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CHAPTER 4 Production and Cost Prepared by: Jamal Husein © 2005 Prentice Hall Business CHAPTER 4 Production and Cost Prepared by: Jamal Husein © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Economic Cost u u In economics, the notion of a firm’s costs is based Economic Cost u u In economics, the notion of a firm’s costs is based on the notion of economic cost. The key principle underlying the computation of economic cost is opportunity cost. PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 2

Accounting versus Economic Cost u An accountant’s notion of costs involves only the firm’s Accounting versus Economic Cost u An accountant’s notion of costs involves only the firm’s explicit costs: l Explicit costs: the firm’s actual cash payments for its inputs. u An economist includes the firm’s implicit costs: l Implicit costs: the opportunity costs of nonpurchased inputs. Economic Cost = Explicit Cost + Implicit Cost © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 3

Accounting versus Economic Cost Accounting Approach Explicit Cost (purchased inputs) $60, 000 Economic Approach Accounting versus Economic Cost Accounting Approach Explicit Cost (purchased inputs) $60, 000 Economic Approach $60, 000 Implicit: opportunity cost of entrepreneur’s time 30, 000 Implicit: opportunity cost of funds 10, 000 ______ $60, 000 Total Cost © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin ______ $100, 000 4

Short-run versus Long-run Decisions u Short run (SR): a period of time over which Short-run versus Long-run Decisions u Short run (SR): a period of time over which one or more factors of production remains fixed. § In the short run, a firm decides how much output to produce in the current facility. u Long run (LR): a period of time long enough that a firm can change all factors pf production. 1. In the long run, a firm decides what size and type of facility to build. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 5

Production and Cost in the Short Run u The key principle behind the firm’s Production and Cost in the Short Run u The key principle behind the firm’s short -run cost curves is the principle of diminishing returns. PRINCIPLE of Diminishing Returns Suppose that output is produced with two or more inputs and we increase one input while holding the other inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 6

The Firm’s Short-run Production Function u The short-run production function, or total product curve, The Firm’s Short-run Production Function u The short-run production function, or total product curve, shows the relationship between the number of workers and the quantity of output produced. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 7

Production and Marginal Product Rakes Per Minute Total product curve Number 0 1 of Production and Marginal Product Rakes Per Minute Total product curve Number 0 1 of Workers 0 8 2 3 4 5 6 7 8 9 10 12 15 20 27 36 48 65 90 130 © 2005 Prentice Hall Business Publishing Total Product Curve: A curve showing the relationship between the quantity of Labor and the quantity of output produced Survey of Economics, 2/e O’Sullivan & Sheffrin 8

Production and Marginal Product u u © 2005 Prentice Hall Business Publishing Survey of Production and Marginal Product u u © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e The shape of the total product curve between d & e is explained by diminishing returns. Beyond 15 workers the total product curve becomes flatter, i. e. , marginal product of labor decreases. In other words, output beyond 15 workers is increasing at a decreasing rate. O’Sullivan & Sheffrin 9

Short-run Production Costs u The short-run costs of production are a reflection of the Short-run Production Costs u The short-run costs of production are a reflection of the relationship between labor and output in the short run under diminishing returns. In the short run, the firm has two types of costs: u u Fixed cost (FC): the cost of the production facility, which is independent of the amount of output produced in it. Variable costs (VC): the costs of labor and materials associated with producing output. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 10

Short-run Production Costs Total Cost = Total Fixed Cost + Total Variable Cost SRTC Short-run Production Costs Total Cost = Total Fixed Cost + Total Variable Cost SRTC TVC TFC © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 11

Short-run Average Cost Curves © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e Short-run Average Cost Curves © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 12

Short-run Average Total Cost u Short-run average total cost (SRATC) measures total cost per Short-run Average Total Cost u Short-run average total cost (SRATC) measures total cost per unit of output produced. Short-run Average Total Cost © 2005 Prentice Hall Business Publishing = Fixed Cost per Unit Survey of Economics, 2/e + Variable Cost per Unit O’Sullivan & Sheffrin 13

