Production and Cost Analysis II

Chapter 9:
Production
and Cost
Analysis II
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
2006 McGraw-Hill Ryerson

Limited. All rights reserved.
Long Run Production

Decisions
To make their long run decisions:
Firms look at costs of various inputs and the

technologies available for combining these inputs.
Then decide which combination offers the lowest

cost.

Technical Efficiency and

Economic Efficiency
Technical efficiency as few inputs as

possible are used to produce a given output.
Technical efficiency is efficiency that does not

consider cost of inputs.

Technical Efficiency and

Economic Efficiency
Economic efficiency the method produces

a given level of output at the lowest possible
cost.
It is the least-cost technically efficient

process.

Long Run Cost Curve
The law of diminishing marginal productivity

does not hold in the long run.
All inputs are variable in the long run.

Long Run Cost Curve
The shape of the long run cost curve is due

to the existence of economies and
diseconomies of scale.

Typical Long Run Average

Total Cost Curve
Costs per unit
$64
62
60
58
56
54
52
50
48
Average
total cost
Minimum efficient
level of production
11 12 13 14 15 16 17 18 19 20 Quantity
Economies of Scale
There are economies of scale in production

when the long run average cost decreases as
output increases.
Economies of scale (increasing returns to

scale) are cost savings associated with larger
scale of production.

Individual Setup Costs
An indivisible setup cost is the cost of an

indivisible input for which a certain minimum
amount of production must be undertaken
before the input becomes economically
feasible to use.

Individual Setup Costs
Indivisible setup costs are the source of many

real-world economies of scale.
The cost of a blast furnace or an oil refinery is

an example of an indivisible setup cost.

10
Economies of Scale
In the longer run all inputs are variable, so

only economies of scale can influence the
shape of the long run cost curve.

11
Economies of Scale
Economies of scale occur whenever inputs

do not need to be increased in proportion to
the increase in output.
As output increases, cost per unit falls in the

long run, so this can also be seen as an
increase in productivity.

12
Economies of Scale
Doubling the inputs more than doubles the

output, when there are economies of scale.
Firms can economize on management cost,

or they can take advantage of specialized
labour and specialized capital.

13
Economies of Scale
Because of the importance of economies of

scale, business people often talk of a
minimum efficient scale of production.

14
Minimum Efficient Scale
The minimum efficient scale of production

is the amount of production that spreads
setup costs out sufficiently for firms to
undertake production profitably.

15
Minimum Efficient Scale
The minimum efficient scale (MES) of

production is reached once the size of the
market expands to a size large enough so
that firms can take advantage of all
economies of scale.

16
Typical Long Run Average

Total Cost Curve
Costs per unit
$64
Economies
62
of scale
60
58
56
54
52
50
48
Constant
returns
to scale
Diseconomies
of scale
Minimum efficient scale

of production
Long run
average
total cost
11 12 13 14 15 16 17 18 19 20 Quantity
17
Economies of Scale
The minimum efficient scale of production will

be at the beginning of the constant returns
portion of the average cost curvewhere
average total costs are at a minimum.

18
Economies of Scale
The implication of economies of scale is that

in some industries firms must be of a certain
size to be able to compete successfully.

19
Increasing Returns to Scale

(IRTS)
Increasing returns to scale is where long

run average total costs fall as output
increases.
It is shown by the decreasing portion of the

LRAC curve.

20
Constant Returns to Scale

(CRTS)
Constant returns to scale is where long run

average total costs do not change as output
increases.
It is shown by the flat portion of the LRAC

curve.

21
Decreasing Returns to Scale

(DRTS)
Decreasing returns to scale or

diseconomies of scale refer to decreases in
productivity which occur when there are
equal increases of all inputs.
Decreasing returns to scale occur where the

long run average cost curve is upward
sloping, meaning that average cost is
increasing.
22
Monitoring Costs
As the size of the firm increases, monitoring

costs generally increase.
Monitoring costs are those incurred by the

organizer of production in seeing to it that the
employees do what they are supposed to do.

23
Diseconomies occur for a number of reasons

as the firm increases its size
Coordination of a large firm is more difficult

Information costs and communication costs
increase as firm increases
Monitoring costs increase
Team spirit may decrease

24
Team spirit is the feelings of friendship and

being part of a team that brings out peoples
best effort.

25
Summary of Returns to Scale

Returns to scale
Doubling inputs
results in:
Slope of the
LRAC
Increasing returns
to scale (IRTS;
economies of
scale)
Output more than

doubles.
downward
Constant returns to Output exactly

scale (CRTS)
doubles.
horizontal
Decreasing returns Output less than

to scale (DRTS;
doubles.
diseconomies of
scale)
upward

26
Economies and Diseconomies

of Scale
Costs per unit
$64
62
60
58
56
54
52
50
48
Increasing
Returns to
Scale
Constant
returns
to Scale
Decreasing
Returns to
Scale
Long run
average
total cost
11 12 13 14 15 16 17 18 19 20 Quantity
27
Importance of Economies of
Scale
Economies and diseconomies of scale play

important roles in real-world long run
production decisions.

