Weeks 5

1
Weeks 5 6 Production and Costs
2
Structure
Weeks 7-8 Competition, market structures and
business decisions
Week 9 Pricing strategies and practices
Week 10 Business and Government.
Weeks 5 - 6 Production and Costs
Managerial Economics
Week 11 Capital budgeting
Weeks 3-4 Demand analysis and estimation
Week. 12 Research question Business and current
economic situation.
Week 2 Basic economics principles demand and
supply.
Week1 Introduction. The nature of managerial
economic decision making
3
Production and Costs
Production functions
Factors of production
Total, marginal and average product, revenue and
costs
Return to factors versus return to scale
Firm and plant size
Economies and diseconomies of scale
Optimal level of single input and optimal
combination of multiple inputs
Fixed and variable costs
Explicit and implicit costs
Short run versus long run in cost analysis
4
Production and Costs
Learning objectives

• This topic addresses the following questions
• At given demand conditions, how does a firm
  determine the optimal level of output during any
  production period?
• How does a firm choose the best technology
  (production process) out of existing ones?
• How does investment in new equipment affect
  employment and productivity of labour?
• How are costs and output interrelated?

5
Production and Costs
Reading
Hirschey, Chapters 8 and 9
6
Production and Costs
Production functions
Descriptive statement/variable that relates
inputs to outputs. Specifies the maximum
output that can be produced at a given level of
input (inputs) Is determined by the level of
technology.
7
Production and Costs
Factors of production
Labour Capital
Labour Capital Mineral resources
Land Materials Energy, Seeds Live stock Rolling
stock Rail tracks Roads Plant equipment Farm
machinery and equipment
8
Production and Costs
Factors of production
9
Returns to Scale and Returns to a Factor
Production and Costs
Factors of production

• Returns to scale measure output effect of
  proportionally increasing all inputs.
• Returns to a factor measure the output effect of
  increasing one input, while other factors are
  kept unchanged.

10
Total, Marginal, and Average Product
Production and Costs
Total, marginal and average product

• Total Product
• Total product is total output.
• Marginal product is the change in output caused
  by increasing input use.
• If MPX?Q/?Xgt 0, total product is rising.
• If MPX?Q/?Xlt 0, total product is falling (rare).
• Average product
• APXQ/X.

11
Production and Costs
Total, marginal and average product
One factor production function a numerical
example
12
Production and Costs
Total, marginal and average product
A numerical example
13
Production and Costs
Total, marginal and average product
One factor production function a numerical
example
14
Production and Costs
Return to factors
Law of Diminishing Returns to a Factor
As the quantity of variable input increases the
resulting rate of increase in output eventually
diminishes

• Concept of Diminishing Returns to a Factor
• MPX tends to diminish as use of X grows.
• If MPX grew with use of X, there would be no
  limit to input usage.
• MPXlt 0 implies irrational input use.

15
Input Combination Choice
Production and Costs
Isoquants

• Production Isoquants
• Technical efficiency is least-cost production.
• Input Factor Substitution
• Isoquant shape shows input substitutability.
• C-shaped isoquants are common and imply imperfect
  substitutability.

16
Production and Costs
Isoquants
Each point on the Isoquant represents A
different combination of two inputs that can be
used to produce the same amount of output
Marginal rate of technical substitution
The slope of the isoquant at a particular point
17
Production and Costs
Isoquants
Perfect substitution
Gas
Q

3
Q
2

Q

1
Oil
18
Production and Costs
Isoquants
Imperfect substitution
Cloth
Decrease in one factor Requires more and
more of the other one for substitution
C
1
Q
C

3
2
Q
C
2
3
Q
1
L
L
L
1
2
3
Labor
19
Production and Costs
Isoquants
Marginal rate of technical substitution
Input
Y
Marginal rate of technical substitution the
slope of an isoquant at a particular point
10
9
8
7
6
5
4
3
2
1
1
2
3
4
5
6
7
8
9
10
0
Input
X
20
Production and Costs
Return to scale
Output elasticity
21
Production and Costs
Return to scale
Increasing
returns
0.5
0.5
Constant returns (
0.8
0.7
Q

