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Production and Cost Analysis I

Chapter 9

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Laugher Curve
A woman hears from her doctor that she has only half a year to live. The doctor advises her to marry an economist and to move to South Dakota.

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Laugher Curve
Will this cure my illness? she asked. No, but the half year will seem pretty long.

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Introduction
In the supply process, people first offer their factors of production to the market. s Then the factors are transformed by firms into goods that consumers want.
s
q Production

is the name given to that transformation of factors into goods.

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The Role of the Firm


s

The firm is an economic institution that transforms factors of production into consumer goods it:
q Organizes

factors of production. q Produces goods and services. q Sells produced goods and services.

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The Role of the Firm


s

A virtual firm only organizes production.


q Virtual

firms subcontract out all work. q More and more of the organizational structure of business is being separated from the business.

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The Firm and the Market


Firms operate within the market, while at the same time s Firms replace the market with command and control.
s

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The Firm and the Market


s

How an economy operates depends on:


q Transaction

costs costs of undertaking trades through the market, and q The rent or command over resources that organizers can appropriate to themselves by organizing the market in a certain way.
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The Firm and the Market


s

Firms are the production organizations that translate factors of production into consumer goods.

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Firms Maximize Profit


s

Profit is the difference between total revenue and total cost.

Profit = total revenue total cost

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Firms Maximize Profit


s

Economists and accountants measure profit differently.


q Accountants

focus on explicit costs and

revenue. q Economist focus on both explicit and implicit costs and revenue.

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Firms Maximize Profit


s

For an economist, total cost is explicit payments to factors of production plus the opportunity cost of the factors provided by the owners of the firm.

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Firms Maximize Profit


s

Economists define total revenue as the amount a firm receives for selling its good or service plus any increase in the value of the assets owned by firms.

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Firms Maximize Profit


s

For economists:

Economic profit = (explicit and implicit revenue) (explicit and implicit cost)

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The Production Process


s

The production process can be divided into the long run and the short run.

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The Long Run and the Short Run


s

A long-run decision is a decision in which the firm can choose among all possible production techniques.

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The Long Run and the Short Run


s

A short-run decision is one in which the firm is constrained in regard to what production decision it can make.

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The Long Run and the Short Run


The terms long run and short run do not necessarily refer to specific periods of time. s They refer to the degree of flexibility the firm has in changing the level of output.
s

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The Long Run and the Short Run


In the long run, all inputs are variable. s In the short run, some inputs are fixed.
s

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Production Production
s

Tables and Functions

A production table shows the output resulting from various combinations of factors of production or inputs.

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Production Production
s

Tables and Functions

Marginal product is the additional output that will be forthcoming from an additional worker, other inputs remaining constant.

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Production Production
s

Tables and Functions

Average product is calculated by dividing total output by the quantity of the output.

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Production Production
s

Tables and Functions

Production function a curve that describes the relationship between the inputs (factors of production) and outputs.

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Production Production
s

Tables and Functions

The production function tells the maximum amount of output that can be derived from a given number of inputs.

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A Production Table
Number of workers 0 1 2 3 4 5 6 7 8 9 10
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Total output 0 4 10 17 23 28 31 32 32 30 25

Marginal product 4 6 7 6 5 3 1 0 2 5

Average product 4 5 5.7 5.8 5.6 5.2 4.6 4.0 3.3 2.5

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A Production Function
32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 7 6 Output per worker TP 5 4 3 2 1 1 2 9 10 3 4 5 6 7 8 9 10 Number of workers MP (b) Marginal and average product 0 1 2 AP

3 4 5 6 7 8 Number of workers (a) Total product

Output

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The Law of Diminishing Marginal Productivity


s

Both marginal and average productivities initially increase, but eventually they both decrease.

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The Law of Diminishing Marginal Productivity


This means that initially the production function exhibits increasing marginal productivity. s Then it exhibits diminishing marginal productivity. s Finally, it exhibits negative marginal productivity.
s
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The Law of Diminishing Marginal Productivity


s

The most relevant part of the production function is that part exhibiting diminishing marginal productivity.

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The Law of Diminishing Marginal Productivity


s

Law of diminishing marginal productivity as more and more of a variable input is added to an existing fixed input, after some point the additional output one gets from the additional input will fall.

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The Law of Diminishing Marginal Productivity


Number of workers 0 1 2 3 4 5 6 7 8 9 10
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Total output 0 4 10 17 23 28 31 32 32 30 25

Marginal product 4 6 7 6 5 3 1 0 2 5

Average product 4 5 5.7 5.8 5.6 5.2 4.6 4.0 3.3 2.5 Increasing marginal returns Diminishing marginal returns Diminishing absolute returns

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The Law of Diminishing Marginal Productivity


32 30 28 26 24 22 20 Increasi 18 ng 16 14 margin al 12 10 returns 8 6 4 2 0 1 2 3 4 5 6 7 8 Number of workers (a) Total product Output Diminishi ng marginal returns Diminishi ng absolute returns Output per worker TP 7 6 5 4 3 2 1 9 10 3 4 5 6 7 8 9 10 Number of workers MP (b) Marginal and average product 0 1 2 AP Diminishi ng marginal returns Diminishi ng absolute returns

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The Law of Diminishing Marginal Productivity


This law is also called the flower pot law. s If it did not hold true, the worlds entire food supply could be grown in a single flower pot.
s

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The Costs of Production


There are many different types of costs. s Invariably, firms believe costs are too high and try to lower them.
s

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Fixed Costs, Variable Costs, and Total Costs


s

Fixed costs are those that are spent and cannot be changed in the period of time under consideration.
q In

the long run there are no fixed costs since all costs are variable. q In the short run, a number of costs will be fixed.