28
Importance of Economies of
Scale
The long run and the short run average cost

curves have the same U-shape, but the
underlying causes of these shapes differ.

29
Short Run Average Cost

Curves
Initially increasing and then eventually

diminishing marginal productivity (as a
variable input is added to a fixed input)
accounts for the shape of the short run
average cost curve.

30
Long Run Average Cost

Curve
Economies and diseconomies of scale

account for the shape of the long run total
cost curve.

31
Envelope Relationship
In the long run all inputs are flexible, while in

the short run some inputs are not flexible.
As a result, long run cost will always be less

than or equal to short run cost.

32
In the short run the firm faces an additional

constraint all expansion must proceed
using only the variable input.
These additional constraints increase cost.

33
The envelope relationship explains that:
At the planned output level, short run average

total cost equals long run average total cost.
At all other levels of output, short run average
total cost is higher than long run average total
cost.

34
Envelope of Short Run

Average Total Cost Curves
Costs per unit
LRATC
SRMC1
SRATC4
SRATC1
SRMC2
SRMC4
SRATC2 SRATC3
SRMC3
Q*
Quantity
35
Industry with Strong

Economies of Scale

36
Entrepreneurial Activity and

the Supply Decision
Profit is what underlies the dynamics of

production in a market economy.
The expected price must exceed the

opportunity cost of supplying the good for a
good to be supplied.

37

the Supply Decision
The greater the difference between price and

average total cost, the greater the
entrepreneurs incentive to tackle the
organizational problems and supply the good.

38

the Supply Decision
An entrepreneur is an individual who sees

an opportunity to sell an item at a price higher
than the average cost of producing it.

39

the Supply Decision
Entrepreneurs organize production.
They visualize the demand and convince the

individuals who own the factors of production
that they want to produce those goods.

40
Using Cost Analysis in the

Real World
Some of the problems of using cost analysis

in the real world include the following:
Economies of scope.
Learning by doing and technological change.
Many dimensions.
Unmeasured costs.

41
Economies of Scope
The cost of production of one product often

depends on what other products a firm is
producing.

42
Economies of Scope
There are economies of scope in

production when the costs of producing
goods are interdependent so that it is less
costly for a firm to produce one good when it
is already producing another.

43
Economies of Scope
Firms look for both economies of scope and

economies of scale.
Economies of scope play an important role in

firms decisions of what combination of goods
to produce.

44
Economies of Scope
Globalization has made economies of scope

even more important to firms in their
production decisions.

45
Learning by Doing and

Technological Change
Production techniques available to real-world

firms are constantly changing because of
learning by doing and technological change.
These changes occur over time and cannot

be accurately predicted.

46

Learning by doing means that as we do

something, we learn what works and doesnt,
and over time we become more proficient at
it.

47

The concept of learning by doing emphasizes

the importance of the past effort in
developing cost advantages.
Many firms estimate worker productivity to

grow 1 to 2 percent a year because of
learning by doing.

48

External economies are present in all

industries those are the external forces at
work which are capable of reducing costs for
all firms belonging to the industry

49

Technological change is an increase in the

range of production techniques that provides
new ways of producing goods.

50

Technological change offers an increase in

the known range of production.

51

Whenever learning by doing or technological

change occurs, the cost curve shifts down
since the same output can be produced at a
lower cost.

52

In some industries such as the computer

business, technological change is occurring
so fast that it overwhelms all other cost
components.

53

Technological change and learning by doing

are intricately related.

54
Many Dimensions
Most decisions that firms make involve more

than one dimension.
The only dimension in the standard model is

the level of output.
Good economic decisions take all relevant

marginal costs and benefits into account.
55
Many Dimensions
The important thing to remember in using the

standard model is the reasoning, not the
specific model.

56
Unmeasured Costs
The relevant costs as defined by economists

are not the costs found in a firms books.
Economists include opportunity costs while

accountants use explicit costs that can be
measured.

57
Economists Include
Opportunity Cost
Economists include the business owners

opportunity cost.
The business owners opportunity cost

includes forgone income that the owner could
have earned by spending his or her time in
another job.

58
The Standard Model as a

Framework
Despite its limitations, the standard model

provides a good framework for cost analysis.
It can be expanded to include real-world

complications.

59
Production and
Cost Analysis II
End of Chapter 9

60
Isocost/Isoquant
Analysis
Chapter 9 Appendix

61
Isocost/Isoquant Analysis
In the long run, a firm can vary all of the

factors of production.
One important decision in the long run is

which combination of factors to use.
Economic efficiency involves choosing the

factors so that the cost of production is at the
minimum.
62
Isocost/Isoquant Analysis
A graphical tool used in economics to

analyze the long run choice of factors of
production is the isocost/isoquant analysis.