Short-run Marginal Cost u Short-run marginal cost (SRMC) is the change in total cost Short-run Marginal Cost u Short-run marginal cost (SRMC) is the change in total cost resulting from a 1 -unit increase in the output of an existing production facility. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 14

The Relationship between Marginal & Average Curves u The marginal cost of production is The Relationship between Marginal & Average Curves u The marginal cost of production is the amount of money necessary to buy the additional labor and materials necessary to produce one more unit of output. u The marginal cost of production increases because output increases at a decreasing rate with additional labor hours. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 15

Short-run Average and Marginal Costs: An Example OUTPUT FIXED Cost TOTAL VARIABLE COST SR Short-run Average and Marginal Costs: An Example OUTPUT FIXED Cost TOTAL VARIABLE COST SR TOTAL COST SR MARGINAL COST AVERAGE FIXED COST SR AVERAGE VARIABLE COST SR AVERAGE TOTAL COST Q FC TVC STC SMC AFC SAVC SATC 0 $36 $0 36 $- $- 1 36 8 44 8 362 $8 44 2 36 12 48 4 183 6 24 3 36 15 51 3 12 5 17 4* 36 20 56 5* 9 5* 14 5 36 27 63 7 7 5. 4 12. 6 6 36 36 72 9 6 6 12 7* 36 48 84 12* 5. 14 6. 86 12* 8 36 65 101 17 4. 5 8. 13 12. 63 9 36 90 126 25 4 10 14 10 36 130 166 40 3. 6 13 16. 6 © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 16

Short-run Average and Marginal Costs: An Example SMC SATC SAVC AFC © 2005 Prentice Short-run Average and Marginal Costs: An Example SMC SATC SAVC AFC © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 17

A Closer Look at SR Production Costs u To study the relationship between the A Closer Look at SR Production Costs u To study the relationship between the components of short-run production costs, consider the following example concerning a producer of computer chips facing diminishing returns. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 18

Short-run Average Total Cost (SATC) Short-run Average Total Cost Quantity of Chips Fixed Cost Short-run Average Total Cost (SATC) Short-run Average Total Cost Quantity of Chips Fixed Cost Labor per Chip Hours Material Labor $8 Labor Cost 100 x Cost per Chip Average Total Cost Small: 100 $72 100 $8 $10 $90 Medium: 300 24 900 7, 200 24 10 58 Large: 400 $7, 200/100 18 $7, 200+800 2, 000 16, 000 40 10$72+$8+$10 68 Assumptions: Total fixed cost: $7, 200 Hourly wage: $8. 00 © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 19

Short-run Average Total Cost (SATC u Average Total Cost is the Sum of Average Short-run Average Total Cost (SATC u Average Total Cost is the Sum of Average Variable and Average Fixed Cost Quantity Produced Average Total Cost ($) Average Fixed Cost ($) Average Variable Cost ($) 100 300 400 90 58 68 72 24 18 18 34 50 u u © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e The gap between SATC and SAVC decreases as output increases. AFC continuously decreases as total fixed cost is spread over more units of output produced. O’Sullivan & Sheffrin 20

Short-run Average Total Cost (SATC) u © 2005 Prentice Hall Business Publishing Survey of Short-run Average Total Cost (SATC) u © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e The SATC curve is Ushaped because of the behavior of its two components as output produced increases. l AFC decreases as output increases. l SAVC increases as output increases. O’Sullivan & Sheffrin 21

Diminishing Returns and Increasing Marginal Cost Quantity of Chips Additional Labor Hours Additional Labor Diminishing Returns and Increasing Marginal Cost Quantity of Chips Additional Labor Hours Additional Labor Cost Material Cost Marginal Cost Small: 100 2 $16 $10 $26 Medium: 300 Large: 400 6 10 48 80 10 10 58 90 Initially, it takes 4 additional labor hours to increase the quantity of chips by 200, from 100 to 300. Then, it takes another 4 hours of labor to increase output by only 100 more chips, from 300 to 400. Marginal cost increases because output increases at a decreasing rate with additional labor hours. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 22

