CHAPTER 12 Production and Cost Analysis I Production is not the application of tools to materials, but logic to work. Peter Drucker McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Maximizing Profit The goal of a firm is to maximize profits Profit = Total Revenue Total Cost 12-2
Explicit versus Implicit Costs Explicit cost =money paid out (rent, wages, etc.) Implicit cost=opportunity cost of the factors of production used by the firm 12-3
Economic versus Accounting Profit Economists and accountants measure profit differently Unlike accountants, economists also consider implicit costs (the opportunity cost of what they could have done instead) McGraw-Hill/Irwin Colander, Economics 4
Economic versus Accounting Profit Economists focus on both explicit and implicit costs and revenue Economic profit = (explicit + implicit revenue) (explicit + implicit cost) Accountants focus on explicit costs and revenues Accounting profit = explicit revenue explicit cost McGraw-Hill/Irwin Colander, Economics 5
Economic versus Accounting Profit When discussing costs, if a firm is making zero economic profit they are always making a positive accounting profit This is because accounting profit does not take into consideration the opportunity cost of what they could have done instead McGraw-Hill/Irwin Colander, Economics 6
Short run versus Long run In the short run a firm is limited in regard to what production decisions it can make Some inputs are fixed and cannot be changed In the long run all inputs are variable inputs and can be changed McGraw-Hill/Irwin Colander, Economics 7
The Production Function The production function tells the maximum amount of output that can be derived from a given number of inputs Note it has three stages McGraw-Hill/Irwin Colander, Economics 8
Q Graphing a Production Function 32 26 20 14 8 TP A production function is the relationship between then inputs and the outputs 2 Increasing marginal productivity 1 2 3 4 5 6 7 8 9 10 Diminishing marginal productivity Diminishing Absolute productivity Number of workers 12-9
Law of Diminishing Marginal Productivity Law of diminishing marginal productivity: as more of a variable input is added to an existing fixed input, after some point the additional output from the additional input will fall McGraw-Hill/Irwin Colander, Economics 10
Law of Diminishing Marginal Productivity # of workers Total Output Marginal Product Average Product 0 0 --- 4 1 4 4 6 2 10 5 7 3 17 5.7 6 4 23 5.8 5 5 28 5.6 3 6 31 5.2 1 7 32 4.6 0 8 32 4.0-2 9 30 3.3-5 10 25 2.5 Increasing marginal productivity Diminishing marginal productivity Diminishing Absolute productivity 12-11
The Costs of Production Fixed costs (FC) are those that are spent and cannot be changed in the period of time under consideration In the short run, a number of inputs and their costs will be fixed In the long run, there are NO fixed costs since all inputs are variable 12-12
The Costs of Production Variable costs (VC) are costs that change as output changes Workers are an example of VC Total cost (TC) is the sum of the variable and fixed costs TC = FC + VC McGraw-Hill/Irwin Colander, Economics 13
The Costs of Production Average fixed costs (AFC) equals fixed cost divided by quantity produced AFC = FC/Q Average variable costs (AVC) equals variable cost divided by quantity produced AVC = VC/Q 12-14
The Costs of Production Average total cost (ATC) equals total cost divided by quantity produced ATC = TC/Q or ATC = AFC + AVC Marginal cost (MC) is the increase in total cost when output increases by one unit MC = ΔTC/ΔQ McGraw-Hill/Irwin Colander, Economics 15
Costs of Production Table Output FC ($) VC ($) TC ($) MC ($) AFC ($) AVC ($) ATC ($) 3 50 38 88 16.67 12.66 29.33 12 4 50 50 100 12.50 12.50 25.00 9 50 100 150 5.56 11.11 16.67 8 10 50 108 158 5.00 10.80 15.80 16 50 150 200 3.13 9.38 12.51 7 17 50 157 207 2.94 9.24 12.18 22 50 200 250 2.27 9.09 11.36 10 23 50 210 260 2.17 9.13 11.30 27 50 255 305 1.85 9.44 11.29 15 28 50 270 320 1.79 9.64 11.43 32 50 400 450 1.56 12.50 14.06 12-16
The Shapes of Cost Curves The variable and total cost curves have the same shape Increasing output increases VC and TC The fixed cost curve is always constant Increasing output doesn t change FC 12-17
Graphing Total Cost Curves Total Cost 500 400 TC VC TC and VC curves increase as Q increases 300 200 100 0 4 8 12 16 20 24 28 32 FC Q FC curve is constant 12-18
The Shapes of Cost Curves The average fixed cost (AFC) curve is downward sloping Increasing output decreases AFC The marginal cost (MC), average variable cost (AVC), and average total cost curves (ATC) are U-shaped Increasing output initially leads to a decrease in MC, AVC, and ATC but eventually they increase McGraw-Hill/Irwin Colander, Economics 19
Graphing Per Unit Output Cost Curves Cost 35 30 25 MC MC, ATC, and AVC curves are U-shaped 20 15 10 ATC AVC 5 0 4 8 12 16 20 24 28 32 AFC Q AFC curve decreases 12-20
The Shapes of Cost Curves The marginal cost curve goes through the minimum points of the ATC and AVC curves (remember this) McGraw-Hill/Irwin Colander, Economics 21
Draw the Graph: Marginal Cost, AVC, and ATC Costs per unit MC ATC AVC The marginal cost curve goes through the minimum point of both the ATC and AVC curves Q 12-22
The Relationship Between Marginal Cost and Average Cost If MC > ATC, then ATC is rising If MC > AVC, then AVC is rising If MC < ATC, then ATC is falling If MC < AVC, then AVC is falling If MC = AVC and MC = ATC, then AVC and ATC are at their minimum points 12-23
