of production – Resource inputs used to produce goods and services, such as land, labor, capital, entrepreneurship.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Production Function The production function is the technological relationship expressing the maximum quantity of a good attainable from different combinations of factor inputs.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Varying Input Levels The purpose of a production function is to tell us just how much output we can produce with varying amounts of factor inputs

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Varying Input Levels The productivity of any factor of production depends on the amount of other resources available to it. –Productivity - Output per unit of input, for example, output per labor hour.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. A Production Function

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficiency The production function represents the maximum technical efficiency. Efficiency (technical) is the maximum output of a good from the resources used in production.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficiency There is an opportunity cost to inefficiency, society either: –Gets fewer goods than it should, or –Gives up too many other goods and services in order to get the good.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Short-Run Constraints When there are fixed inputs, we’re dealing with a short run production condition. The short-run is the period in which the quantity (and quality) of some inputs cannot be changed.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Short-Run Constraints Labor is the variable input that determines how much output we get from our fixed inputs (land and capital). In general, as the amount of labor used increases, output also increases.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Short-Run Production Function Labor Input (machine operators per day) Jeans Output (pairs per day) Total output (per day) A B C D E F H I G Output rates depend on input levels

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Productivity Marginal physical product (MPP) is the change in total output that results from employment of one additional unit of input.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Productivity When the MPP of labor (MPP L >0), then total output increases. Improving the ratio of labor to other factors increases the MPP of labor.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Physical Product

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Physical Product Labor Input (machine operators per day) Jeans Output (pairs per day) Total output (per day) B b C c E e F f G g H h I i + 10 jeans Third worker D d a A Marginal physical product (per worker)

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Diminishing Marginal Returns At some point, the ratio of labor to other factors decreases. As more labor is hired, each unit of labor has less capital and land to work with. Output begins to rise more and more slowly as more workers are hired.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Law of Diminishing Returns According to the law of diminishing returns, the marginal physical product of a variable input declines as more of it is employed with a given quantity of other (fixed) inputs.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Diminishing Marginal Returns Labor Input (machine operators per day) Jeans Output (pairs per day) Total output (per day) B b C c E e F f G g H h I i D d a A Marginal physical product (per worker)

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Resource Costs A production function tells us how much a firm can produce but not how much it should produce. The most desirable rate of output is the one that maximizes total profit. –Profit - The difference between total revenue and total cost.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Resource Cost Marginal cost (MC) is the increase in total costs associated with a one unit increase in production.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Resource Cost Whenever MPP is increasing, the marginal cost of producing a good must be falling. If marginal physical product declines, marginal cost increases.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Falling MPP Implies Rising Marginal Cost Diminishing marginal productivity implies... Rising marginal cost Marginal Physical Product Labor Input Additional Labor Cost Labor Input Diminishing marginal physical product i b c d e f g h 1/b 1/c 1/d 1/e 1/f 1/g Rising marginal cost

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Dollar Costs The dollar costs of production are directly related to the underlying production function.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Total Cost Total cost is the market value of all the resources used to produce a good or service.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Fixed Cost Fixed costs are the costs of production that do not change when the rate of output is altered, such as the cost of basic plant and equipment.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Variable Cost Variable costs are the costs of production that change when the rate of output is altered, such as labor and material costs.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Total Cost How fast total costs rise depends on variable costs only. Total cost is equal to the fixed costs when output is zero. There is no way to avoid fixed costs in the short run.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Total Cost

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Total Cost of Production

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Cost of Jeans Production ,000 1,100 $1,200 Rate of Output (pairs of jeans per day) Production Costs (dollars per day) Total cost G B A Fixed costs Total cost include variable and fixed costs Variable costs

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Costs One of the most common cost is average, or per-unit, cost.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Costs Average total cost (ATC) is total cost divided by the quantity produced in a given time period.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Costs Average fixed cost (AFC) is total fixed cost divided by the quantity produced in a given time period.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Costs Average variable cost (AVC) is total variable cost divided by the quantity produced in a given time period.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Costs Average total cost is the sum of average fixed and average variable cost. ATC = AFC + AVC

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Average Costs

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. $ Rate of Output (pairs per day) Costs (dollars per pair) I J K L M N O ATC AVC AFC Average Costs

