Economics for Managers

by
y Paul Farnham

Chapter 5:
Production and Cost Analysis
in the Short Run

© 2005 Prentice Hall, Inc. 5.1

 Defining the
P d ti
Production Function
F ti
The formula can be read as “quantity
quantity of
output is a function of the inputs
listed inside the parentheses”

Q = f (L, K, M…)
where
Q = quantity of output
L = quantity of labor input
K = quantity
y of capital input
M = quantity of materials input
© 2005 Prentice Hall, Inc. 5.2
 Fixed Inputs Versus
V i bl Inputs
Variable I t

ƒ Fixed input: quantity a manager

cannot change
g during g a given
g
time
ƒ Variable input: quantity a manager
can change during a given time
ƒ Amount of output would vary as
managers made decisions
regarding amounts of input
© 2005 Prentice Hall, Inc. 5.3
 Short-run Versus
L
Long-run P d ti
Production

ƒ Not expressed in terms of

calendar time,, but in terms of
fixed and variable inputs
ƒ Short
Short-run
run production function:
involves at least one fixed input
ƒ Long-run
Long run production function:
production process in which all
inputs are variable
© 2005 Prentice Hall, Inc. 5.4
 Managerial Rule of Thumb:
Short-run
Short run Production and
Long-run Planning

ƒ Managers operate in the short

run, but must have long-run
vision
i i
ƒ They need to be aware that the
currentt amountt off fixed
fi d inputs
i t
may not be appropriate as market
conditions change
ƒ Managers make more long run
economic decisions
© 2005 Prentice Hall, Inc. 5.5
 Model of the Short-run
P d ti
Production Function
F ti
Total product: total quantity of output
produced with a given quantity of
fixed and variable inputs

TP or Q = f (L, K)
where
TP or Q = total p
product or quantity
q y
of output
L = quantity of labor input
K = quantity of capital input
© 2005 Prentice Hall, Inc. 5.6
 Average Product

d t amountt off
Average product:
A
output per unit of variable input

AP = TP / L or Q / L

where
AP = The average product of labor

© 2005 Prentice Hall, Inc. 5.7

 Marginal Product

Marginal
M d t the
i l product: th additional
dditi l
output produced with an
additional unit of variable input

MP = ΔTP / ΔL = ΔQ / ΔL
where
MP = The marginal product of labor

© 2005 Prentice Hall, Inc. 5.8

 Total Product: Short-run
Production Function
Figure 5.1a

Law of diminishing
returns where marginal
product eventually
decreases

TP

0 L
L1 L2 L3
© 2005 Prentice Hall, Inc. 5.9
 TP: Short-run
P d ti
Production Function
F ti

ƒ TP increases rapidly up to level of

labor input L1 then increases at a
slower rate as labor input increases
ƒ TP curve becomes flatter and flatter
until it reaches maximum output
level at L3
ƒ Curve implies that marginal product
of labor first increases rapidly then
decreases, eventually becoming
zero or less
© 2005 Prentice Hall, Inc. 5.10
 AP and MP: Short-run
Production Function
Figure 5.1b

MP

AP

0 L
L1 L2 L3
© 2005 Prentice Hall, Inc. 5.11
 AP and MP: Short-run
Production Function

ƒ Between zero and L2, MP curve

lies above AP curve, causing AP
curve to increase
ƒ Below L2, MP curve is below AP
curve, causing AP curve to
decrease
ƒ Therefore, MP curve must
intersect AP curve at maximum
point
i t off AP curve
© 2005 Prentice Hall, Inc. 5.12
 Economic Explanation

ƒ Increasing marginal returns:

region where MP curve is positive
and
d increasing
i i
ƒ Law of diminishing returns:
region
i where
h marginal
i l product
d t
curve is positive but decreasing
ƒ Negative
N ti marginal
i l returns:
t region
i
where product curve is negative
so that TP is decreasing
© 2005 Prentice Hall, Inc. 5.13
 Law of Diminishing
R t
Returns

ƒ Additional output generated by

additional units of variable input
p
(MP) is decreasing

ƒ Occurs because capital input and

technologies are held constant

© 2005 Prentice Hall, Inc. 5.14

 Productivity Changes
A
Across I
Industries
d t i

Q = f (K, L, E, M, t)
where
Q = industry output
K = capital services
L = labor services
E = energy use
M = materials use
t = level of technology
© 2005 Prentice Hall, Inc. 5.15
 Model of Short-run
C t Functions
Costs F ti

ƒ Cost function: shows relationship

between cost of p
production and
level of output
ƒ Opportunity cost: reflects use of
resources in one activity while
foregoing
g g another

© 2005 Prentice Hall, Inc. 5.16

 Model of Short-run
C t Functions
Costs F ti

ƒ Explicit cost: payment to an

individual that is recorded in an
accounting system
ƒ Implicit costs: value of using a
resource that is not explicitly paid
out,, is often difficult to measure,,
and not recorded in an accounting
system

