1. Chapter 6 Production and Cost
ECONOMICS: Principles and Applications, 4e
HALL & LIEBERMAN, © 2008 Thomson South-Western

2. Production Business firm – an organization Production Technology
Owned and operated by private individuals
Specializes in production
Production
Process of combining inputs to make goods and services
Technology
Method of combining inputs to produce goods or services

3. The Production Function
Indicates the maximum amount of output a firm can produce over some period of time from each combination of inputs
Figure 1 The Firm’s Production Function
Different
Combinations of
Inputs
Different
Quantities
of Output
Production
Function

4. Short-Run versus Long-Run Decisions
A time horizon long enough for a firm to vary all of its inputs
Variable inputs - can be adjusted up or down as the quantity of output changes
Short run
A time period during which at least one of the firm’s inputs is fixed
Fixed inputs - cannot be adjusted as output changes in the short run

5. Production in the Short-Run
Total product
Maximum quantity of output that can be produced from a given combination of inputs
Marginal product of labor: MPL=ΔQ/ΔL
Additional output produced when one more worker is hired

6. Total and Marginal Product
Figure 2 Total and Marginal Product
Units of Output
Number of Workers 6 2 3 4 5 1
196
Total Product
184
160
DQ from hiring fourth worker = 30
130
DQ from hiring third worker = 40 90
DQ from hiring second worker = 60 30
DQ from hiring first worker = 30
increasing marginal returns
diminishing marginal returns

7. Marginal Returns To Labor
Increasing marginal returns to labor
MPL increases as more labor is hired
Diminishing marginal returns to labor
MPL decreases as more labor is hired
Law of Diminishing Marginal Returns
As more and more of any input is added to a fixed amount of other inputs, its marginal product will eventually decline

8. Thinking About Costs Total cost Sunk cost
The opportunity cost of the owners - everything they must give up in order to produce that amount of output
Sunk cost
A cost that has been paid or must be paid, regardless of any future action being considered
Should not be considered when making decisions

9. Explicit vs. Implicit Costs
Explicit cost
Money actually paid out for the use of inputs
Implicit cost
The cost of inputs for which there is no direct money payment

10. Costs in the Short Run Fixed costs Variable costs
Costs of a firm’s fixed inputs
Remain constant as output changes
Variable costs
Costs of a firm’s variable inputs
Change with output

11. Total Costs in the Short Run
Total fixed cost (TFC)
The cost of all inputs that are fixed in the short run
Total variable cost (TVC)
The cost of all variable inputs used in production
Total cost (TC=TFC+TVC)
The costs of all inputs—fixed and variable

12. Total Cost Curves Figure 3 The Firm’s Total Cost Curves Dollars 135
Dollars
135
195
255
315
375
$435 30 90
130
160
Units of Output
184 TC
TVC
TFC
TFC

13. Average Costs Average fixed cost (AFC=TFC/Q)
Total fixed cost divided by the quantity of output produced
Average variable cost (AVC=TVC/Q)
Cost of the variable inputs per unit of output
Average total cost (ATC=TC/Q)
Total cost per unit of output

14. Marginal Cost Marginal Cost (MC) MC curve is U-shaped
Increase in total cost from producing one more unit or output
MC curve is U-shaped
When MPL rises, MC falls
When MPL falls, MC rises.
MPL rises and then falls, MC will fall and then rise.

15. Average And Marginal Costs
Figure 4 Average And Marginal Costs
Units of Output
Dollars $4 3 2 1 30 90
130
160
196 MC
AFC
ATC
AVC

16. Average And Marginal Costs
At low levels of output
MC - below the AVC and ATC curves
AVC and ATC slope downward
At higher levels of output
MC - above the AVC and ATC curves
AVC and ATC slope upward
U-shaped curves
MC curve will intersect the minimum points of the AVC and ATC curves

17. Production And Cost in the Long Run
All inputs and all costs are variable
Least Cost Rule
To produce any given level of output, the firm will choose the input mix with the lowest cost
Long-run total cost (LRTC)
The cost of producing each quantity of output when the least-cost input mix is chosen in the long run

18. Production And Cost in the Long Run
Long-run average total cost (LRATC)
The cost per unit of output
in the long run
all inputs are variable
LRTC ≤ TC
LRATC ≤ ATC

