1 C H A P T E R 8 1 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Production and Cost Market Structures

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© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin

Production and Cost

Market Structures and Pricing

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Economic Cost

The key principle underlying the computation of economic cost is opportunity cost.

PRINCIPLE of Opportunity CostThe opportunity cost of something is what you sacrifice to get it.

In economics, the notion of a firm’s costs is based on the notion of economic cost.

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Accounting versus Economic Cost

An accountant’s notion of costs involves only the firm’s explicit costs:

Explicit costs: the firm’s actual cash payments for its inputs.

An economist includes the firm’s implicit costs: Implicit costs: the opportunity costs of

nonpurchased inputs. Economic cost: the sum of explicit and implicit costs.

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AccountingApproach

EconomicApproach

Explicit Cost (purchased inputs) $60,000 $60,000

Implicit: opportunity cost of entrepreneur’s time 30,000

Implicit: opportunity cost of funds 10,000

______ ______

Total Cost $60,000 $100,000

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Short-run versus Long-run Decisions

Short run: a period of time during which at least one factor of production remains fixed. In the short run, a firm decides how much output to produce in the current facility.

Long run: the time it takes for a firm to build a production facility and start producing output. In the long run, a firm decides what size and type of facility to build.

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Diminishing Returns and Marginal Cost

The key principle behind the firm’s short-run cost curves is the principle of diminishing returns.

PRINCIPLE of Diminishing ReturnsSuppose that output is produced with two or more inputs and we increase one input while holding the other inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate.

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The Firm’s Short-run Production Function

The short-run production function, or total product curve, shows the relationship between the number of workers and the quantity of output produced.

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Labor Input and Output

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Rakes p

er

min

ute

0 20 40 60 80 100 120 140 Labor: Number of workers

Short-run Production Function

WorkersNumber of

Labor:

minuteper

Rakes

00

81

122

153

204

275

366

487

658

909

13010

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Labor Input and Output

The shape of the production function is explained by diminishing returns.

Beyond 15 workers the marginal product of labor decreases and the production function becomes flatter.

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Short-run Production Costs

The short-run costs of production are a reflection of the relationship between labor and output in the short run under diminishing returns.

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Short-Run Production Costs

In the short run, the firm has two types of costs: Fixed cost: the cost of the production facility,

which is independent of the amount of output produced in it.

Variable costs: the costs of labor and materials associated with producing output.

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Short-run Total Cost

T C T FC T VC Total Cost =

Total Fixed Cost

+Total Variable Cost

0

50

100

150

Co

st

in $

0 1 2 3 4 5 6 7 8 9 10 11 Output: Rakes per minute

Total Costs

Total CostShort-run

CostVariable

Total

CostFixed

MinuteRakes perOutput:

STCTVCFCQ

360360

448361

4812362

5115363

5620364

6327365

7236366

8448367

10165368

12690369

1661303610

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Short-run Average Total Cost

Short-run average total cost measures total cost per unit of output produced.

SA T CT FC

Q

T VC

Q

SA T C A FC SA VC


=Fixed Cost per Unit

+Variable Cost per Unit

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Short-run Marginal Cost

Short-run marginal cost is the change in total cost resulting from a 1-unit increase in the output of an existing production facility.

M CT C

Q

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Diminishing Returns and Increasing Marginal Cost

The marginal cost of production is the amount of money necessary to buy the additional labor and materials necessary to produce one more unit of output.

The marginal cost of production increases because output increases at a decreasing rate with additional labor hours.

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Short-run Average and Marginal Costs: An Example

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Co

st

in $


MC ATC AFC AVC

Per-unit costs

Total CostAverage

Short-run

Variable CostAverageShort-run

CostFixed

Average

CostMarginalShort-run

MinuteRakes per

Output:

SATCSAVCAFCSMCQ

----0

44.008.0036.0081

24.006.0018.0042

17.005.0012.0033

14.005.009.0054

12.605.407.2075

12.006.006.0096

12.006.865.14127

12.638.134.50178

14.0010.004.00259

16.6013.003.604010

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Summary of Short-run Production Costs

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50

100

150

Co

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in $


Total Costs

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10

15

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Co

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in $


MC ATC AFC AVC

Per-unit costs

Total CostAverage

Short-run

Variable CostAverage

Short-run

CostFixed

Average

CostMarginalShort-run

Total CostShort-run

CostVariable

Total

CostFixed


SATCSAVCAFCSMCSTCTVCFCQ

----360360

44.008.0036.008448361

24.006.0018.0044812362

17.005.0012.0035115363

14.005.009.0055620364

12.605.407.2076327365

12.006.006.0097236366

12.006.865.14128448367

12.638.134.501710165368

14.0010.004.002512690369

16.6013.003.60401661303610

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A Closer Look at Short-run Production Costs

To study the relationship between the components of short-run production costs, consider the following example concerning a producer of computer chips facing diminishing returns.