Profit Maximization Using Total Revenue and Total Cost (CH 14; Not in your notes) Total Revenue= Price x Quantity Total revenue and total cost curves can be used to determine the profit-maximizing level of output Total cost is the cumulative sum of the marginal costs, plus the fixed costs Total profit is the difference between total revenue and total cost curves 14-24
Total Revenue and Total Cost Table (CH 14; Not in your notes) Q Total Revenue ($) Total Cost ($) Total Profit ($) 0 0 40-40 1 35 68-33 2 70 88-18 3 105 104 1 4 140 118 22 5 175 130 45 6 210 147 63 7 245 169 76 8 280 199 81 9 315 239 76 10 350 293 57 Production and Cost Analysis I 12 Total profit is maximized at 8 units of output 14-25
Total Revenue and Total Cost Table (CH 14; Not in your notes) Production and Cost Analysis I 12 Total Cost, Total Revenue Could see this graph in the multiple choice TC TR The total revenue curve is a straight line $280 $175 The total cost curve is bowed upward at most quantities reflecting increasing marginal cost $130 Losses 3 5 Profits 8 Losses Q Profits are maximized when the vertical distance between TR and TC is greatest 14-26
Chapter Summary Accounting profit is explicit revenue less explicit cost Economists include implicit revenue and cost in determining economic profit Implicit revenue includes the increases in the value of assets owned by the firm Implicit costs include opportunity cost of time and capital provided by owners of the firm In the long run a firm can choose among all possible production techniques; in the short run it is constrained in its choices because at least one input is fixed 12-27
Chapter Summary The law of diminishing marginal productivity states that as more of a variable input is added to a fixed input, the additional output will eventually be decreasing Costs are generally divided into fixed costs, variable costs, and marginal costs TC = FC + VC MC = ΔTC/ΔQ AFC = FC/Q AVC = VC/Q ATC = AFC + AVC 12-28
Chapter Summary The law of diminishing marginal productivity causes marginal and average costs to rise MC goes through the minimum points of the AVC and ATC If MC > ATC, then ATC is rising If MC = ATC, then ATC is constant If MC < ATC, then ATC is falling 12-29
Production and Cost Analysis II 13 CHAPTER 13 Production and Cost Analysis II Economic efficiency consists of making things that are worth more than they cost. J. M. Clark McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Production and Cost Analysis II 13 Technical Efficiency and Economic Efficiency Technical efficiency in production means that as few inputs as possible are used to produce a given output The economically efficient method of production produces a given level of output at the lowest possible cost 13-31
Production and Cost Analysis II 13 Shape of the Long run ATC The law of diminishing marginal productivity does not apply in the long run since all inputs are variable The shape of the long-run cost curve is due to the existence of economies and diseconomies of scale 13-32
Production and Cost Analysis II 13 Economies of Scale Economies of scale exist when long-run average total costs decrease as output increases These are shown by the downward sloping portion of the long-run ATC 13-33
Production and Cost Analysis II 13 Economies of Scale The minimum efficient level of production is the amount of production that spreads setup costs out sufficiently for firms to undertake production profitably This is where average total costs are at a minimum 13-34
Production and Cost Analysis II 13 Diseconomies of Scale Diseconomies of scale exist when long-run average total costs increase as output increases These are shown by the upward sloping portion of the long-run average total cost curve 13-35
Production and Cost Analysis II 13 A Typical Long run Average Total Cost Curve Costs per unit $60 $55 Minimum efficient level of production Long-run average total cost (LRATC) $50 11 Economies of scale 14 17 20 Constant returns to Diseconomies of scale scale Q 13-36
Production and Cost Analysis II 13 Constant Returns to Scale Constant returns to scale exist when average total costs do not change as output increases This is shown by the flat portion of the longrun average total cost curve Constant returns to scale occur when production techniques can be replicated again and again to increase output 13-37
Production and Cost Analysis II 13 A Typical Long run ATC Table Q TC of Labor ($) TC of Machines ($) TC ($) ATC ($) 11 381 254 635 58 12 390 260 650 54 13 402 268 670 52 14 420 280 700 50 15 450 300 750 50 16 480 320 800 50 17 510 340 850 50 18 549 366 915 51 19 600 400 1000 53 20 666 444 1110 56 ATC falls because of economies of scale ATC is constant because of constant returns to scale ATC rises because of diseconomies of scale 13-38
Production and Cost Analysis II 13 Chapter Summary An economically efficient production process must be technically efficient, but a technically efficient process may not be economically efficient The long-run average total cost curve is U-shaped because economies of scale cause average total cost to decrease; diseconomies of scale eventually cause average total cost to increase Marginal cost and short-run average cost curves slope upward because of diminishing marginal productivity 13-39
Production and Cost Analysis II 13 Chapter Summary The long-run average cost curve slopes upward because of diseconomies of scale Costs in the real world are affected by: Economies of scope Learning by doing and technological change Many dimensions to output Unmeasured costs, such as opportunity costs 13-40