CHAPTER

Production and Cost

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Production
Profit
Total revenue minus total cost

Business firm
Organization, owned and operated by private individuals Specializes in production

Production
Process of combining inputs to make goods and services

Production
Technology
Methods available for combining inputs to produce a good or service

Assumption
Production technology Firm uses only two inputs: capital and labor

Long run
A time horizon long enough for a firm to vary all of its inputs

Production
Variable input
An input whose usage can change over some time period

Fixed input
An input whose quantity must remain constant over some time period

Short run
A time horizon during which at least one of the firms inputs cannot be varied

Production in the Short Run

Total product
The maximum quantity of output that can be produced from a given combination of inputs E.g.: maximum output for each number of workers

Total product curve

Horizontal axis: number of workers Vertical axis: total product

Table

Short-Run Production at Spotless Car Wash

Production in the Short Run

Marginal product of labor (MPL= Q/L)
The additional output produced when one more worker is hired Change in total product (Q) divided by the change in the number of workers employed (L) Tells us the rise in output produced when one more worker is hired

Production in the Short Run

Increasing marginal returns to labor
The marginal product of labor increases as more labor is hired

Diminishing marginal returns to labor

The marginal product of labor decreases as more labor is hired

Law of diminishing (marginal) returns

As we continue to add more of any one input, holding the other inputs constant Its marginal product will eventually decline

Figure 1
Total and Marginal Product
Units of output 196 184 160 130 90 Q from hiring second worker = 60 30 1 Increasing marginal returns Q from hiring first worker = 30 2 3 4 5 6 Number of workers Q from hiring fourth worker = 30 Q from hiring third worker = 40 Total product

Diminishing marginal returns

Thinking About Costs

A firms total cost
Of producing a given level of output Is the opportunity cost of the owners
Everything they must give up in order to produce that amount of output Implicit and explicit costs

Thinking About Costs

Sunk cost
Cost that has been paid or must be paid Regardless of any future action being considered Should not be considered when making decisions

Thinking About Costs

Explicit costs
Involve actual payments

Implicit costs
No money changes hands
Forgone rent Forgone interest Forgone labor income

Table

A Firms Costs

Thinking About Costs

Least-Cost Rule
A firm produces any given output level using the lowest cost combination of inputs available

Least-cost input combination depends on

Nature of the firms technology Prices the firm must pay for its inputs Time horizon for the firms planning

Cost in the Short Run

Fixed costs
Costs of fixed inputs Remain constant as output changes

Variable costs
Costs of variable inputs Change with output

Table

Short-Run Costs for Spotless Car Wash

Cost in the Short Run

Total fixed cost (TFC)
The cost of all inputs that are fixed in the short run

Total variable cost (TVC)

The cost of all variable inputs used in producing a particular level of output

Total cost (TC = TFC + TVC)

The costs of all inputs, fixed and variable, used to produce a given output level in the short run

Figure 2
The Firms Total Cost Curves
Dollars $870 750 630 510 390 270 TFC Units of Output TFC = $150 TC TVC

30

90

130

160

184

At any level of output, total cost (TC) is the sum of total fixed cost (TFC) and total variable cost (TVC)

Cost in the Short Run

Average fixed cost (AFC = TFC / Q)
Total fixed cost divided by the quantity of output produced

Average variable cost (AVC = TVC / Q)

Total variable cost divided by the quantity of output produced

Average total cost (ATC = TC / Q)

Total cost divided by the quantity of output produced

Cost in the Short Run

Marginal cost (MC = TC / Q)
The increase in total cost from producing one more unit of output It tells us how much cost rises per unit increase in output

Figure 3
Average and Marginal Costs
Dollars $10 8 6 4 2
Average variable cost (AVC) and average total MC cost (ATC) are Ushaped, first decreasing and then increasing. Average fixed cost (AFC), the vertical distance between ATC and AVC, becomes smaller as output ATC increases. The marginal cost (MC) curve is also AVC U-shaped, reflecting first increasing and then diminishing marginal returns to labor. MC passes through the minimum points of both the AVC and ATC curves.

