chap009 producer choice costs and production analysis

8/3/2019 Chap009 Producer Choice Costs and Production Analysis

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McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., AllRights Reserved.

Production andProduction and

Cost Analysis ICost Analysis I

Chapter 9


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Laugher CurveLaugher Curve

A woman hears from her doctor that shehas only half a year to live.

The doctor advises her to marry aneconomist and to move to South Dakota.


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Laugher CurveLaugher Curve

Will this cure my illness? she asked.

No, but the half year will seem pretty

long.


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IntroductionIntroduction

s In the supply process, people first offertheir factors of production to the market.

s Then the factors are transformed by firmsinto goods that consumers want.qProduction is the name given to that

transformation of factors into goods.


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The Role of the FirmThe Role of the Firm

s The firm is an economic institution thattransforms factors of production into

consumer goods it:qOrganizes factors of production.

q Produces goods and services.

q Sells produced goods and services.


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q Virtual firms subcontract out all work.

qMore and more of the organizationalstructure of business is being separatedfrom the business.

The Role of the FirmThe Role of the Firm

sA virtualfirm only organizes production.


7/67McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All

Rights Reserved.

The Firm and the MarketThe Firm and the Market

s Firms operate within the market, while atthe same time

s Firms replace the market with commandand control.



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s How an economy operates depends on:q Transaction costs costs of

undertaking trades through the market,and

qThe rent or command over resourcesthat organizers can appropriate tothemselves by organizing the market ina certain way.



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s Firms are the production organizations thattranslate factors of production into

consumer goods.



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Firms Maximize ProfitFirms Maximize Profit

s Profitis the difference between totalrevenue and total cost.

Profit = total revenue total cost


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s Economists and accountants measureprofit differently.q Accountants focus on explicit costs and

revenue.

q Economist focus on both explicit and

implicit costs and revenue.


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s For an economist, total costis explicitpayments to factors of production plus the

opportunity cost of the factors provided bythe owners of the firm.


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s Economists define total revenue as theamount a firm receives for selling its good

or service plus any increase in the value ofthe assets owned by firms.


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s For economists:

Economic profit =(explicit and implicit revenue)

(explicit and implicit cost)


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The Production ProcessThe Production Process

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


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The Long Run and theThe Long Run and the

Short RunShort RunsA long-run decision is a decision in which

the firm can choose among all possible

production techniques.


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Short RunShort RunsA short-run decision is one in which the

firm is constrained in regard to what

production decision it can make.


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Short RunShort Runs The terms long run and short run do not

necessarily refer to specific periods of

time.s They refer to the degree of flexibility thefirm has in changing the level of output.


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Short RunShort Runs In the long run, all inputs are variable.

s In the short run, some inputs are fixed.


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Production Tables andProduction Tables and

Production FunctionsProduction FunctionssAproduction table shows the output

resulting from various combinations of

factors of production or inputs.


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Production FunctionsProduction Functionss Marginal productis the additional output

that will be forthcoming from an additional

worker, other inputs remaining constant.


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Production FunctionsProduction FunctionssAverage productis calculated by dividing

total output by the quantity of the output.


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Production FunctionsProduction Functionss Production function a curve that

describes the relationship between the

inputs (factors of production) and outputs.


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Production FunctionsProduction Functionss 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 TableA Production Table

Number ofworkers Total output

Marginalproduct

Averageproduct

467653

1025

12345

6789

10

0 455.75.85.65.24.64.03.32.5

4101723283132323025

0


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Output

3230282624

222018161412108

6420

1 2 3 4 5 6 7 8 9 10Number of workers

TP

Outputperworker

1 2 3 4 5 6 7 8 9 10

Number of workers

7

6

5

4

3

2

1

0

MP

(a) Total product (b) Marginal and average product

AP

A Production FunctionA Production Function


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The Law of DiminishingThe Law of Diminishing

Marginal ProductivityMarginal Productivitys Both marginal and average productivities

initially increase, but eventually they both

decrease.


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Marginal ProductivityMarginal Productivitys This means that initially the production

function exhibits increasing marginal

productivity.s Then it exhibits diminishing marginal

productivity.

s Finally, it exhibits negative marginalproductivity.


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Marginal ProductivityMarginal Productivitys Law of diminishing marginal

productivity as more and more of a

variable input is added to an existing fixedinput, after some point the additionaloutput one gets from the additional input

will fall.


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Marginal ProductivityMarginal ProductivityNumber ofworkers

Totaloutput

Marginalproduct

Averageproduct

Increasingmarginal returns

Diminishingmarginal returns

Diminishingabsolute returns

4676531025

12345

6789

10

0455.75.85.6

5.24.64.03.32.5

4

10172328

3132323025

0


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Output

Diminishing

marginalreturns

Diminishing

absolutereturns

3230282624

222018161412108

6420

1 2 3 4 5 6 7 8 9 10

Increasing

marginal

returns

Number of workers

TP

Outputperworker

1 2 3 4 5 6 7 8 9 10

Number of workers

7

6

5

4

3

2

1

0

MP

Diminishing

marginalreturns

Diminishing

absolutereturns

(a) Total product (b) Marginal and average product

AP


Marginal ProductivityMarginal Productivity


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Marginal ProductivityMarginal Productivitys 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 flowerpot.


