1. © 2003 McGraw-Hill Ryerson Limited. Production and Cost Analysis I Chapter 9

2. © 2003 McGraw-Hill Ryerson Limited 9 - 2 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.

3. © 2003 McGraw-Hill Ryerson Limited 9 - 3 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

4. © 2003 McGraw-Hill Ryerson Limited 9 - 4 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.

5. © 2003 McGraw-Hill Ryerson Limited 9 - 5 Firms Maximize Profit u Implicit costs include the opportunity costs of the factors of production. Economic profit = Revenue – (Implicit costs +Explicit costs)

6. © 2003 McGraw-Hill Ryerson Limited 9 - 6 The Production Process u The production process is generally divided into a long run planning decision and the short run adjustment decision.

7. © 2003 McGraw-Hill Ryerson Limited 9 - 7 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.

8. © 2003 McGraw-Hill Ryerson Limited 9 - 8 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.

9. © 2003 McGraw-Hill Ryerson Limited 9 - 9 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.

10. © 2003 McGraw-Hill Ryerson Limited 9 - 10 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.

11. © 2003 McGraw-Hill Ryerson Limited 9 - 11 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.

12. © 2003 McGraw-Hill Ryerson Limited 9 - 12 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.

13. © 2003 McGraw-Hill Ryerson Limited 9 - 13 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.

14. © 2003 McGraw-Hill Ryerson Limited 9 - 14 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.

15. © 2003 McGraw-Hill Ryerson Limited 9 - 15 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.

16. © 2003 McGraw-Hill Ryerson Limited 9 - 16 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.

17. © 2003 McGraw-Hill Ryerson Limited 9 - 17 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.

18. © 2003 McGraw-Hill Ryerson Limited 9 - 18 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 4 6 7 6 5 3 1 0 2 5 1 2 3 4 5 6 7 8 9 10 0 4 5 5.7 5.8 5.6 5.2 4.6 4.0 3.3 2.5 — 4 10 17 23 28 31 32 30 25 0

19. © 2003 McGraw-Hill Ryerson Limited 9 - 19 A Production Function, Figure 9-1b and c, p 203

20. © 2003 McGraw-Hill Ryerson Limited 9 - 20 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.

21. © 2003 McGraw-Hill Ryerson Limited 9 - 21 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.

22. © 2003 McGraw-Hill Ryerson Limited 9 - 22 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.

23. © 2003 McGraw-Hill Ryerson Limited 9 - 23 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.

24. © 2003 McGraw-Hill Ryerson Limited 9 - 24 The Costs of Production u Costs of production in the short run are: l Fixed Costs, l Variable Costs, and l Total Costs.

25. © 2003 McGraw-Hill Ryerson Limited 9 - 25 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.

26. © 2003 McGraw-Hill Ryerson Limited 9 - 26 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.

27. © 2003 McGraw-Hill Ryerson Limited 9 - 27 Fixed Costs, Variable Costs, and Total Costs u The sum of the variable and fixed costs are total costs: TC = FC + VC

28. © 2003 McGraw-Hill Ryerson Limited 9 - 28 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

29. © 2003 McGraw-Hill Ryerson Limited 9 - 29 Average Costs u Average total cost (often called average cost) equals total cost divided by the quantity produced. ATC = TC/Q

30. © 2003 McGraw-Hill Ryerson Limited 9 - 30 Average Costs u Average fixed cost equals fixed cost divided by quantity produced. AFC = FC/Q

31. © 2003 McGraw-Hill Ryerson Limited 9 - 31 Average Costs u Average variable cost equals variable cost divided by quantity produced. AVC = VC/Q

32. © 2003 McGraw-Hill Ryerson Limited 9 - 32 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

33. © 2003 McGraw-Hill Ryerson Limited 9 - 33 Marginal Cost u Marginal cost is the change (increase) in total cost from a change (increase) in output by one unit. MC =  TC/  Q

34. © 2003 McGraw-Hill Ryerson Limited 9 - 34 The cost of producing earrings, Table 9-1, p 205

35. © 2003 McGraw-Hill Ryerson Limited 9 - 35 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.

36. © 2003 McGraw-Hill Ryerson Limited 9 - 36 Total Cost Curves u The total variable cost curve has the same shape as the total cost curve— increasing output increases variable cost.

37. © 2003 McGraw-Hill Ryerson Limited 9 - 37 Total cost $400 350 300 250 200 150 100 50 0 FC 24 M 68102030 Quantity of earrings VC TC L Total Cost Curves, Fig. 9-2a, p 207 O TC = (VC + FC)

38. © 2003 McGraw-Hill Ryerson Limited 9 - 38 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.

39. © 2003 McGraw-Hill Ryerson Limited 9 - 39 Average and Marginal Cost Curves u The average fixed cost curve slopes down continuously.

40. © 2003 McGraw-Hill Ryerson Limited 9 - 40 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.

41. © 2003 McGraw-Hill Ryerson Limited 9 - 41 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.

42. © 2003 McGraw-Hill Ryerson Limited 9 - 42 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.

43. © 2003 McGraw-Hill Ryerson Limited 9 - 43 The U Shape of the Average and Marginal Cost Curves u And when average productivity of the variable input falls, average variable costs rise.

44. © 2003 McGraw-Hill Ryerson Limited 9 - 44 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.

45. © 2003 McGraw-Hill Ryerson Limited 9 - 45 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.

46. © 2003 McGraw-Hill Ryerson Limited 9 - 46 Cost $30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 Quantity of earrings 246810121416182022 2426283032 Per Unit Cost Curves, Figure 9-2b, p207 AFC AVC ATC MC

47. © 2003 McGraw-Hill Ryerson Limited 9 - 47 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.

48. © 2003 McGraw-Hill Ryerson Limited 9 - 48 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.

49. © 2003 McGraw-Hill Ryerson Limited 9 - 49 The Relationship Between Productivity and Costs, Fig. 9-3, p208 21 Output per worker Costs per unit a) b)

50. © 2003 McGraw-Hill Ryerson Limited 9 - 50 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.

51. © 2003 McGraw-Hill Ryerson Limited 9 - 51 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.

52. © 2003 McGraw-Hill Ryerson Limited 9 - 52 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.

53. © 2003 McGraw-Hill Ryerson Limited 9 - 53 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.

54. © 2003 McGraw-Hill Ryerson Limited 9 - 54 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.

55. © 2003 McGraw-Hill Ryerson Limited 9 - 55 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.

56. © 2003 McGraw-Hill Ryerson Limited 9 - 56 Relationship Between Marginal and Average Costs, Fig 9-4, p209 Costs per unit $90 80 70 60 50 40 30 20 10 0 Quantity of output Area B Area AArea C MC ATC AVC 123456789 Q1Q1 B MC Q0Q0 A

57. © 2003 McGraw-Hill Ryerson Limited. Production and Cost Analysis I End of Chapter 9