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Falling AFC As the rate of output increases, AFC decreases as the fixed cost is spread over more output. Any increase in output lowers average fixed cost.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Rising AVC AVC will eventually rise as the rate of output increases. AVC rises because of diminishing returns in the production process.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. U-Shaped ATC The initial dominance of falling AFC, combined with the later resurgence of rising AVC, is what gives the ATC curve its characteristic U shape.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Minimum Average Cost The bottom of the U-shaped average total cost curve represents the minimum average total costs. It identifies the lowest possible opportunity costs to produce the product. Profit aren’t necessarily maximized where average total costs are minimized.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Cost Marginal cost refers to the change in total costs associated with one more unit of output.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Cost

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Cost $ p q r s t u v Added output is increasingly expensive Rate of Output (pairs per day)

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Cost Diminishing returns in production cause marginal costs to increase as the rate of output is expanded.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. A Cost Summary The output decision has to be based not only on the capacity to produce (the production function) but also on the costs of production (the cost functions).

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. A Cost Summary The marginal cost curve always intersects the ATC curve at its lowest point. If MC > ATC, ATC is increasing If MC < ATC, ATC is decreasing If MC = ATC, ATC at minimum

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Basic Cost Curves $ Cost (dollars per unit) Rate of Output (units per time period) 9 ATC n m AVC AFC MC

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic vs. Accounting Costs Accountants typically count dollar costs only and ignore any resource use that doesn’t result in an explicit dollar cost. Economists consider implicit costs as well as explicit costs to be part of the total costs of production.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic vs. Accounting Cost Explicit costs are the payments made for the use of a resource. Implicit costs are the value of resources used, even when no direct payment is made.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic vs. Accounting Cost Economic cost represents he value of all resources used to produce a good or service; opportunity cost.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic vs. Accounting Cost Economic and accounting costs will diverge whenever any factor of production is not paid an explicit wage, or rent, etc.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run Costs The short-run is characterized by costs that cannot be changed (fixed costs). There are no fixed costs in the long-run. The long run is a period of time long enough for all inputs to be varied (no fixed costs).

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run Average Costs The long-run cost curve is a summary of our best short-run cost possibilities.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run Average Costs ATC 1 ATC 2 ATC 3 Long-run average total cost (LATC) Costs (dollars per pair) 040a60bc Rate of Output (pairs of jeans per day)

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run Marginal Costs The long-run marginal costs curve intersects our long-run cost curve at its lowest point.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run Costs with Unlimited Options 0q2q2 Rate of Output (jeans per day) Costs (dollars per pair) LMC LATC ATC 2 m2m2

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale There are many optional plant sizes available in long-run production. A firm can decide to use one large plant or several smaller plants to produce a given amount of output.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale Economies of scale are reductions in minimum average costs that come about through increases in the size (scale) of plant and equipment.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale Constant returns to scale are increases in plant size do not affect minimum average cost – minimum per-unit costs are identical for small plants and large plants.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale Efficiency and size do not necessarily go hand in hand. Diseconomies of scale occur when an increase in plant size results in reducing operating efficiency.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale QMQM 0 COST (dollars per unit) Constant returns to scale c ATC 1 m1m1 RATE OF OUTPUT (units per period) ATC S QMQM 0 Economies of scale c ATC 2 m2m2 ATC S RATE OF OUTPUT (units per period) QMQM 0 Diseconomies of scale c ATC 3 m3m3 ATC S RATE OF OUTPUT (units per period)

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Global Competitiveness Global competitiveness ultimately depends on the costs of production.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Cheap Foreign Labor? Low wages are not a reliable measure of global competitiveness. A worker’s productivity (MPP) depends on the quantity and quality of other resources in the production process.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Unit Labor Costs Both factor costs and productivity are taken into account to measure competitiveness. Unit labor cost a true measure of global competitiveness.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Productivity Advance American productivity must increase as fast as other nations in order for America to stay competitive in global markets.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Improvements in Productivity Reduce Costs TOTAL OUTPUT (units per time period) When the production function shifts up Resource Inputs (dollars per unit) Cost curves shift down Rate of Output (units per time period) COST (dollars per unit) ATC 1 ATC 2 MC 1 MC 2

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Costs of Production End of Chapter 6