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The Costs of ProductionThe Costs of Production

s There are many different types of costs.

s Invariably, firms believe costs are too high

and try to lower them.


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Fixed Costs, VariableFixed Costs, Variable

Costs, and Total CostsCosts, and Total Costss 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 willbe fixed.


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Costs, and Total CostsCosts, and Total Costss Workers represent variable costs those

that change as output changes.


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Costs, and Total CostsCosts, and Total Costss The sum of the variable and fixed costs are

total costs.

TC = FC + VC


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Average CostsAverage Costs

s Much of the firms discussion is of averagecost.


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sAverage total cost(often called averagecost) equals total cost divided by the

quantity produced.

ATC = TC/Q


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sAverage fixed costequals fixed costdivided by quantity produced.

AFC = FC/Q


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sAverage variable costequals variablecost divided by quantity produced.

AVC = VC/Q


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sAverage total cost can also be thought ofas the sum of average fixed cost and

average variable cost.

ATC = AFC + AVC


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Marginal CostMarginal Cost

s Marginal costis 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.


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Graphing Cost CurvesGraphing Cost Curves

s To gain a greater understanding of theseconcepts, it is a good idea to draw a graph.

s Quantity is put on the horizontal axis and adollar measure of various costs on thevertical axis.


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Total Cost CurvesTotal Cost Curves

s The total variable cost curve has the sameshape as the total cost curveincreasing

output increases variable cost.


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Average and MarginalAverage and Marginal

Cost CurvesCost Curvess The average fixed cost curve slopes down

continuously.


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Downward-Sloping ShapeDownward-Sloping Shapeof the Average Fixedof the Average FixedCost CurveCost Curves 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 theThe U Shape of theAverage and MarginalAverage and MarginalCost CurvesCost Curvess When output is increased in the short-run,

it can only be done by increasing the

variable input.


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The U Shape of theThe U Shape of theAverage and MarginalAverage and MarginalCost CurvesCost Curvess 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.

h h f h


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The U Shape of theThe U Shape of theAverage and MarginalAverage and MarginalCost CurvesCost CurvessAnd when average productivity of the

variable input falls, average variable cost

rise.

h h f h


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The U Shape of theThe U Shape of theAverage and MarginalAverage and MarginalCost CurvesCost Curvess The average total cost curve is the vertical

summation of the average fixed cost curve

and the average variable cost curve.

Th U Sh f h


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The U Shape of theThe U Shape of theAverage and MarginalAverage and MarginalCost CurvesCost Curvess If the firm increased output enormously,

the average variable cost curve and the

average total cost curve would almostmeet.

s The firms eye is focused on average total

costit wants to keep it low.


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Cost

$302826242220

18161412108

642

0Quantity of earrings

2 4 6 8 10 12 14 16 18 20 22 2426 28 30 32

Per Unit Output CostPer Unit Output Cost

CurvesCurves

AFC

AVCATCMC

h l i hiTh R l ti hi


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The RelationshipThe RelationshipBetween ProductivityBetween Productivityand Costsand Costss The shapes of the cost curves are mirror-

image reflections of the shapes of the

corresponding productivity curves.

Th R l i hiTh R l ti hi


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The RelationshipThe RelationshipBetween ProductivityBetween Productivityand Costsand Costss When one is increasing, the other is

decreasing.

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

Th R l i hiTh R l ti hi


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Costsperunit

Productivity

ofworkersa

tthisoutput

$1816

14121086

42

0 4 8 12162024

98

76543

21

0 4 8 12162024

AVC

MC

Output Output

A

AP ofworker

s

MP of workers

The RelationshipThe RelationshipBetween ProductivityBetween Productivityand Costsand Costs

R l ti hi B tR l ti hi B t


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Relationship BetweenRelationship BetweenMarginal and AverageMarginal and Average

CostsCostss The marginal cost and average cost curves

are related.

qWhen marginal cost exceeds averagecost, average cost must be rising.

qWhen marginal cost is less than averagecost, average cost must be falling.



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CostsCostss Marginal cost curves always intersect

average cost curves at the minimum of the

average cost curve.



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CostsCostss 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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CostsCostss 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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CostsCostss 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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CostsCostssAs long as average variable cost does not

rise by more than average fixed cost falls,

average total cost will fall when marginalcost is above average variable cost,

R l ti hi B tRelationship Bet een


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CostsCosts

Co

stsperunit

$90

80

70

6050

4030

2010

0Quantity

Area B

Area A Area CMC

ATC

AVC

1 2 3 4 5 6 7 8 9

Q1

B

AVC

ATC

MCQ0

A


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Production andProduction and

Cost Analysis ICost Analysis I

End of Chapter 9

chap009 producer choice costs and production analysis

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