The Costs of Production Chapter 6

In This Chapter… 6.1. The Production Process 6.2. How Much to Produce? 6.3. The Right Size: Large or Small?

6.1. The Production Process

Factors of Production (Inputs) Final Goods and Services (Output) Production Process

6.1.The Production Process Factors of production – Resource inputs used to produce goods and services. land, labor, capital, entrepreneurship. It takes some or all factors of production to produce a good or service – no matter what the good; OUTPUT

6.1. The Production Process Production function : is the technical relationship that expresses the maximum quantity of a good that can be produced (attainable) from different combinations of factors (inputs). The technical relationship between the quantities of inputs used in the production process and the maximum output that can be produced.

The purpose of a production function is to tell us how much output we can produce with varying amounts of factor inputs Varying Input Levels During some time period the amount of some inputs that can be employed are fixed or can’t be varied….Fixed Inputs (E.g. Land; Plant Size) While the amount of some other inputs can be easily changed… Variable Input (E.g., Labor) 6.1. The Production Process

Short-Run …. The time period during which the quantity (and quality) of some inputs cannot be changed. When there are fixed inputs, we’re dealing with a short run production condition The Production Process

In the Long Run, however, all inputs can be varied Thus long run is a time period that allows us to sufficiently vary the amount of inputs we can use in the production process. When we vary the amounts of input we use in the production process it affects productivity 6.1. The Production Process

Productivity - Output per unit of input, for example, output per labor hour. The productivity of any factor of production depends on the amount of other resources available to it The Production Process

6.1. The Production Process: In the Short Run

The Production Function Labor Input (machine operators per day) Jeans Output (pairs per day) Total output A B C D E F H I G Amount of Output depends on Input levels

Marginal Productivity An important Concept

Marginal Productivity  Marginal physical product (MPP): is the change in total output that results from employment of one additional unit of the variable input.

Number of Workers Total Output Marginal Physical Product A00 B115 C23419 D34410 E4484 F5502 G6511 H7 0 I847-4

Marginal Physical Product Labor Input (machine operators per day) Jeans Output (pairs per day) Total output B b C c E e F f G g H h I i + 10 jeans Third worker D d a A MPP

MPP:…Important Feature… When the MPP of labor (MPP L >0), then total output increases. Improving the ratio of the variable input (labor) to other factors increases the MPP of the variable input (labor). But there is a limit to which we can do this because the capacity of the fixed resources will be exhausted This leads to eventual decline in the additional and total output we could produce

Diminishing Marginal Returns I.e., as more labor is hired, each unit of labor will have less capital and land to work with. Thus output begins to rise more and more slowly as more workers are hired and will eventually fall

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. All types of production are subject to this natural law

Diminishing Marginal Returns Labor Input (machine operators per day) Jeans Output (pairs per day) Total output B b C c E e F f G g H h I i + 10 jeans Third worker D d a A MPP

Resource Costs 6.2. The Costs of Production (The components of the Costs of Production)

Resource Costs A production function tells us how much a firm can produce but not how much it should produce. Goal of a firm: Maximizing profit Profit: The difference between Total Revenue (PxQ) and Total Cost (TC) Requires every firm to decide on its most desirable level of output

Explicit vs. Implicit 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.

Economic vs. Accounting Profit Accounting Profit Accountants typically count dollar costs only and ignore any resource use that doesn’t result in an explicit dollar cost. Economic Profit: Economists consider implicit costs as well as explicit costs to be part of the total costs of production.

Economic vs. Accounting profit I.e., Economic cost represents he value of all resources used to produce a good or service; opportunity cost.

Dollar Costs (Economic Costs) The dollar costs of production are directly related to the underlying production function. 1.Total Fixed Costs (TFC) 2.Total Variable Costs (TVC) 3.Total Costs (TC)

Costs of Production

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 ,000 1,100 $1,200 Rate of Output (pairs of jeans per day) Production Costs (dollars per day) TFC=$120

Variable Cost Variable costs are the costs of production that change when the rate of output is altered, such as labor and material costs ,000 1,100 $1,200 Rate of Output (pairs of jeans per day) Production Costs (dollars per day) TVC

Total Cost Total cost is the market value of all the resources used to produce a good or service ,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 Variable costs

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.

Total Cost of Production

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

Average Costs One of the most common cost is average, or per-unit, cost. 4. Average Fixed Cost (AFC) 5. Average Variable Cost (AVC) 6. Average Total Cost (ATC)

Average Costs Average fixed cost (AFC) is total fixed cost divided by the quantity produced in a given time period.