63
Isocost/Isoquant Graph
The analyst creates a graph showing various

combinations of factors of production that can
produce a certain amount of output.

64
Isocost/Isoquant Graph
More than 3 units of

machinery and more
than 4 units of labour
Less than 3 units
of machinery and
less than 4 units
of labour

65
Isoquant Curve
Isoquant curve An isoquant curve (equal

quantity) represents combinations of factors
of production that result in equal amounts of
output.
A point on the isoquant curve is technically

efficient.

66
Isoquant Curve for 60

Earrings

67
Isoquant Curve for 60

Earrings
Machines
A
B
G
C
D
E
F Q60
Units of labour
68
Isoquant Curve
The isoquant curve is bowed inward because

of the law of diminishing marginal
productivity.

69
Isoquant Curve
Marginal rate of technical substitution

the rate at which one factor must be added to
compensate for the loss of another factor, to
keep output constant.
It is the slope of the isoquant curve.

70
Isoquant Curve
The absolute value of the slope at a point on

the isoquant curve equals the ratio of the
marginal productivity of labour to the
marginal productivity of machines.
MPlabour
Slope
MPmachine
Marginal rate of substitution
71
Isoquant Curve
Isoquant map a set of isoquant curves that

show technically efficient combinations of
inputs that can produce different levels of
output.

72
Isoquant Map
Q100
Q60
Q40

73
The Isocost line
The isocost line (equal cost) represents

alternative combinations of factors of
production that have the same cost.
The slope of the isocost line equals the ratio

of prices of the factors of production.

74
The Isocost Line
The slope of the isocost curve:

Slope = Plabour/Pmachines

75
The Isocost Lines

Machines
20
C
Slope = -Plabour/Pmachines
=-5/3
D
6
A
12
18
Units of labour

76
Choosing the Economically

Efficient Point of Production
The least cost combination of inputs for a

given output occurs where the isocost curve
is tangent to the isoquant curve for that
output.

77

The slopes of the two curves are equal at that

point of tangency.
MPlabour Plabour
MPlabour MPmachines
so that
MPmachines Pmachines
Plabour
Pmachines

78

The firm is operating efficiently when an

additional output per dollar spent on labour
equals the additional output per dollar spent
on machines.

79
Combining Isoquant and

Isocost Curves
Machines
20
B
A
MPlabour/MPmachines =Plabour/Pmachines
C
Q2
Q1
12
Units of labour

80
Isocost/Isoquant
Analysis
End of Chapter 9 Appendix

81

Production and Cost Analysis II

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Chapter 9:

2006 McGraw-Hill Ryerson

Long Run Production

To make their long run decisions:

Firms look at costs of various inputs and the

Then decide which combination offers the lowest

2006 McGraw-Hill Ryerson

Technical Efficiency and

Technical efficiency as few inputs as

Technical efficiency is efficiency that does not

2006 McGraw-Hill Ryerson

Technical Efficiency and

Economic efficiency the method produces

It is the least-cost technically efficient

2006 McGraw-Hill Ryerson

Long Run Cost Curve

The law of diminishing marginal productivity

All inputs are variable in the long run.

2006 McGraw-Hill Ryerson

Long Run Cost Curve

The shape of the long run cost curve is due

2006 McGraw-Hill Ryerson

Typical Long Run Average

Costs per unit

There are economies of scale in production

Economies of scale (increasing returns to

2006 McGraw-Hill Ryerson

Individual Setup Costs

An indivisible setup cost is the cost of an

2006 McGraw-Hill Ryerson

Individual Setup Costs

Indivisible setup costs are the source of many

The cost of a blast furnace or an oil refinery is

2006 McGraw-Hill Ryerson

In the longer run all inputs are variable, so

2006 McGraw-Hill Ryerson

Economies of scale occur whenever inputs

As output increases, cost per unit falls in the

2006 McGraw-Hill Ryerson

Doubling the inputs more than doubles the

Firms can economize on management cost,

2006 McGraw-Hill Ryerson

Because of the importance of economies of

2006 McGraw-Hill Ryerson

Minimum Efficient Scale

The minimum efficient scale of production

2006 McGraw-Hill Ryerson

Minimum Efficient Scale

The minimum efficient scale (MES) of

2006 McGraw-Hill Ryerson

Typical Long Run Average

Minimum efficient scale

The minimum efficient scale of production will

2006 McGraw-Hill Ryerson

The implication of economies of scale is that

2006 McGraw-Hill Ryerson

Increasing Returns to Scale

Increasing returns to scale is where long

It is shown by the decreasing portion of the

2006 McGraw-Hill Ryerson

Constant Returns to Scale

Constant returns to scale is where long run

It is shown by the flat portion of the LRAC