Production and Cost

Analysis: Part I
Chapter 9
 Introduction
• In the supply process, households first
offer the factors of production they
control to the factor market.
– The factors are then transformed by
firms into goods that consumers want.
– Production is the name given to that
transformation of factors into goods.
 The Role of the Firm

• A key concept in production is the firm.

• The firm is an economic institution that
transforms factors of production (inputs)
into consumer goods (output, quantity
supplied).
 The Role of the Firm
• A firm:
– Organizes factors of production.
– Produces goods and/or services.
– Sells goods it produces to individuals.
 The Role of the Firm

• When the firm only organizes production it

is called a virtual firm.

– Virtual firms subcontract out all work.

– While most firms are not virtual, more
and more of the organizational structure
of business is being separated from
production.
 The Firm and the Market

• Whether an activity is organized through

the market depends on transaction costs.

• Transaction costs – costs of

undertaking trades through the
market.
 The Firm and the Market

• The various forms that businesses organize

themselves include
– sole proprietorships,
– partnerships,
– corporations,
– for-profit firm,
– nonprofit firms, and
– cooperatives.
 Firms That Maximize Profit

• Profit is the difference between total revenue

and total cost.

Profit = total revenue – total cost

∏ = TR – TC

∏ = P*Q – (TC/Q)*Q
 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.
• Total Costs = accounting costs + opportunity
costs.
• Accounting costs = expenses that appear “on the
books.”
 Firms Maximize Profit

• Total revenue is the amount a firm

receives for selling its good or service plus
any increase in the value of the assets
owned by firms.
 Firms Maximize Profit

• Economists and accountants measure

profit differently.
 Firms Maximize Profit

• For accountants, total revenue is total

sales times price.
• Profit is explicit revenue less explicit cost.
 Firms Maximize Profit

• For economists, revenue includes any

increase or decrease in the value of any
assets the firm owns.

• They count implicit costs which

include the opportunity costs of
owner-provided factors of
production.
 Firms Maximize Profit
• For economists:

Economic profit =

(explicit and implicit revenue)– (explicit and implicit cost)

 The Production Process

• The production process can be divided into

the long run and the short run
 The Long Run and the Short Run

• A long-run decision is a decision in which

the firm can choose among all possible
production techniques.
 The Long Run and the Short Run

• A short-run decision is one in which the

firm is constrained in regard to what
production decisions it can make.
 The Long Run and the Short Run

• The terms long run and short run do not

necessarily refer to specific periods of
time.

• They refer to the degree of

flexibility the firm has in changing
the level of output.
 The Long Run and the Short Run

• In the long run:

– By definition, the firm can vary any

inputs as much as it wants.
– All inputs are variable.
 The Long Run and the Short Run

• In the short run:

– Some the flexibility that existed in the

long run no longer exists.
– Some inputs are so costly to adjust that
they are treated as fixed.
Production Tables and Production Functions

• How a firm combines factors of production

to produce consumer goods can be
presented in a production table.
• A production table shows the output
resulting from various combinations of
factors of production or inputs.
Production Tables and Production
Functions

• Production tables are so complicated that

in introductory economics we concentrate
on short-run production analysis in which
one of the factors is fixed.
Production Tables and Production
Functions

• Marginal product is the additional output

that will be forthcoming from an additional
worker, other inputs remaining constant.
Production Tables and Production
Functions

• Average product is calculated by dividing

total output by the quantity of the output.
Production Tables and Production
Functions

• The information in a production table is

often summarized in a production function
– a curve that describes the relationship
between the inputs (factors of production)
and outputs.
Production Tables and Production
Functions

• The production function discloses the

maximum amount of output that can be
derived from a given number of inputs.
 A Production Table

Number of Total Marginal Average

workers output product product

0 0 4 — Increasing
1 4 6 4 marginal returns
2 10 5
3 7
17 6 5.7
4 23 5.8
5 Diminishing
5 28 3 5.6 marginal returns
6 31 1 5.2
7 32 0 4.6
8 32 2 4.0 Diminishing
9 30 5 3.3 absolute returns
10 25 2.5
 A Production Function

Diminishing Diminishing Diminishing Diminishing

32 marginal absolute 7 marginal absolute
30 returns returns returns returns
28
26 6
24
22 TP 5
20

Output per worker

Increasing
Output

18 4
16 marginal
14 returns
3
12
10
8 2
AP
6
4 1
2
0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Number of workers Number of workers MP
(a) Total product (b) Marginal and average product
 The Law of Diminishing Marginal
Productivity

• The law of diminishing marginal

productivity is an important element in all
real-world production processes.
• Both marginal and average productivities
initially increase, but eventually they both
decrease.
 The Law of Diminishing Marginal
Productivity

• This means that initially the production

function exhibits increasing marginal
productivity.
• Then it exhibits diminishing marginal
productivity.
• Finally, it exhibits negative marginal
productivity.
 The Law of Diminishing Marginal
Productivity

• The most relevant part of the production

function is that part exhibiting diminishing
marginal productivity.
 The Law of Diminishing Marginal
Productivity

• The law of diminishing marginal

productivity states that 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 variable input will fall.
 The Law of Diminishing Marginal
Productivity

• This law is true since, as a firm adds more

and more workers, they must share the
existing machines, so the marginal product
of the machines increases while the
marginal product of the workers
decreases.
 The Law of Diminishing Marginal
Productivity

• This law is also called the flower pot law,

because it if did not hold true, the world’s
entire food supply could be grown in a
single flower pot.
 The Costs of Production

• There are many different types of costs.