19. Average Cost And Plant Size
Plant - Collection of fixed inputs at a firm’s disposal
Short run
Cannot change the plant size
Move along ATC curve
Long run
Choose among ATC curves
Can change the plant size
Produce at lowest possible ATC

20. Graphing the LRATC Curve
Figure 5 Long-Run Average Total Cost
196
184
Dollars
1.00
2.00
3.00
$4.00
Units of Output 30 90
130
160
250
300
ATC1
LRATC
ATC3
ATC0
ATC2 C D B A E
175
Use 0 automated lines
Use 1 automated lines
Use 2 automated lines
Use 3 automated lines

21. The Shape of LRATC
Economies of scale - LRATC decreases as output increases
LRATC curve slopes downward
More likely to occur at lower levels of output
Spreading costs of Lumpy inputs
Diseconomies of scale - LRATC increases as output increases
LRATC curve slopes upward
More likely at higher output levels

22. The Shape of LRATC
Constant returns to scale - LRATC is unchanged as output increases
LRATC curve is flat
U-shape of LRATC curve
Economies of scale at relatively low levels of output
Constant returns to scale at some intermediate levels of output
Diseconomies of scale at relatively high levels of output

23. Constant Returns to Scale
The Shape Of LRATC
Figure 6 The Shape Of LRATC
Dollars
1.00
2.00
3.00
$4.00
130
184
LRATC
Economies of Scale
Constant Returns to Scale
Diseconomies of Scale
Units of Output

24. The Urge to Merge Minimum efficient scale (MES) Mergers
The lowest output level at the minimum cost per unit in the long run
Mergers
Significant, unexploited economies of scale
Because the market has too many firms for each to operate near its MES

25. The Urge to Merge
Figure 7 LRATC for a Typical Firm in a Merger-Prone Industry
3. Other firms lose market share and end up at C
Dollars
Quantity
per Month A B C
LRATC
$240
200 80
8,000
10,000
20,000
4.Price war - other firms must match the first-mover’s
price; each firm ends up back at A - they suffer losses
1. With market quantity demanded fixed at 60,000, and six firms of equal market share, each operates at A
2. But any one firm can cut price slightly, increase market share, and operate with lower cost per unit, such as at the MES (point B)
5. Mergers to create three large firms would enable each
to operate at its MES with less likelihood of price wars and losses

26. Appendix: Isoquant Analysis
Every point on an isoquant represents an input mix that produces the same quantity of output
Isoquants slope downward
An increase in one input requires a decrease in the other input to keep total production unchanged
Higher isoquants
Greater levels of output than lower isoquants

27. Appendix: An Isoquant Map
Figure A.1 An Isoquant Map
Labor
(workers)
Land (hectares) 11 3 5 F
Q=6,000
Q=4,000 A B C
Q=2,000

28. Appendix: MRTS Marginal rate of technical substitution
The rate at which a firm can substitute one input for another while keeping output constant
Decreases as we move rightward along an isoquant
Is the slope of the isoquant
MRTS = MPN/MPL

29. Appendix: Isocost Lines
An isocost line
all combinations of the two inputs
same total cost for the firm
Isocost lines always slope downward
To use more of one input - must use less of the other input; to keep total cost unchanged
The slope of an isocost line: PN / PL; constant
Higher isocost lines
Greater total costs for the firm

30. Appendix: Isocost Lines
Figure A.2 Isocost Lines
Labor
(workers)
Land
(hectares) 10 3 9 5
7.5 20 15
TC=$10,000
TC=$7,500 C
TC=$5,000

31. Appendix: The Least-Cost Input Combination
The point where an isocost line is tangent to the isoquant for that output level
MRTS=MPN/MPL=PN /PL
MPN/PN = MPL/PL
Many variable inputs
the marginal product per dollar of any input will be equal to the marginal product per dollar of any other input

32. Appendix: Isocost Lines
Figure A.3 The Least-Cost Input Combination for a Given Output Level
Labor
(workers)
Land
(hectares) 5
7.5 10
Labor
(workers) 20 15
TC=$10,000 20
Q=4,000
The input combinations at
J, C, and K can all be used
to produce 4,000 units of output. 15 J
The input combination at
C - where the isoquant is
tangent to the isocost line,
is the least expensive 10
TC=$5,000 5 C K
TC=$7,500