Transcript Chapter 8: Production And Cost Analysis I

Chapter 8:
Production and
Cost Analysis I
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
1
Chapter Objectives

1. Summarize briefly the advantages and
disadvantages of three types of businesses.

2. Differentiate between economic profit and
accounting profit.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
2
Chapter Objectives

3a. Distinguish between long-run and shortrun production.
3b. State the law of diminishing marginal
productivity.

4. Calculate fixed costs, variable costs, total
costs, average fixed costs, average variable
costs, and average total costs, given the
appropriate information.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
3
Chapter Objectives

5a. Distinguish the various kinds of cost
curves and describe the relationships among
them.
5b. Explain why the marginal and average
cost curves are U-shaped.
5c. Explain why the marginal cost curve
always goes through the minimum point of the
average cost curve.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
4
Role of the Firm

The firm is an economic institution that
transforms factors of production into
consumer goods.



Organizes factors of production.
Produces goods and services.
Sells produced goods and services.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
5
Forms of Business
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
6
The Firm and the Market

How an economy operates depends on
transaction costs — the costs of
undertaking trades through the market.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
7
Firms Maximize Profit

Profit is the difference between total revenue
and total cost.
Profit = total revenue – total cost
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
8
Firms Maximize Profit

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, which is an implicit cost.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
9
Firms Maximize Profit

For economists:

Economic Profit =
total revenue – (implicit and explicit cost)
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
10
The Long Run and the Short Run

A long-run decision is a decision in which
the firm can choose the least expensive
method of producing from among all possible
production techniques.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
11
The Long Run and the Short Run

A short-run decision is one in which the firm
is constrained by past choices in regard to
what production decision it can make.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
12
The Long Run and the Short Run

In the long run, all inputs are variable.

In the short run:



Flexibility is limited.
Some factors of production cannot be changed.
Generally, the production facility (“the plant”) is
fixed.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
13
Production Table

Total product is the number of units of the
good or service produced by different
numbers of workers.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
14
Production

Marginal product is the additional output
that will be forthcoming from an additional
worker, other inputs remaining constant.

Average product is calculated by dividing
total output by the number of workers who
produced it.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
15
Production Functions

Production function – a curve that
describes the relationship between the inputs
(factors of production) and output.

The production function tells the maximum
amount of output that can be derived from a
given number of inputs.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
16
Production Table
Number of
workers
Total output
Marginal
product
Average
product
0
1
2
3
4
5
6
7
8
9
10
0
4
10
17
23
28
31
32
32
30
25
4
6
7
6
5
3
1
0
2
5
—
4
5
5.7
5.8
5.6
5.2
4.6
4.0
3.3
2.5
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
17
32
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
0
7
6
TP
5
Output per worker
Output
Production Function
4
3
2
AP
1
1
2
(a) Total product
3 4 5 6 7
Number of workers
8
9
10
0
1
2
3 4 5 6 7
Number of workers
(b) Marginal and average product
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
8
9
MP
10
18
Diminishing Marginal Productivity

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.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
19
Diminishing Marginal Productivity
Diminishing
absolute
returns
32
30
28
26
24
22
20 Increasing
18
16 marginal
returns
14
12
10
8
6
4
2
0
1 2 3 4 5 6 7
Number of workers
(a) Total product
Diminishing
marginal
returns
7
Diminishing
absolute
returns
6
TP
5
Output per worker
Output
Diminishing
marginal
returns
4
3
2 Increasing
1
8
9
10
0
AP
marginal
returns
1
2
3 4 5 6 7
Number of workers
(b) Marginal and average product
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
8
9
MP
10
20
Fixed Costs

Fixed costs are those that cannot be
changed in the period of time under
consideration regardless of output.


In the long run there are no fixed costs since all
costs are variable.
In the short run, a number of costs will be fixed.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
21
Variable Costs

Variable costs are costs that change as
output changes, such as the costs of labour
and materials.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
22
Fixed Costs, Variable Costs, and Total
Costs

The sum of the fixed costs and variable costs
are total costs.
TC = FC + VC
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
23
Average Costs

Average total cost (often called average
cost) equals total cost divided by the quantity
produced.
ATC = TC/Q
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
24
Average Costs

Average fixed cost equals fixed cost divided
by quantity produced.
AFC = FC/Q
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
25
Average Costs

Average variable cost equals variable cost
divided by quantity produced.
AVC = VC/Q
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
26
Average Costs

Average total cost can also be thought of as
the sum of average fixed cost and average
variable cost.
ATC = AFC + AVC
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
27
Marginal Cost

Marginal cost is the increase in total cost of
increasing the level of output by one unit,
MC = TC/Q

In deciding how many units to produce, the
most important variable is marginal cost.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
28
The Cost of Producing Earrings
Output
FC
VC
TC
MC
AFC
AVC
ATC
3
4
9
10
16
17
22
23
27
28
50
50
50
50
50
50
50
50
50
50
38
50
100
108
150
157
200
210
255
270
88
100
150
158
200
207
250
260
305
320
—
12
—
8
—
7
—
10
—
15
16.67
12.50
5.56
5.00
3.13
2.94
2.27
2.17
1.85
1.79
12.66
12.50
11.11
10.80
9.38
9.24
9.09
9.13
9.44
9.64
29.33
25.00
16.67
15.80
12.50
12.18
11.36
11.30
11.30
11.42
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
29
Total cost
Total Cost Curves
$400
350
300
250
200
150
100
50
0
TC
VC
TC = (VC + FC)
L
O
M
2 4 6 8 10
FC
20
Quantity of earrings
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
30
30
Cost
Per Unit 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
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
31
Relationship Between Productivity and
Costs

The shapes of the cost curves are mirrorimage reflections of the shapes of the
corresponding productivity curves.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
32
Relationship Between Productivity and
Costs
Costs per unit
$18
16
14
12
10
8
6
4
2
0
MC
AVC
18
21
Output
9
8
7
6
5
4
3
2
1
Output per worker
0
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
AP
MP
21/2
4
Labour
33
Relationship Between Marginal and
Average Costs

The marginal cost and average cost curves
are related.

When marginal cost exceeds average cost,
average cost must be rising.

When marginal cost is less than average cost,
average cost must be falling.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
34
Relationship Between Marginal and
Average Costs

This relationship explains why marginal cost
curves always intersect average cost curves
at the minimum of the average cost curve.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
35
Relationship Between Marginal and
Average Costs

To summarize:
If MC > ATC, then ATC is rising.
If MC = ATC, then ATC is at its minimum.
If MC < ATC, then ATC is falling.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
36
Relationship Between Marginal and
Average Costs

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 minimum.
If MC < AVC, then AVC is falling.
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
37
Relationship Between Marginal and
Average Costs
$90
80
70
60
50
40
30
20
10
0
MC
Area A
Area C
Area B
ATC
AVC
B
1
2
3
A
Q0 Q1
4 5 6
7
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
8
9 Quantity
38
Production and
Cost Analysis I
End of Chapter 8
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
39