Production and Cost

1
Production and Cost

Hall and Lieberman, 3rd edition, Thomson
South-Western, Chapter 6
2
Overview

• What you will learn from this lecture
• Business firm and the time horizon related
  problems
• Total and marginal product
• Law of diminishing returns
• Different types of costs explicit versus
  implicit costs, and fixed versus variable costs
  and sunk costs
• Total cost in terms of total fixed cost and total
  variable cost
• Marginal cost
• The least-cost rule
• Long-run average total cost curve in terms of
  economies of scale, constant returns to scale,
  and diseconomies of scale.
• Minimum efficient scale (MES) and how many firms
  will serve a market.

3
Part I The Nature of Firm

• What is a business firm?
• An organization, owned and operated by private
  individuals, that specializes in production
• Production is the process of combining inputs to
  make outputs

4
The Nature of the Firm

• The firm must deal with a variety of individuals
  and organizations
• Sells its output to customers
• Receives revenue from them in return
• Every firm must deal with the government
• Pays taxes to the government
• Must obey government laws and regulations
• Receive valuable services from the government
• Legal systems
• Financial systems

5
Profit

• Where does the revenue go?
• Much of it goes to input suppliers
• The total of all of these payments makes up the
  firms costs of production
• Profit Revenue Costs

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Fig. 1 The Firm and Its Environment
7
Part II Production

• Inputs include resources
• Labor
• Capital
• Land
• Raw materials
• Other goods and services provided by other firms
• Way in which these inputs may be combined to
  produce output is the firms technology
• Treated as a given
• For each different combination of inputs, the
  production function tells us the maximum quantity
  of output a firm can produce over some period of
  time

8
Figure 2 The Firms Production Function
9
Time Horizon -- The Short Run and the Long
Run

• Useful to categorize firms decisions into
• Long-run decisionsinvolves a time horizon long
  enough for a firm to vary all of its inputs
• To guide the firm over the next several years
  (long run lens)
• Short-run decisionsinvolves any time horizon
  over which at least one of the firms inputs
  cannot be varied
• To determine what the firm should do next week (
  short run lens)

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Production in the Short Run

• There is nothing they can do about their fixed
  inputs
• Stuck with whatever quantity they have
• However, can make choices about their variable
  inputs
• Fixed inputs
• An input whose quantity must remain constant,
  regardless of how much output is produced
• For example
• Variable input
• An input whose usage can change as the level of
  output changes
• For example

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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) is the change in
  total product (?Q) divided by the change in the
  number of workers hired (?L)

• Tells us the rise in output produced when one
  more worker is hired

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Figure 3 Total and Marginal Product
Total Product
196
184
161
DQ from hiring fourth worker
130
DQ from hiring third worker
90
DQ from hiring second worker
30
DQ from hiring first worker
increasing marginal returns
diminishing marginal returns
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Marginal Returns To Labor

• As more and more workers are hired
• MPL first increases
• Then decreases
• Pattern is believed to be typical at many types
  of firms

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Increasing Marginal Returns to Labor

• When the marginal product of labor increases as
  employment rises, we say there are increasing
  marginal returns to labor
• Each time a worker is hired, total output rises
  by more than it did when the previous worker was
  hired

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Diminishing Returns To Labor

• When the marginal product of labor is decreasing
• There are diminishing marginal returns to labor
• Output rises when another worker is added so
  marginal product is positive
• But the rise in output is smaller and smaller
  with each successive worker
• Law of diminishing (marginal) returns states that
  as we continue to add more of any one input
  (holding the other inputs constant)
• Its marginal product will eventually decline

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Part III Costs

• A firms total cost of producing a given level of
  output is the opportunity cost of the owners
• Explicit (involving actual payments)
• Money actually paid out for the use of inputs
• Implicit (no money changes hands)
• The cost of inputs for which there is no direct
  money payment
• This is the core of economists thinking about
  costs
• Cost is measured in dollars in this chapter

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Economic Profit vs Accounting Profit

• Accounting profit
• The businesss revenue minus the explicit cost
  and depreciation
• Depreciation occurs because machines war out over
  time
• Economic profit
• The businesss revenue minus opportunity cost
• In economics, profit is simplification of
  economic profit.