Average Costs Average variable cost (AVC) is total variable cost divided by the quantity produced in a given time period.

Average Costs Average total cost (ATC) is total cost divided by the quantity produced in a given time period.

Average Costs Average total cost is the sum of average fixed and average variable cost. ATC = AFC + AVC

Average Costs

$ Rate of Output (pairs per day) Costs (dollars per pair) I J K L M N O ATC AVC AFC Average Costs

Characteristic of Average Costs 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.

Falling and then Rising AVC AVC will eventually rise as the rate of output increases. AVC rises because of diminishing returns in the production process. Characteristic of Average Costs

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. Characteristic of Average Costs

Minimum Point of the Average Total 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. Note: Profit aren’t necessarily maximized where average total costs are minimized.

7. Marginal Cost (MC)

Marginal Cost Marginal cost refers to the change in total costs associated with one more unit of output.

Marginal Cost

$ p q r s t u v Higher output level becomes increasingly expensive Rate of Output (pairs per day)

Relationship between MPP and MC  Whenever MPP is increasing, the marginal cost of producing a good must be falling.  If marginal physical product declines, marginal cost increases.  Diminishing returns in production cause marginal costs to increase as the rate of output is expanded.

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

Summarizing the Relationship between different types of Costs of Production and their Implication

Relationships Output decision (how much to produce) has to be based not only on the capacity to produce (the production function) but also on the costs of production (the cost functions). The relationship between the different cost components is thus important

Basic Cost Curves-relationships $ Cost (dollars per unit) Rate of Output (units per time period) 9 ATC n m AVC AFC MC

Relationships… 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

Number of Employees (L) Output (Bottles per Day); Q Fixed Cost (TFC) Variable cost (TVC) Total Cost (TC) Average Fixed Cost (AFC) Average Variable Cost (AVC) Average Total Cost (ATC) Marginal Cost (MC) A00$40 B180 C2200 D3260$36 E4300$48 F5330 G6350 H7362$84 Complete the Table Below

Number of Employees (L) Output (Bottles per Day) Total Cost (TC) Total Revenue TR=P x Q Profit TR-TC A00 B180 C2200 D3260 E4300 F5330 G6350 H7362 Bottles sell for 35 cents each. Complete the table below

Long-Run Costs The short-run is characterized by some costs that cannot be changed (fixed costs). In the long run, there are no fixed costs. The long run is a period of time long enough for all inputs to be varied (no fixed costs).

Long-Run Average Costs The long-run cost curve is a summary of our best short-run cost possibilities.

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)

Long-Run Marginal Costs  The long-run marginal costs curve intersects our long-run cost curve at its lowest point. 0q2q2 Rate of Output (jeans per day) Costs (dollars per pair) LMC LATC ATC 2 m2m2

Long-Run Costs with Unlimited Options 0q2q2 Rate of Output (jeans per day) Costs (dollars per pair) LMC LATC ATC 2 m2m2

What is the appropriate Size? In the long run, there are many optional plant sizes available to the firm. Decision as to which size is appropriate has to be made. A firm can decide to use one large plant or several smaller plants to produce a given amount of output. What guides the firm on such a decision?

Economies of Scale Three Types: 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. Economies of scale: are reductions in minimum average costs that come about through increases in the size (scale) of plant and equipment. Diseconomies of scale: Diseconomies of scale: occur when an increase in plant size results in reducing operating efficiency.

Economies of Scale 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) QMQM 0 COST (dollars per unit) Constant returns to scale c ATC 1 m1m1 RATE OF OUTPUT (units per period) ATC S

Economies of Scale QMQM 0 Diseconomies of scale c ATC 3 m3m3 ATC S RATE OF OUTPUT (units per period) QMQM 0 Economies of scale c ATC 2 m2m2 ATC S RATE OF OUTPUT (units per period) QMQM 0 COST (dollars per unit) Constant returns to scale c ATC 1 m1m1 RATE OF OUTPUT (units per period) ATC S

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)

Global Competitiveness: Low Wages and Advances in Productivity Global competitiveness ultimately depends on the costs of production. 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.

Global Competitiveness: Low Wages and Advances in Productivity What should American Firms do to remain globally competitive? American productivity must increase as fast as other nations in order for America to stay competitive in global markets.

Unit Labor Costs Both factor costs and productivity are taken into account to measure competitiveness. Unit labor cost a true measure of global competitiveness.

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