© 2003 McGraw-Hill Ryerson Limited. Production and Cost Analysis I Chapter 9

© 2003 McGraw-Hill Ryerson Limited Introduction u In the supply process, people first offer the factors of production they control to the market. l Then the factors are transformed by firms into goods that consumers want. l Production occurs when factors of production (inputs) transform into goods and services.

© 2003 McGraw-Hill Ryerson Limited Firms Maximize Profit u Firm’s goal is to maximize profit. u Profit is the difference between total revenue and total cost. Profit = Total revenue – Total cost

© 2003 McGraw-Hill Ryerson Limited Firms Maximize Profit u An accountant will calculate profit by subtracting explicit costs from the revenue. u For an economist,the measure of profit is revenues minus both implicit and explicit costs.

© 2003 McGraw-Hill Ryerson Limited Firms Maximize Profit u Implicit costs include the opportunity costs of the factors of production. Economic profit = Revenue – (Implicit costs +Explicit costs)

© 2003 McGraw-Hill Ryerson Limited The Production Process u The production process is generally divided into a long run planning decision and the short run adjustment decision.

© 2003 McGraw-Hill Ryerson Limited The Long Run and the Short Run u 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.

© 2003 McGraw-Hill Ryerson Limited The Long Run and the Short Run u A short-run decision is one in which the firm is constrained by past choices in regard to what production decisions it can make.

© 2003 McGraw-Hill Ryerson Limited The Long Run and the Short Run u The terms long run and short run do not necessarily refer to specific periods of time. u They refer to the degree of flexibility the firm has in changing the level of output.

© 2003 McGraw-Hill Ryerson Limited The Long Run and the Short Run u In the long run: l By definition, the firm can vary the inputs as much as it wants. l All inputs are variable.

© 2003 McGraw-Hill Ryerson Limited The Long Run and the Short Run u In the short run: l Flexibility is limited. l Some factors of production cannot be changed. l Generally, the production facility (“the plant”) is fixed in the short run.

© 2003 McGraw-Hill Ryerson Limited Production Tables and Production Functions u How a firm combines factors of production to produce consumer goods can be presented in a production table. u A production table shows the output resulting from various combinations of factors of production or inputs.

© 2003 McGraw-Hill Ryerson Limited Production Tables and Production Functions u Most of the production decisions firms make are short run decisions involving changes in output at a given production facility. u The firm can increase or decrease production by adjusting the amount of variable inputs, such as labour or materials.

© 2003 McGraw-Hill Ryerson Limited Production Tables and Production Functions u Total product is the number of units of the good or service produced by a different number of workers.

© 2003 McGraw-Hill Ryerson Limited Production Tables and Production Functions u Marginal product is the additional output that will result from an additional worker, other inputs remaining constant. u Average product is calculated by dividing total output by the number of workers who produced it.

© 2003 McGraw-Hill Ryerson Limited Production Tables and Production Functions u The information in a production table is often summarized in a production function – a curve that describes the relationship between the inputs (factors of production) and outputs.

© 2003 McGraw-Hill Ryerson Limited Production Tables and Production Functions u The production function discloses the maximum amount of output that can be derived from a given number of inputs.

© 2003 McGraw-Hill Ryerson Limited A Production Table, Figure 9-1a, p 203 Number of workers Total output Marginal product Average product Increasing marginal productivity Diminishing marginal productivity Diminishing absolute productivity —

© 2003 McGraw-Hill Ryerson Limited A Production Function, Figure 9-1b and c, p 203

© 2003 McGraw-Hill Ryerson Limited The Law of Diminishing Marginal Productivity u The law of diminishing marginal productivity is an important element in all real-world production processes. u Both marginal and average productivities initially increase, but eventually they both decrease.

© 2003 McGraw-Hill Ryerson Limited The Law of Diminishing Marginal Productivity u This means that initially the production function exhibits increasing marginal productivity. u Then it exhibits diminishing marginal productivity. u Eventually, the production function exhibits negative marginal productivity.

© 2003 McGraw-Hill Ryerson Limited The Law of Diminishing Marginal Productivity u The most important part of the production function is the part exhibiting diminishing marginal productivity and falling average product.

© 2003 McGraw-Hill Ryerson Limited The Law of Diminishing Marginal Productivity u The law of diminishing marginal productivity states that as more and more of a variable input is added to an existing fixed input, after some point the additional output obtained from the additional input will fall.

© 2003 McGraw-Hill Ryerson Limited The Costs of Production u Costs of production in the short run are: l Fixed Costs, l Variable Costs, and l Total Costs.

© 2003 McGraw-Hill Ryerson Limited Fixed Costs, Variable Costs, and Total Costs u Fixed costs are those that are spent and cannot be changed in the period of time under consideration. u In the long run there are no fixed costs since all costs are variable.

© 2003 McGraw-Hill Ryerson Limited Fixed Costs, Variable Costs, and Total Costs u Variable costs are costs that change as output changes, such as the costs of labour and materials.

