Micro Economie: Lecture 4

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Micro Economie Lecture 4
PRODUCTION AND COSTS
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COSTS

• TWO BASIC TYPES
• Production costs
• Organisation/co-ordination costs (Transaction
  costs)

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The costs of production

• Michael Porter (1985) cost drivers
• Four of these cost drivers are of particular
  importance
• Capacity utilisation the intensity of
  utilisation of a firms resources.
• Economies and/or diseconomies of scale.
• Learning and/or experience effects.
• Economies and/or diseconomies of scope.
• THE PRODUCTION FUNCTION
• Q f (K, L)
• K capital, L labour

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Production time periods

• An input is fixed if it does not vary with the
  quantity of output.
• An input is variable if the quantity employed
  varies with the firms output. e.g. a blast
  furnace electricity consumption.
• But fixity is not primarily a physical property
  it is a matter of contracts.

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Two production time periods

• The Short Run is that period during which at
  least one input is fixed.
• The Long Run is that period during which all
  factors are considered to be variable.
• Aspects
• Think about the short run and the long run as
  different types of planning periods
• The long run a hypothetical state in which
  decisions are not hemmed in by any input
  constraints.
• Choices constrained in the short run by legacies
  of past choices fixed inputs (and so fixed
  costs).

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Production and costs in the short run

• How do production costs vary with the level of
  output?
• Two counteracting forces
• Spreading of fixed costs
• Diminishing returns at the margin.
• A set of cost measures for use in subsequent
  analysis
• Let C Total Cost and Q Total Output
• Average Cost (AC) C/Q
• Marginal Cost (MC) ?C/?Q

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AFC and AVC in relation to output Q
AFC
AVC
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AC and MC in relation to output Q
MC
AC
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Production and costs in the long run

• In the long run, the firm is in a position where
  it can make strategic choices about
• its scale of output
• its output mix (its scope of output)
• the length of its production runs
• the locations of its production units.

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K
Q125
Q100
Q75
Q50
L
Fig 5.8 Isoquants from the Cobb-Douglas
production function
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Fig 5.3 Substitution possibilities for three
production functions
L
16.67
Q min5K,5L Q50
10
0
Q2K3L Q50
25
K

10
12
K
L
Fig 5.9 Isocost lines
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K
K100
Q100
L
L100
Fig 5.10 A cost-minimising input choice
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K
d
c
4
b
3
a
2
1
L
Fig 5.11 The firms expansion path
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LRAC
0
Output scale per period
Fig 5.14a Constant returns to scale
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LRAC
0
Output scale per period
Fig 5.14b Diseconomies of scale
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LRAC
0
Output scale per period
Fig 5.14bc Economies of scale
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LRAC
0
Output scale per period
Fig 5.15 The L-shaped long-run average cost curve
and the minimum efficient technical scale
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Firm Y (each plant)
SRACy
Firm X
SRACX
LRAC
0
100 million
25 million
Output per period
Fig 5.18 Long-run and short-run average costs
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Long run average costs in European car production
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The METS for processes within car making
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Other cost advantages

• ECONOMIES OF SCOPE
• Many firms produce a variety of goods, which
  suggests that there may be cost advantages
  available to firms which do this. One source of
  this advantage is economies of scope.
• Where cost complementarity occurs in the
  production of two or more goods.
• Where a number of related goods are produced
  using a common process or input
• The commonality need not be tangible. e.g. RD,
  Reputation.
• CUMULATIVE SCALE ECONOMIES
• e.g. The development of a jet aircraft
• LEARNING OR EXPERIENCE EFFECTS

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Output of cars per period
A
D
C
0.5A
0
0.5B
B
Output of lorries per period
Fig 5.16 Economies of scope
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US refining cost
(for refinery of given capacity and complexity,
1940 - 1973)
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The experience effect at Ford
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Costs and firms
Economic activity within firms also involves
costs We may call these organisation
costs They are the costs of establishing and
operating the organisational hierarchy But, a
firm may be able to deal with the problems we
mentioned earlier more effectively than can be
done through pure market contracting
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Costs and firms

• Implications
• Firms develop whenever the costs of transactions
  through markets exceed the costs of organising
  and co-ordinating production within firms.
• Their boundaries and structures depend on these
  relative costs and their changes over time.
• We shall see later how this affects
• Horizontal integration
• Vertical integration
• Diversification/conglomeration
• Networks/cooperation
• Supply chain relationships

• Examples
• Telephone call centres.
• UK insurance industry.
• UK car industry.