15
X
Y
)
(
Q

10
X
Y
)
Total product Q
Decreasing
returns
0.4
0.2
(
Q

20
X
Y
)
Units of Input
X
,
Y
22
Production and Costs
Marginal Revenue product
Marginal revenue product Amount of revenue
generated By employing the last input unit
In particular, used for the optimisation of
factor usage
23
Production and Costs
Optimal combination of multiple inputs
Isocost curves.
All combinations of products that can be
purchased for a fixed dollar amount
Units of
Y
12
10
Downward sloping curve.
8
B
1,000
1
B
2,000
2
6
B
3,000
3
4
2
Units of
X
0
2
4
6
24
Production and Costs
Optimal combination of multiple inputs
Optimal combination corresponds to the point of
tangency of the isoquant and isocost.
Units of
Y
B
3
B
2
B
1
Expansion path
Y
3
C
Y
2
B
Y
1
A
Q
3
Q
2
Q
1
X
X
X
2
1
3
Units of
X
25
Production and Costs
Optimal combination of multiple inputs

• Budget Lines
• Least-cost production occurs when MPX/PX MPY/PY
  and PX/PY MPX/MPY
• Expansion Path
• Shows efficient input combinations as output
  grows.
• Illustration of Optimal Input Proportions
• Input proportions are optimal when no additional
  output could be produced for the same cost.
• Optimal input proportions is a necessary but not
  sufficient condition for profit maximization.

Optimal combination corresponds to the point of
tangency isoquant and isocost.
Units of
Y
B
3
B
2
B
1
Expansion path
Y
3
C
Y
2
B
Y
1
A
Q
3
Q
2
Q
1
X
X
X
2
1
3
Units of
X
26
Production and Costs
Optimal combination of multiple inputs

• Profits are maximized when MRPX PX for all
  inputs.
• Profit maximization requires optimal input
  proportions plus an optimal level of output.

Optimal combination corresponds to the point of
tangency isoquant and isocost.
Units of
Y
B
3
B
2
B
1
Expansion path
Y
3
C
Y
2
B
Y
1
A
Q
3
Q
2
Q
1
X
X
X
2
1
3
Units of
X
27
What Makes Cost Analysis Difficult?
Production and Costs
Costs analysis

• Link Between Accounting and Economic Valuations
• Accounting and economic costs often differ.
• Historical Versus Current Costs
• Historical cost is the actual cash outlay.
• Current cost is the present cost of previously
  acquired items.
• Replacement Cost
• Cost of replacing productive capacity using
  current technology.

28
Opportunity Cost
Production and Costs
Costs analysis

• Opportunity Cost Concept
• Opportunity cost is foregone value.
• Reflects second-best use.

29
Explicit and implicit cost
Production and Costs
Costs analysis

• Explicit out-of-pocket
• Wages
• Utilities
• Materials
• Interest
• Rent
• Implicit
• Forgone earning if not explicitly spent for the
  chosen alternative

30
Incremental and Sunk Costs in Decision Analysis
Production and Costs
Costs analysis

• Incremental Cost
• Incremental cost is the change in cost tied to a
  managerial decision.
• Night shift
• New production line
• New production plant
• New (additional) product
• Incremental cost can involve multiple units of
  output.
• (Marginal cost involves a single unit of output.)

31
Incremental and Sunk Costs in Decision Analysis
Production and Costs
Costs analysis

• Sunk Cost
• Irreversible expenses incurred previously.
• Sunk costs are irrelevant to present decisions.
• Cost of bidding for contract
• Cost of failed project

32
Accounting and Economic Valuations
Production and Costs
Costs analysis

• Accounting actual
• Economic - actual alternative

33
Historical vs Current Costs
Production and Costs
Costs analysis

• Historical for accounting purposes
• Current based on prevailing market conditions
  for short-run decision making
• Future forecasted for long-run decision making
• Replacement - what is required to renew the
  productive capacity at the existing technology
  for efficiency evaluation

34
Short and long run in managerial economics
Production and Costs
Short run and long run costs

• Short run operating decisions are made
• At least one input is fixed
• Long run planning decisions are made
• Complete flexibility of inputs
• No fixed costs

35
Production and Costs
Short run and long run costs
Short run costs

• Short-run Cost Categories
• Total Cost Fixed Cost Variable Cost
• For averages, ATC AFC AVC
• Marginal Cost, MC ?TC/?Q
• Short-run Cost Relations
• Short-run cost curves show
• minimum cost in a given
• production environment.

per time period
MC
ATC
AVC
AFC

• TCTFCTVC
• AFCTFC/Q
• AVCTVC/Q
• ATC/TC/Q
• MC?TC/ ?Q ? TVC/Q

Q
Q
Q
3
2
1
Output per time period (units)
(
b
) Unit costs
36
Long-run Cost Curves
Production and Costs
Short run and long run costs

• Economies of Scale
• Long-run cost curves show minimum cost in an
  ideal environment.