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Short-run Average Total Cost (SATC)


Quantity of Chips

Fixed Cost per Chip

Labor Hours

Labor Cost

Labor Cost per Chip

Material Cost per Chip

Average Total Cost

Small: 100 $72 100 $800 $8 $10 $90

Medium: 300 24 900 7,200 24 10 58

Large: 400 18 2,000 16,000 40 10 68

Assumptions: Total fixed cost: $7,200 Hourly wage: $8.00

$7,200/100

100 x $8

$7,200+800 100 $72+$8+$10


Quantity of Chips

Fixed Cost per Chip

Labor Hours

Labor Cost

Labor Cost per Chip

Material Cost per Chip

Average Total Cost

Small: 100 $72 100 $800 $8 $10 $90

Medium: 300 24 900 7,200 24 10 58

Large: 400 18 2,000 16,000 40 10 68

Assumptions: Total fixed cost: $7,200 Hourly wage: $8.00

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Average Variable Cost ($)

Average Fixed

Cost ($)

Average Total

Cost ($)

Quantity Produced

Average Total Cost is the Sum of Average Variable and Average Fixed Cost

The gap between SATC and SAVC decreases as output increases.

AFC continuously decreases as total fixed cost is spread over more units of output produced.

187290100

342458300

501868400

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Short-run Average Total Cost (SATC)

The SATC curve is U-shaped because of the behavior of its two components as output produced increases.

AFC decreases as output increases.

SAVC increases as output increases.

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Quantity of ChipsAdditional Labor Hours

Additional Labor Cost

Additional Material Cost

Marginal Cost

Small: 100 2 $16 $10 $26

Medium: 300 6 48 10 58

Large: 400 10 80 10 90

Initially, it takes 4 additional labor hours to increase the quantity of chips by 200, from 100 to 300. Then, it takes another 4 hours of labor to increase output by only 100 more chips, from 300 to 400. Marginal cost increases because output increases at a decreasing rate with additional labor hours.

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Relationship between Short-run Marginal and Average Cost Curves

As long as SATC is declining, marginal cost lies below it.

When SATC rises, SMC is greater than SATC.

At point m, SATC=SMC.

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Relationship between Short-run Marginal and Average Cost Curves

9026100

5858300

6890400

The marginal cost curve (SMC) intersects the average cost curve (SATC) when average cost is minimum.

Average Total Cost

($)

Marginal Cost($)

Quantity Produced

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Production and Cost in the Long Run

The key difference between the short run and the long run is that there are no diminishing returns in the long run.

Diminishing returns occur because workers share a fixed facility. In the long run the firm can expand its production facility as its workforce grows.

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Long-run Average Cost

Long-run average cost (LAC) is total cost divided by the quantity of output when the firm can choose a production facility of any size.

The LAC curve describes the behavior of average cost as the plant size expands. Initially, the curve is negatively sloped, then beyond some point, it becomes horizontal.

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Indivisible Inputs

Because of indivisible inputs, the long-run average cost curve will be negatively sloped.

Indivisible input: an input that cannot be scaled down to produce a small quantity of output.

Most production processes have at least one indivisible input.

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Examples of Indivisible Inputs

A computer factory uses sophisticated machines and testing equipment.

A transatlantic shipper uses a large ship to carry TV sets from Japan to the United States.

A cable-TV firm uses a cable running throughout its territory.

A steel mill uses a large furnace. A freight hauler uses a freight truck. A pizzeria uses a pizza oven.

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Long-run Average Cost

When long-run total cost is proportionate to the quantity produced, long-run average cost does not change as output increases.

The long-run average cost curve is horizontal for 7 or more rakes per hour.

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Avera

ge c

ost:

$ p

er

rake

0 7 14 21 28 Output: Rakes per minute

Long-run Average Cost Curve

CostAverage

Long-run

Total CostLong-run


LAC

$20.00$703.5

$12.00$847

$12.00$16814

$12.00$33628

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Labor Specialization

In a large operation, each worker specializes in fewer tasks thus is more productive than his or her counterpart in a small operation.

Higher productivity (more output per worker) means lower labor costs per unit of output, thus lower production costs (ever-decreasing average cost).

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Economies of Scale

Economies of scale: a situation in which an increase in the quantity produced decreases the long-run average cost of production.

Economies of scale refer to cost savings associated with spreading the cost of indivisible inputs and input specialization.

When economies of scale are present, the LAC curve will be negatively sloped.

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Minimum Efficient Scale

The minimum efficient scale describes the output at which economies of scale are exhausted and the long-run average cost curve becomes horizontal.

Once the minimum efficient scale has been reached, an increase in output no longer decreases the long-run average cost.

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Diseconomies of Scale

A firm experiences diseconomies of scale when an increase in output leads to an increase in long-run average cost—the LAC curve becomes positively sloped.

Diseconomies of scale may arise for two reasons:

Coordination problems Increasing input costs

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Examples of Economies of Scale

LAC Curve for Aluminum Production

LAC Curve for Electricity Generation

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Examples of Economies of Scale

LAC Curve for Truck FreightLAC Curve for Hospital

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Documents

1 C H A P T E R 8 1 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Production and Cost Market Structures