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Fixed Costs, Variable Costs, and Total Costs


s

Workers represent variable costs those that change as output changes.

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Fixed Costs, Variable Costs, and Total Costs


s

The sum of the variable and fixed costs are total costs.

TC = FC + VC

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Average Costs
s

Much of the firms discussion is of average cost.

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Average Costs
s

Average total cost (often called average cost) equals total cost divided by the quantity produced.

ATC = TC/Q

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Average Costs
s

Average fixed cost equals fixed cost divided by quantity produced.

AFC = FC/Q

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Average Costs
s

Average variable cost equals variable cost divided by quantity produced.

AVC = VC/Q

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Average Costs
s

Average total cost can also be thought of as the sum of average fixed cost and average variable cost.

ATC = AFC + AVC

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Marginal Cost
Marginal cost is the increase (decrease) in total cost of increasing (or decreasing) the level of output by one unit. s In deciding how many units to produce, the most important variable is marginal cost.
s

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Graphing Cost Curves


To gain a greater understanding of these concepts, it is a good idea to draw a graph. s Quantity is put on the horizontal axis and a dollar measure of various costs on the vertical axis.
s

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Total Cost Curves


s

The total variable cost curve has the same shape as the total cost curveincreasing output increases variable cost.

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Total Cost Curves


$400 350 300 250 200 150 100 50 0 TC VC

Total cost

TC = (VC + FC) L O M 2 4 6 8 10
Quantity of earrings

FC 20 30

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Average and Marginal Cost Curves


The marginal cost curve goes through the minimum point of the average total cost curve and average variable cost curve. s Each of these curves is U-shaped.
s

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Average and Marginal Cost Curves


s

The average fixed cost curve slopes down continuously.

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Downward-Sloping Shape of the Average Fixed Cost Curve s


The average fixed cost curve looks like a childs slide it starts out with a steep decline, then it becomes flatter and flatter. s It tells us that as output increases, the same fixed cost can be spread out over a wider range of output.

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The U Shape of the Average and Marginal Cost Curves s

When output is increased in the short-run, it can only be done by increasing the variable input.

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The law of diminishing marginal productivity sets in as more and more of a variable input is added to a fixed input. s Marginal and average productivities fall and marginal costs rise.

The U Shape of the Average and Marginal Cost Curves s

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The U Shape of the Average and Marginal Cost Curves s

And when average productivity of the variable input falls, average variable cost rise.

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The U Shape of the Average and Marginal Cost Curves s

The average total cost curve is the vertical summation of the average fixed cost curve and the average variable cost curve.

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If the firm increased output enormously, the average variable cost curve and the average total cost curve would almost meet. s The firms eye is focused on average total costit wants to keep it low.

The U Shape of the Average and Marginal Cost Curves s

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Per Unit Output Cost Curves $30


28 26 24 22 20 18 16 14 12 10 8 6 4 2 0

MC ATC AVC AFC 2 4 6 8 10 12 14 16 18 20 22 2426 28 30 32


Quantity of earrings
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Cost

The Relationship Between Productivity and Costs s

The shapes of the cost curves are mirrorimage reflections of the shapes of the corresponding productivity curves.

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When one is increasing, the other is decreasing. s When one is at a maximum, the other is at a minimum.

The Relationship Between Productivity and Costs s

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$18 16 14 12 10 8 6 4 2 0

Productivity of workers at this output

The Relationship Between Productivity and Costs


Costs per unit

MC AVC

9 8 7 6 5 4 3 2 1

A AP of worker s MP of workers

4 8 12162024Output

0 4 8 12162024Output

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Relationship Between Marginal and Average Costs s


q When

The marginal cost and average cost curves are related.


marginal cost exceeds average cost, average cost must be rising. q When marginal cost is less than average cost, average cost must be falling.

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Relationship Between Marginal and Average Costs s

Marginal cost curves always intersect average cost curves at the minimum of the average cost curve.

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Relationship Between Marginal and Average Costs s

The position of the marginal cost relative to average total cost tells us whether average total cost is rising or falling.

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Relationship Between Marginal and Average Costs s


To summarize:
If MC > ATC, then ATC is rising. If MC = ATC, then ATC is at its low point. If MC < ATC, then ATC is falling.

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Relationship Between Marginal and Average Costs s

Marginal and average total cost reflect a general relationship that also holds for marginal cost and average variable cost.
If MC > AVC, then AVC is rising. If MC = AVC, then AVC is at its low point. If MC < AVC, then AVC is falling.

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Relationship Between Marginal and Average Costs s

As long as average variable cost does not rise by more than average fixed cost falls, average total cost will fall when marginal cost is above average variable cost,

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Relationship Between Marginal and Average Costs


Costs per unit

$90 ATC MC 80 Area A Area C 70 60 AVC Area B ATC 50 AVC 40 30 B 20 A 10 MC Q0 Q1 0 1 2 3 4 5 6 7 8 9 Quantity


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Production and Cost Analysis I


End of Chapter 9

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