Production theory and

cost analysis

Huy Quynh Nguyen, PhD

PRODUCTION THEORY
AND COST ANALYSIS

The cost of production

FIRM AND DECISIONS
 Firm’s decision

• Profit maximization
• Profit = Revenue-Costs = P*Q – TC(Q)
• Cost minimization
Output

Costs

Price
 Firm’s decision

• Profit maximization
• Profit = Revenue-Costs = P*Q – TC(Q)
• Cost minimization
Output

Costs

Price
WHAT HAPPEN TO THE FIRM’S PROFITS
IF IT CONTINUTES RECRUTING LABOR?
 Basic Concepts of Production

¨ Production function: Maximum amount of output that can be produced

from any specified set of inputs, given existing technology: Q = f(L, K)
Production for auto parts (Plant size: thousands of square feet)
No of workers Plant size: 10 Plant size: 20 Plant size: 30 Plant size: 40
10 93 120 145 165
20 135 190 235 264
30 180 255 300 337
40 230 315 365 410
50 263 360 425 460
60 293 395 478 510
70 321 430 520 555
80 346 460 552 600
90 368 485 580 645
100 388 508 605 680
 Basic Concepts of Production Theory

v Production function
v Maximum amount of output that can be produced from any
specified set of inputs, given existing technology
v Q = f(L, K)

v Technical efficiency
v Achieved when maximum amount of output is produced with
a given combination of inputs
v Economic efficiency
v Achieved when firm is producing a given output at the lowest
possible total cost
 Basic Concepts of Production Theory

v Short run
v At least one input is fixed

v All changes in output achieved by changing usage of

variable inputs
v Long run
v All inputs are variable

v Output changed by varying usage of all inputs

 Total Product and Marginal Product

v MPL: the additional output produced by an additional unit of labor or

change in output per unit change in labor input
v Law of diminishing marginal returns: as units of one input are added
(with all other inputs held constant), resulting additions to output will
eventually begin to decrease; that is MP will decline
 Marginal product for auto parts supplier

MP for each
No of workers Plant size: 10 MP for 10
worker
10 93 93 9.3
20 135 42 4.2
30 180 45 4.5
40 230 50 5
50 263 33 3.3
60 293 30 3
70 321 28 2.8
80 346 25 2.5
90 368 22 2.2
100 388 20 2
110 400 12 1.2
120 403 3 0.3
130 391 -12 -1.2
140 380 -11 -1.1
 Optimal use of an input

v The law of diminishing return: firms face a trade-off in determining

its level of production, Q=f(L,K)
v What level of the input maximizes profits?
v An input’s marginal revenue product: extra revenue that results from a
unit increase in the input” MRP(L) = (MR) (MPL), where MR:
marginal revenue per unit of output, MPL: marginal product of labor
- Example: the auto parts supplier considers increasing labor from 20 to
30 workers
- MPL: 4.5 parts per worker, if MR=$40 per part
- MRP(L)=($40)(4.5)=$180 per worker; MCL=$160
- MRP (L) for a move from 30 to 40 workers is ($40)(5)=$200 per
worker
 Optimal use of an input

¨ Marginal cost of an input: the amout of an additional unit of the

input adds to the firm’s total cost
- Example: firm hires as many additional workers at a constant wage
($160 per day) => MCL = $160
¨ To maximize profit, the firm should increase the amount of a

variable input up to the point at which the input’s marginal revenue

product equals its marginal cost, that is, until: MRP(L)=MCL
- The human resource manager of auto part firms: MCL of hiring an

extra worker is $160 perday while MRP(L) for moving from 20 to

30 workers is $180 per worker => This move is profitable
- What happens if there is an increase from 40 to 50 workers?
COSTS OF PRODUCTION
 Opportunity Costs and Economic Profits
v Economic costs = Explicit cost + Implicit costs
v Explicit cost: a cost that involves spending money
v Implicit cost: a non-monetary opportunity cost: resources used in the firm
that could have been used for another beneficial purpose
v Starting a business: Opening a Pizza Store: Huy quits his $30,000 a job to
start a pizza store. He uses $50,000 of his savings to buy equipments and
takes out a loan as well
Pizza dough, tomato sauce and others 20,000
Wages 48,000
Interest payments on loan to buy ovens 10,000
Electricity 6,000
Lease payment for store 24,000
Foregone salary 30,000
Foregone interest 3,000
Total 141,0000
 Opportunity Costs and Economic Profits
v Huy’s restaurant turns its inputs (pizza ovens, ingredients, labor,
electricity etc.) into pizzas for sale
v Let’s consider two inputs: pizza ovens and workers
v Pizza ovesn: fixed costs
v Workers: variable costs