AFC

30

90

130

160

184 196

Units of Output

Cost in the Short Run

Explaining the shape of the MC curve
When the marginal product of labor (MPL) rises, marginal cost (MC) falls When MPL falls, MC rises Since MPL ordinarily rises and then falls, MC will do the opposite MC curve is U-shaped
Increasing then diminishing marginal returns to labor

Table

Average and Marginal Test Scores

Cost in the Short Run

ATC curve is U-shaped
Because AFC decreases and AVC first decreases, then increases At low levels of output, AVC and AFC are both falling, so the ATC curve slopes downward At higher levels of output, rising AVC overcomes falling AFC, and the ATC curve slopes upward

Cost in the Short Run

AVC curve is U-shaped
Because MC curve is U-shaped (increasing and then diminishing returns to labor)

MC curve
Crosses both the AVC curve and the ATC curve at their respective minimum points

Production and Cost in the Long Run

In the long run
No fixed inputs; no fixed costs All inputs and all costs are variable

Output production
Least-cost rule

Long-run total cost (LRTC)

Cost of producing each quantity of output when all inputs are variable and the leastcost input mix is chosen

Production and Cost in the Long Run

Long-run average total cost (LRATC = LRTC / Q)
Cost per unit of producing each quantity of output, in the long run, when all inputs are variable Long-run total cost divided by quantity

Relationship between long-run and shortrun costs

LRTC TC LRATC ATC

Table

Four Ways to Wash 196 Cars per Day

Table

Long-Run Costs for Spotless Car Wash

Production and Cost in the Long Run

Plant
The collection of fixed inputs at a firms disposal

Size of the firms plant

Can be changed in the long run Cannot be changed in the short run

Production and Cost in the Long Run

A firms LRATC curve
Combines portions of each ATC curve available to the firm in the long run For each output level, the firm will always choose to operate on the ATC curve with the lowest possible cost

Production and Cost in the Long Run

In the short run
A firm can only move along its current ATC curve

In the long run

A firm can move from one ATC curve to another
By varying the size of its plant Moving along its LRATC curve

Figure 4
Long-Run Average Total Cost
Dollars $8.00 $6.00 $4.00 A $2.00 E ATC0 ATC1 ATC2 C B D
Average-total cost ATC3 curves ATC0, ATC1, ATC2, and ATC3 show average costs when the firm has zero, one, two, and three automated lines, respectively. The LRATC curve combines LRATC portions of all the firms ATC curves. In the long run, the firm will choose the lowest-cost ATC curve for each level of output.

30
Use 0 automated lines

90

130
Use 1 automated lines

175 184

250

300 Units of Output

Use 3 automated lines

Use 2 automated lines

Production and Cost in the Long Run

The U-shape of the LRATC curve:
As output increases, long-run average costs: First decline (economies of scale) Then remain constant (constant returns to scale) And finally rise (diseconomies of scale)

Production and Cost in the Long Run

Economies of scale
Long-run average total cost decreases as output increases LRATC curve slopes downward Long-run total cost rises proportionately less than output

Causes for economies of scale

Gains from specialization Spreading costs of lumpy inputs

Production and Cost in the Long Run

Lumpy input
An input whose quantity cannot be increased gradually as output increases But must instead be adjusted in large jumps

Production and Cost in the Long Run

Diseconomies of scale
Long-run average total cost increases as output increases LRATC curve slopes upward Long-run total cost rises more than in proportion to output

Production and Cost in the Long Run

Constant returns to scale
Long-run average total cost is unchanged as output increases LRATC curve is flat Both output and long-run total cost rise by the same proportion

Figure 5
The Shape of LRATC
Dollars $8.00 $6.00 $4.00 $2.00 LRATC
Minimum efficient scale (MES)

Constant Returns to Scale

0
Economies of Scale

200

250

Pizzas Served per Day

If long-run total cost rises proportionately less than output, production reflects economies of scale, and LRATC slopes downward. If cost rises proportionately more than output, there are diseconomies of scale, and LRATC slopes upward. Between those regions, cost and output rise proportionately, yielding constant returns to scale. The lowest output level at which the LRATC hits bottom is the firms minimum efficient scale.

Diseconomies of Scale

Production and Cost in the Long Run

Minimum efficient scale (MES)
The lowest output level at which the firms LRATC curve hits bottom Tells us how large a firm must grow in order to fully exploit economies of scale

Firms that grow to their MES

Have a cost advantage over other firms that operate at smaller output levels

Table
Term

7
Symbol/Form ula Definition

Types of Costs
Costs in general Explicit cost Implicit cost Sunk cost Lumpy input cost Short-run costs Total fixed cost Total variable cost Total cost Average fixed cost Average variable cost Average total cost Marginal cost Long-run costs Long-run total cost Long-run average

An opportunity cost where an actual payment is made An opportunity cost, but no actual payment is made An irrelevant cost because it cannot be affected by any current or future decision The cost of an input that can only be adjusted in large, indivisible amounts TFC TVC TC=TFC+TVC AFC = TFC/Q AVC = TVC/Q ATC = TC/Q MC=TC/Q The cost of all inputs that are fixed (cannot be adjusted) in the short run The cost of all inputs that are variable (can be adjusted) in the short run The cost of all inputs in the short run The cost of all fixed inputs per unit of output The cost of all variable inputs per unit of output The cost of all inputs per unit of output The change in total cost for each one-unit rise in output