© 2005 Prentice Hall, Inc. 5.17

 Measuring
O
Opportunity
t it Cost
C t

ƒ Prices that a firm pays for input

reflects opportunity cost
ƒ If managers do not recognize
opportunity costs, they may have
t
too muchh invested
i t d in
i buildings
b ildi or
other assets
ƒ Historic
Hi t i cost: t amountt off money a
firm paid for an input when it was
purchased
© 2005 Prentice Hall, Inc. 5.18
 Accounting Profit and
E
Economic
i Profit
P fit

ƒ Profit: difference between total

revenue and total cost of
production
d ti
ƒ Accounting profit: difference
b t
between total
t t l revenue and d total
t t l
explicit cost
ƒ Economic
E fit difference
i profit: diff
between total revenue and total
costs, both implicit and explicit
© 2005 Prentice Hall, Inc. 5.19
 Managerial Rule of Thumb:
I
Importance
t off Opportunity
O t it Costs
C t

ƒ Measuring opportunity costs can

be difficult because accountants
are trained to examine explicit
costs
ƒ Managers need to take into
account both types
yp of costs
(explicit and opportunity costs)

© 2005 Prentice Hall, Inc. 5.20

 Short-run
Short run Cost Functions

ƒ Short-run cost function: shows

relationship p between output
p and
costs based on underlying short-
run production function
ƒ It is a cost function for short-run
production process
p p in which there
is at least one fixed unit of
production

© 2005 Prentice Hall, Inc. 5.21

 Costs

ƒ Total fixed cost: cost of using

fixed input
p
ƒ Total variable cost: price per unit
of labor times quantity of labor
input
ƒ Total cost: sum of total fixed cost
plus total variable costs

© 2005 Prentice Hall, Inc. 5.22

 Costs

ƒ Average
A fi d cost: totall fixed
fixed fi d cost
per unit of output
ƒ Average variable cost: total variable
cost per unit of output
ƒ Average total cost: total cost per
unit of output plus average variable
cost
ƒ Marginal cost: additional cost of
producing additional units of output
© 2005 Prentice Hall, Inc. 5.23
 Total, Average, and
M
Marginal
i l Cost
C t

ƒ AFC decreases continuously as

more output
p is produced
p
ƒ Since TFC is constant, AFC must
decline as output increases
ƒ AVC and ATC first decrease then
increase
ƒ ATC always equals AFC plus AVC

© 2005 Prentice Hall, Inc. 5.24

 TC, TCV, TFC Functions
Figure 5.2a

TC TVC

TFC

0 Q
Q1 Q2 Q3
© 2005 Prentice Hall, Inc. 5.25
 MC, ATC, AVC,
and
d AFC Functions
F ti
Figure 5.2b

MC
ATC
AVC

AFC
0
Q1 Q2 Q3 Q
© 2005 Prentice Hall, Inc. 5.26
 Short-run
P d ti
Production and
d Cost
C t

MC

AP AVC

MP
0 0
L1 L2 L Q1 Q2 Q
© 2005 Prentice Hall, Inc. 5.27
 Managerial Rule of Thumb:
U d
Understanding
t di Your
Y Costs
C t

M
Managers need
d to
t understand
d t d
• Technology and prices paid for
iinputs
t off production
d ti
• Difference between variable and fixed
costs
t
• Difference between average costs
(costs per unit of output) and
marginal costs (additional costs of
producing
p g additional units of output)
p )

© 2005 Prentice Hall, Inc. 5.28

 Econometric Estimation
off C
Costt F
Functions
ti
ƒ Dean’s
D ’ studies
t di off a furniture
f it factory,
f t
a leather belt shop, 1976
ƒ Johnston’s
J h t ’ study
t d off British
B iti h electric
l ti
generating plants, road passenger
transport and food processing firm,
transport, firm
1960
ƒ Hall,
Hall 1986
ƒ Blinder, et al, 1990s

© 2005 Prentice Hall, Inc. 5.29

 Summary of Key Terms

ƒ Accounting profit ƒ Explicit cost

ƒ Average
g fixed ƒ Fixed input
p
cost ƒ Historic cost
ƒ Average product ƒ Implicit cost
ƒ Average total cost ƒ Marginal returns
ƒ Average variable ƒ Diminishing returns
costt
ƒ Long-run production
ƒ Cost function functions
ƒ Economic profit
© 2005 Prentice Hall, Inc. 5.30
 Summary of Key Terms

ƒ Marginal cost ƒ Total

T t l costt
ƒ Marginal product ƒ Total fixed cost
ƒ Negative
N ti marginal
i l ƒ Total product
returns
ƒ Production function ƒ Opportunity
pp y
cost
ƒ Short-run
production function ƒ Total variable
cost
ƒ Short-run cost
function ƒ Variable input
p

© 2005 Prentice Hall, Inc. 5.31