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The Irrelevance of Sunk Costs

• Sunk cost is one that already has been paid, or
  must be paid, regardless of any future action
  being considered
• Should not be considered when making decisions
• Even a future payment can be sunk
• If an unavoidable commitment to pay it has
  already been made

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Costs in the Short Run

• Fixed costs
• Costs of a firms fixed inputs
• Variable costs
• Costs of obtaining the firms variable inputs

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Measuring Short Run Costs Total Costs

• Types of total costs
• Total fixed costs
• Cost of all inputs that are fixed in the short
  run
• Total variable costs
• Cost of all variable inputs used in producing a
  particular level of output
• Total cost
• Cost of all inputsfixed and variable
• TC TFC TVC

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Figure 4 The Firms Total Cost Curves In The
Short Run
TC
TVC
TFC
TFC
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Average Costs

• Average fixed cost (AFC)
• Total fixed cost per unit of output produced

• Average variable cost (TVC)
• Total variable cost per unit of output produced

• Average total cost (TC)
• Total cost per unit of output produced

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Marginal Cost

• Marginal Cost
• Increase in total cost from producing one more
  unit or output
• Marginal cost is the change in total cost (?TC)
  divided by the change in output (?Q)

• Tells us how much cost rises per unit increase in
  output
• Marginal cost for any change in output is equal
  to shape of total cost curve along that interval
  of output

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Figure 5 Average And Marginal Costs In The
Short Run
MC
AFC
ATC
AVC
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The Shape of the Marginal Cost Curve

• When the marginal product of labor (MPL) rises
  (falls), marginal cost (MC) falls (rises)
• Since MPL ordinarily rises and then falls, MC
  will do the oppositeit will fall and then rise
• Thus, the MC curve is U-shaped

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The Relationship Between Average And Marginal
Costs

• At low levels of output, the MC curve lies below
  the AVC and ATC curves
• These curves will slope downward
• At higher levels of output, the MC curve will
  rise above the AVC and ATC curves
• These curves will slope upward
• As output increases the average curves will
  first slope downward and then slope upward
• Will have a U-shape
• MC curve will intersect the minimum points of the
  AVC and ATC curves

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Production And Cost in the Long Run

• Goal earn the highest possible profit
• To do this, it must follow the least cost rule
• To produce any given level of output the firm
  will choose the input mix with the lowest cost
• Firm must decide what combination of inputs to
  use in producing any level of output
• 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
• Long-run average total cost (LRATC)
• The cost per unit of output in the long run, when
  all inputs are variable

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The Relationship Between Long-Run And Short-Run
Costs

• For some output levels, LRTC is smaller than TC
• Long-run total cost of producing a given level of
  output can be less than or equal to, but never
  greater than, short-run total cost (LRTC TC)
• Long-run average cost of producing a given level
  of output can be less than or equal to, but never
  greater than, shortrun average total cost (LRATC
  ATC)

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Plant Size

• Plant - collection of fixed inputs at a firms
  disposal
• Can distinguish between the long run and the
  short run
• In the long run, the firm can change the size of
  its plant
• In the short run, it is stuck with its current
  plant size

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Average Cost And Plant Size

• ATC curve tells us how average cost behaves in
  the short run, given plant size fixed
• moving along the current ATC curve
• To produce any level of output in the long run,
  the firm will always choose that ATC curve with
  lowest ATC among all of the ATC curves available
• move from one ATC curve to another by varying the
  size of its plant
• Will also be moving along its LRATC curve
• This insight tells us how we can graph the firms
  LRATC curve

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Figure 7 Long-Run Average Total CostFor each
output level, firm will always choose to operate
on the ATC curve with the lowest possible cost
ATC1
LRATC
ATC3
ATC0
ATC2
C
D
B
E
A
175
Use 0 automated lines
Use 1 automated lines
Use 2 automated lines
Use 3 automated lines
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Part IV Economics of Scale

