1. Production and Cost
“Anybody can cut prices, but it takes brains to
produce a better article”
-P.D. Armour
Slide 1 of 58
2. First, some notes
This module is a critical part of this class.
The concepts we learn here are a
foundation for material we will discuss in
each of the next three modules…and in
your final project!
We are now turning our attention
from the behavior of consumers
(Modules 4 and 6) to the behavior
of producers (Modules 7-11).
Slide 2 of 58
3. This module has been
divided into three major parts
Part 1: Production
Relationships
Part 2: Short Run
Production Costs
Part 3: Long Run Production
Costs
The relationship between the amount of inputs
used and the amount of output produced will be
explored. One input in particular, labor, will be
emphasized.
Short run costs are a key part of determining how
much a producer will produce. Several short run
costs will be discussed
Long run costs are key in examining how big your
firm should be.
Slide 3 of 58
4. Production relationships help show
a key microeconomic concept
• Total Product (TP)
– This is the total output or total quantity of a
particular good or service produced
• Marginal Product (MP)
– This is the increase in output associated with
adding one more unit of a resource (for example one
more unit of labor)
• Average Product (AP)
– This is the output per unit of input (for example the
amount of output each unit of labor produces)
– In reference to labor, this is productivity
Part 1: Production
Relationships
Three production relationships will be explored:
TP
MP
AP
Slide 4 of 58
5. Total product (TP) describes how
much can be produced by a firm
In this example, we’ll talk
about bricklayers.
With no employees, your firm will
not produce any brick walls.
With the hire of your first
employee, your firm may be able
to produce 10 feet of brick wall
per day.
With the hire of your second
employee, your firm may be able
to produce 25 feet of brick wall
per day.
Note how two employees are
more productive then twice one
employee. They are working
together and are more efficient.
With the hire of your third
employee, your firm may be able
to produce 45 feet of brick wall
per day.
Note how three employees are
more productive then three times
one employee. They are working
together and again they are more
efficient.
Eventually these gains from
efficiency start to wear off.
If you keep adding employees to
the same job, eventually they
become increasingly
unproductive.
In the extreme, production can
decline with added employees as
the worksite becomes crowded
and confused.
Part 1: Production
Relationships
TP
Slide 5 of 58
6. Total product, seen graphically
This line is referred
to as the production
function.
A producer may
produce anywhere
up to and including
points on this line.
But note how the line
eventually declines
as an increasing
number of inputs are
added!
With one
employee,
your firm will
produce 10
feet of product
With two
employees,
your firm will
produce 25
feet of product
With three
employees,
your firm will
produce 45
feet of product
With four
employees,
your firm will
produce 60
feet of product
With five
employees,
your firm will
produce 70
feet of product
With six
employees,
your firm will
produce 75 feet
of product
With seven
employees,
your firm will
still produce 75
feet of product
Part 1: Production
Relationships
TP
This is the key lesson in this section:
Beyond some point, as extra variable resources are
added (in this case, labor), product that can be
attributed to each additional unit will decline.
With eight
employees,
your firm will
only produce 70
feet of product
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7. Marginal product (MP) shows how much
can be produced given one more input
When we are discussing Marginal
Product, we are asking, “How
much more output will I get if I hire
another worker”?
The technical definition:
Marginal product is the extra output
associated with adding an extra unit
of input such as labor.
Part 1: Production
Relationships
MP
Slide 7 of 58
8. Calculating marginal product
The first
worker
produces
10 units.
MP =10
The 2nd
worker
produces
15 units.
MP =15
The 3rd
worker
produces
20 units.
MP =20
The 4th
worker
produces
15 units.
MP =15
The 5th
worker
produces
10 units.
MP =10
The 6th
worker
produces
5 units.
MP =5
The 7th
worker
produces
0 units.
MP =0
The 8th
worker
actually
hurts
production.
The
workplace is
too
crowded.
MP =-5
Part 1: Production
Relationships
MP
Slide 8 of 58
9. Note: Increasing MP
as a second worker is
added
Note: MP is
increasing at a
decreasing rate
as more
workers are
added
Note: MP is
negative as
workers get in each
other’s way
This highlights the
“Law of Diminishing
Marginal Returns”
(see next slide)
Marginal product, seen graphically
Marginal product is increasing.
People are working together and
“specializing”.
Added employees are
still productive (MP>0)
but not as much as
the first few. Perhaps
they have to wait in
line for tools.