Relationship between Short-run MC and AC Curves u As long as SATC is declining, Relationship between Short-run MC and AC Curves u As long as SATC is declining, marginal cost lies below it. u When SATC rises, SMC is greater than SATC. At point m, SATC=SMC. u © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 23

Relationship between Short-run MC and AC Curves Quantity Produced Marginal Cost ($) Average Total Relationship between Short-run MC and AC Curves Quantity Produced Marginal Cost ($) Average Total Cost ($) 100 26 90 300 400 58 90 58 68 u © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e The marginal cost curve (SMC) intersects the average cost curve (SATC) when average cost is minimum. O’Sullivan & Sheffrin 24

Production and Cost in the Long Run u The key difference between the short Production and Cost in the Long Run u The key difference between the short run and the long run is that there are no diminishing returns in the long run. u Diminishing returns occur because workers share a fixed facility. In the long run the firm can expand its production facility as its workforce grows. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 25

Long-run Average Cost u u Long-run average cost (LAC) is total cost divided by Long-run Average Cost u u Long-run average cost (LAC) is total cost divided by the quantity of output when the firm can choose a production facility of any size. The LAC curve describes the behavior of average cost as the plant size expands. Initially, the curve is negatively sloped, then beyond some point, it becomes horizontal. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 26

Indivisible Inputs u Because of indivisible inputs, the long-run average cost curve will be Indivisible Inputs u Because of indivisible inputs, the long-run average cost curve will be negatively sloped. Indivisible input: an input that cannot be scaled down to produce a small quantity of output. Most production processes have at least one indivisible input. l u © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 27

Examples of Indivisible Inputs u u u A computer factory uses sophisticated machines and Examples of Indivisible Inputs u u u A computer factory uses sophisticated machines and testing equipment. A transatlantic shipper uses a large ship to carry TV sets from Japan to the United States. A cable-TV firm uses a cable running throughout its territory. A steel mill uses a large furnace. A freight hauler uses a freight truck. A pizzeria uses a pizza oven. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 28

Long-run Average Cost u When long-run total cost is proportionate to the quantity produced, Long-run Average Cost u When long-run total cost is proportionate to the quantity produced, long-run average cost does not change as output increases. u © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e The long-run average cost curve is horizontal for 7 or more rakes per hour. O’Sullivan & Sheffrin 29

Labor Specialization u u In a large operation, each worker specializes in fewer tasks Labor Specialization u u In a large operation, each worker specializes in fewer tasks thus is more productive than his or her counterpart in a small operation. Higher productivity (more output per worker) means lower labor costs per unit of output, thus lower production costs (ever-decreasing average cost). © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 30

Economies of Scale u Economies of scale: a situation in which an increase in Economies of Scale u Economies of scale: a situation in which an increase in the quantity produced decreases the long-run average cost of production. u Economies of scale refer to cost savings associated with spreading the cost of indivisible inputs and input specialization. When economies of scale are present, the LAC curve will be negatively sloped. u © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 31

Minimum Efficient Scale u The minimum efficient scale describes the output at which scale Minimum Efficient Scale u The minimum efficient scale describes the output at which scale economies are exhausted; q u The long-run average cost curve becomes horizontal. Once the minimum efficient scale has been reached, an increase in output no longer decreases the longrun average cost. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 32

Diseconomies of Scale u u A firm experiences diseconomies of scale when an increase Diseconomies of Scale u u A firm experiences diseconomies of scale when an increase in output leads to an increase in long-run average cost—the LAC curve becomes positively sloped. Diseconomies of scale may arise for two reasons: q Coordination problems q Increasing input costs © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 33

Examples of Economies of Scale LAC Curve for Electricity Generation © 2005 Prentice Hall Examples of Economies of Scale LAC Curve for Electricity Generation © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e LAC Curve for Aluminum Production O’Sullivan & Sheffrin 34

Examples of Economies of Scale LAC Curve for Truck Freight © 2005 Prentice Hall Examples of Economies of Scale LAC Curve for Truck Freight © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e LAC Curve for Hospital Services O’Sullivan & Sheffrin 35