• According to whether the LRATC decreases / does
  not change / increase as output increases, there
  are three types of issues
• Economies of scale (decreasing LRATC) at
  relatively low levels of output
• Constant returns to scale (constant LRATC) at
  some intermediate levels of output
• Diseconomies of scale (increasing LRATC) at
  relatively high levels of output
• LRATC curves are typically U-shaped

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Figure 8 The Shape Of LRATC
LRATC
0
Economies of Scale
Constant Returns to Scale
Diseconomies of Scale
Units of Output
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Economies of Scale

• An increase in output causes LRATC to decrease
• The more output produced, the lower the cost per
  unit
• LRATC curve slopes downward
• Long-run total cost rises proportionately less
  than output
• Increasing return to scale
• Example

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Why Should A Firm Experience The Economies of
Scale?

• Gains from specialization
• greatest opportunities for increased
  specialization at a relatively low level of
  output
• More efficient use of lumpy inputs
• Some types of inputs cannot be increased in tiny
  increments, but rather must be increased in large
  jumps, therefore must be purchased in large lumps
• Low cost per unit is achieved only at high levels
  of output
• More efficient use of lumpy inputs will have more
  impact on LRATC at low levels of outputs

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Diseconomies of Scale

• LRATC increases as output increases
• LRATC curve slopes upward
• LRTC rises more than in proportion to output
• More likely at higher output levels
• As output continues to increase, most firms will
  reach a point where bigness begins to cause
  problems
• True even in the long run, when the firm is free
  to increase its plant size as well as its
  workforce

37
Using the Theory Long Run Costs, Market
Structure and Mergers

• The number of firms in a market is an important
  aspect of market structure a general term for
  the environment in which trading takes place
• What accounts for these differences in the number
  of sellers in the market?
• Shape of the LRATC curve plays an important role
  in the answer

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LRATC and the Size of Firms

• Minimum efficient scale (MES) for the firm
• Lowest level of output at which it can achieve
  minimum cost per unit
• The output level at which the LRATC first hits
  bottom
• By comparing the MES (from LRATC curve) for the
  typical firm and and the maximum potential
  market (from the market demand curve)
• we may say something about the market structure

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Two Extreme Cases - 1

• MES far smaller than market quantities demanded
• firms that are relatively small will have a cost
  advantage over relatively large firms
• economies of scale are exhausted rapidly
• Market should be populated by many small firms,
  each producing for only a tiny share of the
  market
• Examples market for personal services
• Figure 9(a)

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Figure 9(a) Many Small Firms
LRATCTypical Firm
F
E
DMarket
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Two Extreme Cases - 2

• There are significant economies of scale that
  continue as output increases
• Even to the point where a typical firm is
  supplying the maximum possible quantity demanded
• This market will gravitate naturally toward
  monopoly
• A single seller in the market
• Examples regular mail delivery, city subway
  system, etc
• Figure 9(b)

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Figure 9(b) Monopoly
LRATCTypical Firm
DMarket
43
Other Cases

• In some cases the MES occurs at 25 of the
  maximum potential market
• In this type of market, expect to see a few large
  competitors
• Significant lumpy inputs creating economies of
  scale
• Until each firm has expanded to produce for a
  large share of the market
• Figure 9(c)

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Figure 9(c)A Few Large Firms in the market
LRATCTypical Firm
H
F
E
DMarket
45
Other Cases

• When both small and large firms can have equally
  low average costs with neither having any
  advantage over the other
• Firms of varying sizes can coexist
• Figure 9(d)
• diseconomies of scale dont set in until output
  exceeds 10,000 units

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Figure 9(d)Coexistence of Large and Small Firms
LRATCTypical Firm
E
F
DMarket
47
The Urge To Merge

• If by doubling their output, firms could slide
  down the LRATC curve in Figure 9, and enjoy a
  significant cost advantage over any other,
  still-smaller firm, they would
• This is a market that is ripe for a merger wave
• A sudden merger wave is usually set off by some
  change in the market
• Market structure in generaland mergers and
  acquisitions in particularraise many important
  issues for public policy
• Low-cost production can benefit consumersif it
  results in lower prices