© 2003 McGraw-Hill Ryerson Limited Fixed Costs, Variable Costs, and Total Costs u The sum of the variable and fixed costs are total costs: TC = FC + VC

© 2003 McGraw-Hill Ryerson Limited The Costs of Production u Besides total costs, firms are concerned with their costs per unit of output. u Per unit costs are l Average Total Cost, l Average Fixed Cost, and l Average Variable Cost

© 2003 McGraw-Hill Ryerson Limited Average Costs u Average total cost (often called average cost) equals total cost divided by the quantity produced. ATC = TC/Q

© 2003 McGraw-Hill Ryerson Limited Average Costs u Average fixed cost equals fixed cost divided by quantity produced. AFC = FC/Q

© 2003 McGraw-Hill Ryerson Limited Average Costs u Average variable cost equals variable cost divided by quantity produced. AVC = VC/Q

© 2003 McGraw-Hill Ryerson Limited Average Costs u Since total cost is the sum of fixed and variable costs, u Average total cost is the sum of average fixed cost and average variable cost ATC = AFC + AVC

© 2003 McGraw-Hill Ryerson Limited Marginal Cost u Marginal cost is the change (increase) in total cost from a change (increase) in output by one unit. MC =  TC/  Q

© 2003 McGraw-Hill Ryerson Limited The cost of producing earrings, Table 9-1, p 205

© 2003 McGraw-Hill Ryerson Limited Graphing Cost Curves u To gain a better understanding of the costs concepts, we can illustrate them by drawing a graph. u Quantity is plotted on the horizontal axis and a dollar measure of various costs on the vertical axis.

© 2003 McGraw-Hill Ryerson Limited Total Cost Curves u The total variable cost curve has the same shape as the total cost curve— increasing output increases variable cost.

© 2003 McGraw-Hill Ryerson Limited Total cost $ FC 24 M Quantity of earrings VC TC L Total Cost Curves, Fig. 9-2a, p 207 O TC = (VC + FC)

© 2003 McGraw-Hill Ryerson Limited Average and Marginal Cost Curves u Marginal cost, average cost and average variable cost curves are U- shaped. u The marginal cost curve will intersect the average total cost curve and the average variable cost curve at their minimum points.

© 2003 McGraw-Hill Ryerson Limited Average and Marginal Cost Curves u The average fixed cost curve slopes down continuously.

© 2003 McGraw-Hill Ryerson Limited Downward-Sloping Shape of the Average Fixed Cost Curve u The average fixed cost curve looks like a child’s slide – it starts out with a steep decline, then it becomes flatter and flatter. u It tells us that as output increases, the same fixed cost can be spread out over a wider range of output.

© 2003 McGraw-Hill Ryerson Limited The U Shape of the Average and Marginal Cost Curves u In the short-run, output can only be increased by increasing the variable input.

© 2003 McGraw-Hill Ryerson Limited The U Shape of the Average and Marginal Cost Curves u As more and more variable input is added to a fixed input, the law of diminishing marginal productivity sets in. u Marginal and average productivities fall and marginal costs rise.

© 2003 McGraw-Hill Ryerson Limited The U Shape of the Average and Marginal Cost Curves u And when average productivity of the variable input falls, average variable costs rise.

© 2003 McGraw-Hill Ryerson Limited The U Shape of the Average and Marginal Cost Curves u The average total cost curve is the vertical summation of the average fixed cost curve and the average variable cost curve, so it is always higher than both of them.

© 2003 McGraw-Hill Ryerson Limited The U Shape of the Average and Marginal Cost Curves u If the firm increased output enormously, the average variable cost curve and the average total cost curve would almost meet.

© 2003 McGraw-Hill Ryerson Limited Cost $ Quantity of earrings Per Unit Cost Curves, Figure 9-2b, p207 AFC AVC ATC MC

© 2003 McGraw-Hill Ryerson Limited The Relationship Between Productivity and Costs u The shapes of the cost curves are mirror-image reflections of the shapes of the corresponding productivity curves.

© 2003 McGraw-Hill Ryerson Limited The Relationship Between Productivity and Costs u When one is increasing, the other is decreasing. u When one is at a maximum, the other is at a minimum.

© 2003 McGraw-Hill Ryerson Limited The Relationship Between Productivity and Costs, Fig. 9-3, p Output per worker Costs per unit a) b)

© 2003 McGraw-Hill Ryerson Limited Relationship Between Marginal and Average Costs u The marginal cost and average cost curves are related. l When marginal cost exceeds average cost, average cost is rising. l When marginal cost is less than average cost, average cost is falling.

© 2003 McGraw-Hill Ryerson Limited Relationship Between Marginal and Average Costs u This relationship explains why marginal cost curves always intersect average cost curves at the minimum of the average cost curve.

© 2003 McGraw-Hill Ryerson Limited Relationship Between Marginal and Average Costs u The position of the marginal cost relative to average total cost tells us whether average total cost is rising or falling.

© 2003 McGraw-Hill Ryerson Limited Relationship Between Marginal and Average Costs u To summarize: If MC < ATC, then ATC is falling. If MC = ATC, then ATC is at its low point. If MC > ATC, then ATC is rising.

© 2003 McGraw-Hill Ryerson Limited Relationship Between Marginal and Average Costs u 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 falling. If MC = AVC, then AVC is at its low point. If MC > AVC, then AVC is rising.

© 2003 McGraw-Hill Ryerson Limited Relationship Between Marginal and Average Costs u Average total cost will fall when marginal cost is above average variable cost, so long as average variable cost does not rise by more than average fixed cost falls.

© 2003 McGraw-Hill Ryerson Limited Relationship Between Marginal and Average Costs, Fig 9-4, p209 Costs per unit $ Quantity of output Area B Area AArea C MC ATC AVC Q1Q1 B MC Q0Q0 A

© 2003 McGraw-Hill Ryerson Limited. Production and Cost Analysis I End of Chapter 9