37
Production and Costs
Short run and long run costs
Short run costs
per time period
Total
cost
Decreasing
Increasing
returns
returns
Output per time period (units)
38
Production and Costs
Short run and long run costs
Short run costs
Output per
time period (units)
Total product
Decreasing
returns
Increasing
returns
Input per time period (units)
39
Cost Elasticity and Economies of Scale
Production and Costs
Short run and long run costs

• Cost elasticity is eC ?C/C ?Q/Q.
• eC lt 1 means falling AC, increasing returns.
• eC 1 means constant AC constant returns.
• eC gt 1 means rising AC, decreasing returns.

40
Production and Costs
Short run and long run costs
Long run costs
per unit
of output
SRAC
A
SRAC
SRAC
B
C
SRAC
M
D

Q
Q
Q
Q
1
2
3
Output per time period (units)
41
Production and Costs
Short run and long run costs
Long run costs
per unit of output
Long-run average cost
Minimum LRAC
Least-cost plant
Q
Output per time period (units)
42
Firm Size and Plant Size
Production and Costs
Short run and long run costs

• Multi-plant Economies and Diseconomies of Scale
• Multi-plant economies are cost advantages from
  operating several plants.
• Multi-plant diseconomies are cost disadvantages
  from operating several plants.

43
Production and Costs
Short run and long run costs
Long run costs, return to scale and the optimal
size of plant and firm
Q - the size of plant QF The size of firm
Cost per unit
Cost per unit
Cost per unit
Long-run average cost
Long-run average cost
Long-run average cost
Q

Q

Q

Q


Q

Q




F
F
F
Output
Output
Output
(a)
Constant costs Constant return to scale
(b)
Declining costs- Increasing return to scale
(c)
U-shaped cost curve Decreasing return to
scale
44
Production and Costs
Short run and long run costs
Long run costs, return to scale and the optimal
size of plant and firm
per unit
625
of output
MR
500
MC
Single Plant
375
AC
Single Plant
250
MC
Multiplant
125
0
5,000
10,000
15,000
20,000
Units of output
45
Cost-volume-profit Analysis
Production and Costs
Short run and long run costs

• Cost-volume-profit Charts
• Cost-volume-profit analysis shows effects of
  varying scale.
• Breakeven analysis shows zero profit points of
  cost coverage.

46
Production and Costs
Short run and long run costs
Cost output profit analysis
Net
profit
240
per time period
Profit
Total Revenue
210
(000)
180
Total Cost
150
Variable
cost
120
Breakeven point
90
Fixed cost
Loss
60
Fixed
30
cost
0
10
20
30
40
50
60
70
80
Units produced and sold per time period (000)
47
Production and Costs
Short run and long run costs
Firm
A
Selling price 2.00
Income and
Fixed cost 20,000
costs
xQ
Variable cost 1.50
240
200
Units
Total Revenue
Sales
Cost
Profit
sold (
Q
)
160
Breakeven
20,000
40,000
50,000

10,000
Total Cost
120
point
40,000
80,000
80,000
0
60,000
120,000
110,000
10,000
80
80,000
160,000
140,000
20,000
40
100,000
200,000
170,000
30,000
Fixed cost
120,000
240,000
200,000
40,000
0
20
40
60
80
100
120
Units (
Q
)
48
Sample exam questions on consumer demand

• Among other goods and services, bananas and
  apples are standard consumer basket components.
  Both are normal goods. Assuming all other
  factors unchanged and using an appropriate theory
  explain the income, substitution, and total
  effects on consumption following a price for
  bananas decrease.
• OR
• During the past 40 years the average price of a
  new single-family home has risen by a factor of
  ten, making the cost of housing prohibitive for
  many Australians. Over the same time frame,
  however, the number of new house approvals per
  year has considerably increased. Are these data
  inconsistent with the idea of a downward-sloping
  demand curve for new housing? Illustrate you
  answer using an appropriate diagram.

49
Sample exam question on productivity and costs

• A. Outline some potential way for increasing
  companys productivity
• In the long run
• In the short run
• B. Using an appropriate diagram, demonstrate, how
  increase in labour productivity affects total,
  average and marginal cost of a company, producing
  a homogenous product.
• C. Explain why company productivity is important
  to managers, employees, and investors.
• D. Is superior worker productivity a necessary
  and sufficient condition for above-average
  compensation? Explain.