© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 9: Production and Cost Analysis II Prepared by: Kevin Richter, Douglas College Charlene

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

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Chapter 9: Production and Cost Analysis IIPrepared by:Kevin Richter, Douglas CollegeCharlene Richter,British Columbia Institute of Technology


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Chapter Objectives 1. Distinguish technical efficiency from

economic efficiency.

2a. State the envelope relationship between short run cost curves and long run cost curves.2b. Differentiate between increasing, decreasing, and constant returns to scale.2c. Explain how economies of scale and diseconomies of scale influence the shape of long run cost curves.


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Chapter Objectives

3a. Explain the role of the entrepreneur in translating cost of production to supply.

3b. Discuss some of the problems of using cost analysis in the real world.


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Technical Efficiency and Economic Efficiency Technical efficiency – as few inputs as

possible are used to produce a given output.

Technical efficiency is efficiency that does not consider cost of inputs.


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Technical Efficiency and Economic Efficiency Economic efficiency – the method produces

a given level of output at the lowest possible cost.

It is the least-cost technically efficient process.


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Economies of Scale

There are economies of scale in production when the long run average cost decreases as output increases.

Economies of scale (increasing returns to scale) are cost savings associated with larger scale of production.


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Individual Setup Costs

An indivisible setup cost is the cost of an indivisible input for which a certain minimum amount of production must be undertaken before the input becomes economically feasible to use.


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Economies of Scale

Economies of scale occur whenever inputs do not need to be increased in proportion to the increase in output.

As output increases, cost per unit falls in the long run, so this can also be seen as an increase in productivity.


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Minimum Efficient Scale

The minimum efficient scale of production is the amount of production that spreads setup costs out sufficiently for firms to undertake production profitably.


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Increasing Returns to Scale (IRTS) Increasing returns to scale is where long

run average total costs fall as output increases.

It is shown by the decreasing portion of the LRAC curve.


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Constant Returns to Scale (CRTS) Constant returns to scale is where long run

average total costs do not change as output increases.

It is shown by the flat portion of the LRAC curve.


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Decreasing Returns to Scale (DRTS) Decreasing returns to scale or

diseconomies of scale refer to decreases in productivity which occur when there are equal increases of all inputs.

Decreasing returns to scale occur where the long run average cost curve is upward sloping, meaning that average cost is increasing.


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Monitoring Costs

As the size of the firm increases, monitoring costs generally increase.

Monitoring costs are those incurred by the organizer of production in seeing to it that the employees do what they are supposed to do.


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Decreasing Returns to Scale

Diseconomies occur for a number of reasons as the firm increases its size Coordination of a large firm is more difficult Information costs and communication costs

increase as firm increases Monitoring costs increase Team spirit may decrease


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Team spirit is the feelings of friendship and being part of a team that brings out people’s best effort.

Decreasing Returns to Scale


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Summary of Returns to Scale

Returns to scale Doubling inputs results in:

Slope of the LRAC

Increasing returns to scale (IRTS; economies of scale)

Output more than doubles.

downward

Constant returns to scale (CRTS)

Output exactly doubles.

horizontal

Decreasing returns to scale (DRTS; diseconomies of scale)

Output less than doubles.

upward


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Long run average total cost

$64 62 60 58 56 54 52 50 48

11 12 13 14 15 16 17 18 19 20 Quantity

Minimum efficient scale of production

Typical Long Run Average Total Cost Curve

Economiesof scale

Constant returns to scale

Diseconomiesof scale

Costs per unit


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Envelope Relationship

In the long run all inputs are flexible, while in the short run some inputs are not flexible.

As a result, long run cost will always be less than or equal to short run cost.


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Envelope Relationship

The envelope relationship explains that:

At the planned output level, short run average total cost equals long run average total cost.

At all other levels of output, short run average total cost is higher than long run average total cost.


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Cos

ts p

er u

nit

0 Quantity

SRATC2 SRATC3

SRATC4

LRATC

SRATC1SRMC1

SRMC2

SRMC3

SRMC4

Q*

Envelope of Short Run Average Total Cost Curves


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Industry with Strong Economies of Scale


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Entrepreneurial Activity and the Supply Decision

An entrepreneur is an individual who sees an opportunity to sell an item at a price higher than the average cost of producing it.


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Using Cost Analysis in the Real World Some of the problems of using cost analysis

in the real world include the following: Economies of scope. Learning by doing and technological change. Many dimensions. Unmeasured costs.


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Economies of Scope

There are economies of scope in production when the costs of producing goods are interdependent so that it is less costly for a firm to produce one good when it is already producing another.


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Learning by Doing and Technological Change Learning by doing means that as we do

something, we learn what works and doesn’t, and over time we become more proficient at it.


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Learning by Doing and Technological Change External economies are present in all

industries – those are the external forces at work which are capable of reducing costs for all firms belonging to the industry


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Learning by Doing and Technological Change Technological change is an increase in the

range of production techniques that provides new ways of producing goods.


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Production and Cost Analysis II

End of Chapter 9


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Isocost/Isoquant Analysis

Chapter 9 Appendix


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Isoquant Curve

Isoquant curve –An isoquant curve (equal quantity) represents combinations of factors of production that result in equal amounts of output.

A point on the isoquant curve is technically efficient.


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Isoquant Curve for 60 Earrings


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Isoquant Curve for 60 Earrings

Units of labour

Machines

B

A

G

C

D

FE Q60


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Isoquant Curve

Marginal rate of technical substitution – the rate at which one factor must be added to compensate for the loss of another factor, to keep output constant.

It is the slope of the isoquant curve.


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Isoquant Curve

The absolute value of the slope at a point on the isoquant curve equals the ratio of the marginal productivity of labour to the marginal productivity of machines.

onsubstituti of rate MarginalMP

MPSlope

machine

labour


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Isoquant Map

Q40

Q60

Q100


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Isocost line

The isocost line (equal cost) represents alternative combinations of factors of production that have the same cost.

The slope of the isocost line equals the ratio of prices of the factors of production.


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Isocost Lines

Units of labour

Machines

Slope = -Plabour/Pmachines

=-5/3

6 12

20

18

C

D A


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Combining Isoquant and Isocost Curves

Units of labour

Machines

20

12

C

AB

MPlabour/MPmachines =Plabour/Pmachines

Q1

Q2


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Isocost/Isoquant Analysis

End of Chapter 9 Appendix

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 9: Production and Cost Analysis II Prepared by: Kevin Richter, Douglas College Charlene