• Invariably, firms believe costs are too high
and try to lower them.
 Costs of Production

• Fixed Costs,
• Variable Costs, and
• Total Costs
 Fixed Costs, Variable Costs, and
Total Costs

• Fixed costs are those that are spent and

cannot be changed in the period of time
under consideration.
• 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.
 Fixed Costs, Variable Costs, and
Total Costs

• Workers represent variable costs – those

that change as output changes.
 Fixed Costs, Variable Costs, and
Total Costs

• The sum of the variable and fixed costs

are total costs.

TC = FC + VC
 Costs of Production:
Average Costs

• Average Total Cost, Average Fixed Cost,

and Average Variable Cost
• Average costs are costs per unit of output
 Average Costs

• Much of the firm’s discussion is of average

cost.
 Average Costs

• Average total cost (often called average

cost) equals total cost divided by the
quantity produced.
ATC = TC/Q
 Average Costs

• Average fixed cost equals fixed cost

divided by quantity produced.
AFC = FC/Q
 Average Costs

• Average variable cost equals variable cost

divided by quantity produced.
AVC = VC/Q
 Average Costs

• Average total cost can also be thought of

as the sum of average fixed cost and
average variable cost.
ATC = AFC + AVC
 Marginal Cost

• Marginal cost is the increase (decrease) in

total cost of increasing (or decreasing) the
level of output by one unit.
• In deciding how many units to produce, the
most important variable is marginal cost.
 The Cost of Producing Earrings
Output FC VC TC MC AFC AVC ATC
3 50 38 88 — 16.67 12.66 29.33
4 50 50 100 12 12.50 12.50 25.00
9 50 100 150 — 5.56 11.11 16.67
10 50 108 158 8 5.00 10.80 15.80
16 50 150 200 — 3.13 9.38 12.50
17 50 157 207 7 2.94 9.24 12.18
22 50 200 250 — 2.27 9.09 11.36
23 50 210 260 10 2.17 9.13 11.30
27 50 255 305 — 1.85 9.44 11.30
28 50 270 320 15 1.79 9.64 11.42
 Graphing Cost Curves

• To gain a greater understanding of these

concepts, it is a good idea to draw a graph.
• Quantity is put on the horizontal axis and a
dollar measure of various costs on the
vertical axis.
 Total Cost Curves

• The total variable cost curve has the same

shape as the total cost curve—increasing
output increases variable cost.
 Total Cost Curves
TC
$400 VC
350
300
Total cost

TC = (VC + FC)
250
200 L
150
100 O
M
50 FC
0
2 4 6 8 10 20 30
Quantity of earrings
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.
• Each of these curves is U-shaped.
Average and Marginal Cost Curves

• The average fixed cost curve slopes down

continuously.
 Downward-Sloping Shape of the
Average Fixed Cost Curve

• The average fixed cost curve looks like a

child’s slide – it starts out with a steep
decline, then it becomes flatter and
flatter.
• It tells us that as output increases, the
same fixed cost can be spread out over a
wider range of output.
The U Shape of the Average and
Marginal Cost Curves

• When output is increased in the short-run,

it can only be done by increasing the
variable output.
The U Shape of the Average and
Marginal Cost Curves

• The law of diminishing marginal

productivity sets in as more and more of a
variable input is added to a fixed input.

• Marginal and average productivities

fall and marginal costs rise.
The U Shape of the Average and
Marginal Cost Curves

• And when average productivity of the

variable input falls, average variable cost
rise.
The U Shape of the Average and
Marginal Cost Curves

• The average total cost curve is the

vertical summation of the average fixed
cost curve and the average variable cost
curve, so it is always higher than both of
them.
The U Shape of the Average and
Marginal Cost Curves

• If the firm increased output enormously,

the average variable cost curve and the
average total cost curve would almost
meet.
• The firm’s eye is focused on average
total cost—it wants to keep it low.
Per Unit Output Cost Curves
$30
28
26
24
22
20
18
16
MC
Cost

14
12 ATC
10 AVC
8
6
4
2 AFC
0 2 4 6 8 10 12 14 16 18 20 22 2426 28 30 32
Quantity of earrings
 The Relationship Between
Productivity and Costs

• The shapes of the cost curves are mirror-

image reflections of the shapes of the
corresponding productivity curves.
 The Relationship Between
Productivity and Costs

• When one is increasing, the other is

decreasing.
• When one is at a maximum, the other
is at a minimum.
 The Relationship Between
Productivity and Costs

Productivity of workers at this output

$18 9
16 MC 8
14 7
Costs per unit

12 AVC 6 A
10 5
8 4 AP of
6 3 workers
4 2
2 1 MP of workers
0 4 8 12 16 20 24 Output 0 4 8 12 16 20 24 Output
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.
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.
Relationship Between Marginal and
Average Costs

• The position of the marginal cost relative

to average total cost tells us whether
average total cost is rising or falling.
Relationship Between Marginal and
Average Costs

• 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.
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 low point.
If MC < AVC, then AVC is falling.
Relationship Between Marginal and
Average Costs

• Average total cost will fall when marginal

cost is above average variable cost, so long
as average variable cost does not rise by
more than average fixed cost falls.
Relationship Between Marginal and
Average Costs

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

Quantity of output
Production and Cost
Analysis: Part I
End of Chapter 9