06. costs of production
TRANSCRIPT
The Meaning of Costs
• Opportunity costs– meaning of opportunity cost
– examples
• Measuring a firm’s opportunity costs– factors not owned by the firm: explicit costs
– factors already owned by the firm: implicit costs
– irrelevance of:• historic costs
• replacement costs
Production in the Short run
• Production functions
– factors of production
• labour
• land and raw materials
• capital
• entrepreneurship
– the relationship between inputs and output
• TPP = ƒ(F1, F2, F3, … Fn)
Production in the Short run
• Long-run and short-run production – fixed and variable factors
– distinction between short run and long run
• The law of diminishing returns
• The short-run production function:– total physical product (TPP)
– average physical product (APP)
– marginal physical product (MPP)
– the graphical relationship between TPP, APP and MPP
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Number of farm workers
Wheat production per year from a particular farmT
onne
s o
f wh
eat p
rod
uce
d p
er y
ear
Number of workers
012345678
TPP 0 310243640424240
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Number of farm workers
Ton
nes
of w
hea
t pro
du
ced
per
ye
ar
Number of workers
012345678
TPP 0 310243640424240
Wheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farm
Number of farm workers
Ton
nes
of w
hea
t pro
du
ced
per
ye
ar TPP
b
Diminishing returnsset in here
d
Maximum output
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Number offarm workers (L)
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
Number offarm workers (L)
∆TPP = 7
∆L = 1
MPP = ∆TPP / ∆L = 7
Wheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
MPP
Number offarm workers (L)
Number offarm workers (L)
Wheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
APP
MPP
APP = TPP / L
Number offarm workers (L)
Number offarm workers (L)
Wheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
b
b
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
APP
MPP
Diminishing returnsset in here
Number offarm workers (L)
Number offarm workers (L)
Wheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
APP
MPP
b
d
d
Number offarm workers (L)
Number offarm workers (L)
Maximumoutput
b
Wheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
c
c
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
APP
MPP
b
b
d
d
Number offarm workers (L)
Number offarm workers (L)
Slope = TPP / L= APP
Wheat production per year from a particular farm
Costs in the Short run
• Costs and inputs
– costs and the productivity of factors
– costs and the price of factors
• Fixed costs and variable costs
• Total costs
– total fixed cost (TFC)
– total variable cost (TVC)• TVC and the law of diminishing returns
– total cost (TC = TFC + TVC)
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
Output(Q)
01234567
TFC(£)
1212121212121212
Total costs for firm X
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TFC
Output(Q)
01234567
TFC(£)
1212121212121212
Total costs for firm X
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TFC
Total costs for firm XOutput
(Q)
01234567
TFC(£)
1212121212121212
TVC(£)
010162128406091
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TVC
Output(Q)
01234567
TFC(£)
1212121212121212
TVC(£)
010162128406091
TFC
Total costs for firm X
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TVC
TFC
Total costs for firm XOutput
(Q)
01234567
TFC(£)
1212121212121212
TVC(£)
010162128406091
TC(£)
12222833405272
103
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TCOutput
(Q)
01234567
TFC(£)
1212121212121212
TVC(£)
010162128406091
TC(£)
12222833405272
103
TVC
TFC
Total costs for firm X
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TC
TVC
TFC
Total costs for firm X
Diminishing marginalreturns set in here
Costs in the Short run
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between MC and TC curves
Costs in the Short run
• Average cost
– average fixed cost (AFC)
– average variable cost (AVC)
– average (total) cost (AC)
• Relationship between average and marginal cost
Production in the Long run
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
Production in the Long run
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
Production in the Long run
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
• Returns to scale and economies and diseconomies of scale
Production in the Long run
• Economies of scale– specialisation & division of labour
– indivisibilities
– container principle
– greater efficiency of large machines
– by-products
–multi-stage production
– organisational & administrative economies
– financial economies
• Economies of scope
Production in the Long run
• Diseconomies of scale–managerial diseconomies
– effects of workers and industrial relations
– risks of interdependencies
• External economies of scale
• External diseconomies of scale
• Location– balancing the distance from suppliers and
consumers
– importance of transport costs
Production in the Long run
• Optimum combination of factors
–MPPa/Pa = MPPb/Pb ... = MPPn/Pn
• Decision making in different time periods– very short run
– short run
– long run
– very long run
– decisions can be made for all time periods at the same time
Costs in the Long run
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
A typical long-run average cost curve
OutputO
Costs
LRACEconomiesof scale
Constantcosts
Diseconomiesof scale
Costs in the Long run
• Long-run average costs
– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
OutputO
Costs
Long-run average and marginal costs
LRMC
LRAC
Initial economies of scale,then diseconomies of scale
Costs in the Long run
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs
Costs in the Long run
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
Deriving long-run average cost curves: factories of fixed size
SRAC3
Costs
OutputO
SRAC4
SRAC5
5 factories
4 factories3 factories2 factories
1 factory
SRAC1 SRAC2
SRAC1SRAC3
SRAC2 SRAC4
SRAC5
LRAC
Costs
OutputO
Deriving long-run average cost curves: factories of fixed size
Deriving a long-run average cost curve: choice of factory sizeCosts
OutputO
Examples of short-runaverage cost curves
Costs in the Long run
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice
Costs in the Long run
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice– the evidence