Production and Cost

1. Production and Cost

2. PRINCIPLEof Opportunity CostThe opportunity cost of something is what you sacrifice to get it. Economic Cost • In economics, the notion of a firm’s costs is based on the notion of economic cost. • The key principle underlying the computation of economic cost is the principle of opportunity cost.

3. Accounting Versus Economic Cost • An accountant’s notion of costs involves only the firm’s explicit costs. • Explicit cost: the firm’s actual cash payments for its inputs. • An economist includes the firm’s implicit costs. • Implicit cost: the opportunity cost of nonpurchased inputs. • Economic cost: the sum of explicit cost plus implicit cost.

4. Accounting Versus Economic Cost

5. 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.

6. Production and Cost in the Short Run • The key principle behind the firm’s short-run cost curves is the principle of diminishing returns. PRINCIPLEof Diminishing ReturnsSuppose output is produced with two or more inputs and we increase one input while holding the other input or inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasingrate.

7. Production and Marginal Product • The total product curve shows the relationship between the quantity of labor and the quantity of output produced.

8. Production and Marginal Product

9. Production and Marginal Product • 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.

10. Short-Run Total Cost There are two types of production cost in the short run: • Fixed cost (FC): cost that does not depend on the quantity produced. • Variable cost: a cost that varies with the quantity produced. Total variable cost (TVC) is the cost that varies as the firm changes its output. The short-run total cost (STC) equals the sum of fixed and variable costs.

11. Short-Run Total Cost

12. Short-Run Marginal Cost • Short-run marginal cost (SMC) is the change in total cost resulting from producing one more unit of the good.

13. Short-Run Average Cost There are three types of short run average cost: • Average fixed cost (AFC): fixed cost divided by the quantity produced. • Short-run average variable cost (SAVC): total variable cost divided by the quantity produced. • Short-run average total cost (SATC): short-run total cost divided by the quantity of output.

14. Short-run Average and Marginal Costs: An Example

15. The Relationship Between Marginal and Average Cost Curves • Throughout the range of output where average cost decreases, marginal cost lies below average cost (points b and c). • When the marginal contribution is greater than the average contribution, the marginal rises above the average (points f and h). • At point m, average cost is minimum and equal to marginal cost.

16. The Cost Mystery • Because the short-run average total cost curve is U-shaped, it is possible to have the same short-run average cost at two—but not three—different quantities of output.

17. 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.

18. Expansion and Replication • The firm’s long-run total cost is the total cost of production in the long run when a firm is perfectly flexible in its choice of inputs and can choose a production facility of any size. • The firm’s long-run average cost of production (LAC) is the long-run total cost divided by the quantity of output produced.

19. Expansion and Replication • The replication process—i.e. doubling the output produced in the original operation—means that long-run total cost increases proportionately with the quantity produced.

20. Decrease in Outputand Indivisible Inputs • An input is indivisible if it cannot be scaled down to produce a smaller quantity of output. • Most production processes have at least one indivisible input. • In general, if there are indivisible inputs, the long-run average total cost curve will be negatively sloped.

21. Decrease in Outputand Indivisible Inputs • When inputs cannot be scaled down to produce a smaller quantity of output, the long-run average cost of production will rise (from point f to point e).

22. Examples of Indivisible Inputs • A cable-TV firm uses a cable running throughout its territory. • A shipping firm uses a large ship to carry TV sets from Japan to the United States. • A steel producer uses a large blast furnace. • A hospital uses imaging machines (for X-rays, CAT scans, and MRIs). • A pizzeria uses a pizza oven.

23. Decrease in Outputand Labor Specialization • A second reason for higher average long-run costs in a smaller operation is that labor will be less specialized in the small operation. • A jack of all trades is a master of none. • In a large operation, each worker specializes in fewer tasks, thus, is more productive than his or her counterpart in a small operation.

24. Economies of Scale • Economies of scale is a situation in which an increase in the quantity produced decreases the long-run average cost of production (or during the trajectory from e to f). • Economies of scale refer to cost savings associated with spreading the cost of indivisible inputs and the benefits of input specialization.

25. Scale Economies in Wind Power • The average cost per kilowatt hour is $0.032 for the large turbine, compared to $0.065 for the smaller turbine.

26. Minimum Efficient Scale • The minimum efficient scale describes the output at which 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.

27. LAC Curve for Electricity Generation LAC Curve for Aluminum Production Actual Long-Run Average Cost Curves

28. LAC Curve for Truck Freight LAC Curve for Hospital Services Actual Long-Run Average Cost Curves

29. 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