LRTC LRATC=LRTC/ Q

The cost of all inputs in the long run Cost per unit in the long run

The Urge to Merge When there are significant, unexploited economies of scale
Because the market has too many firms for each to operate near its minimum efficient scale Mergers often follow

Figure 6
LRATC for a Typical Firm in a Merger-Prone Industry
Dollars
With market quantity demanded fixed at 60,000, and six firms of equal market share, each operates at point A, producing 10,000 units at $200 per unit. But any one firm can cut price slightly, increase market share, and operate with lower cost per unit, such as at the MES (point B). Other firms must match the firstmovers price; otherwise they lose LRATC market share and end up at .a point like C, with higher cost per unit than originally. The result is a price war, with each firm ending up back at point A, only nowdue to the lower pricethey suffer losses. A series Quantity of mergers to create three large per Month firms would enable each to operate at its MES (point B), with less likelihood of price wars and losses.

$240 200 80

C A B

8,000 10,000 Original Output Level

20,000 MES

Isoquant Analysis: Finding the Least-Cost Input Mix Every point on an isoquant
Input mix that produces the same quantity of output An increase in one input requires a decrease in the other input to keep total production unchanged

Isoquants
Always slope downward

Isoquant Analysis Higher isoquants

Greater levels of output than lower isoquants

Marginal rate of technical substitution

The (absolute value of the) slope of an isoquant Measures the rate at which a firm can substitute one input for another while keeping output constant

Isoquant Analysis Move rightward along any given isoquant

Marginal rate of technical substitution (MRTS) decreases

Slope of the isoquant (MRTSL,N)

With land measured horizontally And labor measured vertically

MRTSL,N is the ratio of the marginal products, MPN/MPL

Isoquant Analysis An isoquant

Becomes flatter as we move rightward The MPN decreases, while the MPL increases The ratio (MPN/MPL) decreases

Table A.1
Production Technology for an Artichoke Farm

Figure A.1
An Isoquant Map
Labor (workers) 22 20 18 16 14 12 10 8 6 4 2 0 2 4 6 8 10 12 C Q=6,000 B F A
Each of the curves in the figure is an isoquant, showing all combinations of labor and land that can produce a given output level. The middle curve, for example, shows that 4,000 units of output can be produced with 11 workers and 3 hectares of land (point B), with 5 workers and 5 hectares of land (point C), as well as other combinations of labor and land. Each isoquant is drawn for a different level of output. The higher the isoquant line, the greater the level of output.

Q=4,000 Q=2,000 Land 14 16 18 (hectares)

Isocost Lines Isocost lines always slope downward

If you use more of one input, you must use less of the other input in order to keep your total cost unchanged

Slope of an isocost line: - PN /PL

With land (N) on the horizontal axis and labor (L) on the vertical axis Remains constant as we move along the line

Higher isocost lines

Greater total costs for the firm

Figure A.2
Isocost Lines
Labor (workers)
Each of the lines in the figure is an isocost line, showing all combinations of labor and land that have the same total cost. The middle line, for example, shows that total cost will be $7,500 if 9 workers and 3 hectares of land are used (point C). All other combinations of land and labor on the middle line have the same total cost of $7,500. Each isocost line is drawn for a different value of total cost. The higher the isocost line, the greater is total cost.

20

15 12 10 9 C TC=$7,500 TC=$5,000 3 5 7.5 TC=$10,000

10

Land (hectares)

The Least-Cost Input Combination

Least-cost input combination

Of two inputs (L, N) for producing any level of output
Is found at the point where an isocost line is tangent to the isoquant for that output level The firms MRTS between the two inputs (MPN/MPL) will equal the ratio of input prices (PN /PL) The marginal product per dollar of land (MPN/PN) must equal the marginal product per dollar of labor (MPL/PL)

Figure A.3
The Least-Cost Input Combination for a Given Output Level
Labor (workers)
To produce any given level of output at the least possible cost, the firm should use the input combination where the isoquant for that output level is tangent to an isocost line. In the figure, the input combinations at points J, C, and K can all be used to produce 4,000 units of output. But the combination at point C (5 workers and 5 hectares of land), where the isoquant is tangent to the isocost line, is the least expensive input combination for that output level.

20

15 TC=$7,500 10 TC=$5,000 5

TC=$10,000 K Q=4,000

7.5

10

Land (hectares)

The Least-Cost Input Combination

Least-cost input mix with many variable inputs

Marginal product per dollar of any input is equal to marginal product per dollar of any other input