Pizza dough, tomato sauce and others 20,000

Wages 48,000
Interest payments on loan to buy ovens 10,000
Electricity 6,000
Lease payment for store 24,000
Foregone salary 30,000
Foregone interest 3,000
Total 141,0000
 Short Run Production Costs

¨ Total variable cost (TVC)

¤ Total amount paid for variable inputs

¤ Increases as output increases

¨ Total fixed cost (TFC)

¤ Total amount paid for fixed inputs

¤ Does not vary with output

¨ Total cost (TC)

¤ TC = TVC + TFC
 Short-term costs

Average costs

v Average variable cost: AVC = TVC/Q

v Average fixed cost: AFC = TFC/Q

v Average total cost (ATC) = TC/Q = AVC+AFC

 Short-Run Total Cost Schedules

Output (Q) Total fixed cost Total variable Total Cost

(TFC) cost (TVC) (TC=TFC+TVC)
0 $6,000 0 $ 6,000
100 6,000 4,000 10,000
200 6,000 6,000 12,000
300 6,000 9,000 15,000
400 6,000 14,000 20,000
500 6,000 22,000 28,000
600 6,000 34,000 40,000
Total Cost Curves
Short-run costs

Marginal cost (MC): measures rate of change in total

cost (TC) as output varies

MC = DTC
DQ
 Short-term costs

Output Fixed Variable Total Marginal Average Average Average

Q Cost Cost Cost Cost Fixed Variable Total
(TFC) (TVC) (TC) (MC) Cost Cost Cost
(AFC) (AVC) (ATC)
0 50 0 50 --- --- --- ---
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
Marginal Physical Product and Marginal Cost
Total, Average, and Marginal Costs
Total, Average, and Marginal Costs (Continued)
Average and Marginal Cost Curves
Firm’s cost curves

100
($/Q)
MC

75

50 ATC
AVC

25

AFC
Q
0 1 2 3 4 5 6 7 8 9 10 11
 Short Run Cost Curve Relations

v AFC decreases continuously as output increases

v AVC is U-shaped
v Equals MC at AVC’s minimum

v ATC is U-shaped
v Equals MC at ATC’s minimum
 Restructuring Short-Run Costs

v Because managers have greatest flexibility to choose inputs in

the long run, costs are lower in the long run than in the short
run for all output levels except that for which the fixed input is
at its optimal level
v Short-run costs can be reduced by adjusting fixed inputs to
their optimal long-run levels when the opportunity arises
Long-Run Average Total Cost Curve (LRATC)
 Returns to Scale

¨ Firm choose the proportion of inputs to use:

- Example: a law firm may vary the proportion of its inputs to

economize on the side of its staff by investing in computers and

software => substituting capital for labor
- Rising the cost of fuel, wages, and others caused many airlines to

modify their fleets: large aircrafts to smaller aircraft

- The impact of IR 4.0: labor intensive industries, banking etc.

q Firm determines the scale of its operations:

- Building and operating a new facility twice the size of the firm’s
existing plant ahieve a doubling (or more than doubling) of output?
 Returns to Scale

v Returns to scale: % change in output resulting from a given %

change in inputs.
v Constant returns to scale (eg: replicate the production process)
v Increasing returns to scale: a given % increase in all inputs results
in a greater % change in output
v An assembly plant with a capacity of 200,000 cars per year uses
significantly less than twice the input quantities of a plant having
a 100,000-car capacity
v Decreasing returns to scale: a given % increase in all inputs results
in a smaller % change in output (eg: organization factors in a large
firms)
 Economies and Diseconomies of Scale

Average
Total
Cost
ATC in long run

Economies Constant Returns Diseconomies

of scale to scale of scale

0 Quantity of
Cars per Day
 Reasons for EOS

• The reduction of AFC => ATC falls

• Specialization
• Substitutes between inputs: R&D,mechanization
 Discussion

v Why are hospitals getting larger?

v Why do software firms often locate near to other
software firms, e.g., in Silicon Valley and Bangalore?
v Why do hairdressers tend to be small businesses?
Next: Firms in competitive markets