Part 1: Production
Relationships
MP
Slide 9 of 58
10. Eventually the MP curve turns
downward and becomes negative
This idea is embodied in the Law of
Diminishing Marginal Return:
As successive units of variable resources
(such as labor) are added to a fixed resource
(such as a factory), beyond some point, the
added product (i.e. marginal product) that
can be attributed to each additional unit of
the variable resource will decline
Part 1: Production
Relationships
In common language:
As you continually hire
more employees without
increasing your factory
size, eventually each one
will produce less than the
last.
MP
Slide 10 of 58
11. There is a relationship between the
production function and MP
Early in production,
we observe increasing
marginal returns
At some point,
diminishing marginal returns
sets in
Eventually,negative
marginalreturnsoccurs
Part 1: Production
Relationships
MP
Slide 11 of 58
12. To make sure you understand,
try this exercise
At what point does diminishing marginal returns set in?
____________
At what point does negative MP occur? ____________
Please fill in the blank cells and answer the
questions below. Click to see the answers.
4th employee
7th employee
Part 1: Production
Relationships
MP
Slide 12 of 58
13. Average product (AP) describes
output per unit of labor
When we are discussing Marginal
Product, we are asking, “How
much does the average employee
produce”?
The technical definition:
Average product is the total output
produced per unit of resource
employed.
Part 1: Production
Relationships
AP
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14. Calculating average product
The first
worker
produces
10 units.
AP =10
The first 2
workers
produce
25 units.
AP =12.5
The first 3
workers
produce
45 units.
AP =15
The first 4
workers
produce
60 units.
AP =15
The first 5
workers
produce
70 units.
AP=14
The first 6
workers
produce
75 units.
AP =12.5
The first 7
workers
produce
75 units.
AP =10.7
The first 8
workers
produce
70 units.
AP =8.8
Part 1: Production
Relationships
AP
Slide 14 of 58
15. AP and MP, seen graphically
Diminishing Marginal
Returns is evident in
both these measures:
Eventually, the curves
slope downward.
When does diminishing
marginal returns set in?
Part 1: Production
Relationships
AP
When does diminishing
marginal returns set in?
With the fourth worker.
Slide 15 of 58
16. Part 2: Short run
costs of production
Let’s turn our
attention from
production to
producer
costs
We’ll use the shipbuilding
industry as an example.
Part 2: Short Run
Production Costs
Slide 16 of 58
17. First, a clarification about time
• When analyzing production costs, we must
first differentiate between the short run and
the long run.
• In the short run, “the plant” is fixed
– plant capacity can’t be altered, but the intensity with
which that plant is used can be altered. For
example, you can hire a night shift.
• In the long run, “the plant” is variable
In the long run, the producer can alter plant
capacity and any other resource. For
example, you can add another dry dock.
But you can’t do that in the short run.
Part 2: Short Run
Production Costs
Slide 17 of 58
18. Opportunities to change production
differ in the short run versus the long run
Part 2: Short Run
Production Costs
Assume you own a farm and decided
to plant corn last spring. It is time to
harvest.
You are now reading in the paper that
corn prices are falling and soybean
prices are rising.
In the long run, you can change your
crop to soybean (i.e. next year).
In the short run, you are going to
harvest corn.
Slide 18 of 58
19. Short run costs are a major factor
in deciding how much to produce
• Total Costs (TC)
– It is the sum of all producer’s costs
– It includes fixed and variable costs
• Average Total Costs (ATC)
– It is the average cost per unit of production
– Includes average fixed and average variable costs
• Marginal Costs (MC)
– It is change in costs associated with a one unit
change in production
– Remember: marginal means “additional”
Part 2: Short Run
Production Costs
Three short run producer costs will be explored:
TC
ATC
MC
Slide 19 of 58
20. Producer cost concept #1:
Total Costs (TC)
• Total costs of production include the value
of all resources used in the production
process
– Total costs include:
• Fixed costs
• Variable costs
TC
Part 2: Short Run
Production Costs
Slide 20 of 58
These (and other) relationships are a key learning
outcome. Each cost has a special, but different
relationship with output.
Understanding the producer costs outlined from here
forward will be critical in your success in this class.
21. Fixed costs include costs
that don’t change
• Costs that do not vary with changes in output
are fixed costs
Examples include:
•Rental payments
•Interest on a firm’s debt
•Depreciation on equipment
•Insurance premiums
TC
Part 2: Short Run
Production Costs
Rent is a great example. It
doesn’t matter how many
units of output you produce
your rent is the same.
Interest on debt is another
example. Do you think
these guys care how much
output you produced?
Slide 21 of 58
22. An example of fixed costs
Which of these costs are fixed?
Note: Many other costs such as taxes, insurance, pensions, energy, fuel, and others are ignored.
TC
Part 2: Short Run
Production Costs
Hypothetical Costs for a Shipbuilder
Slide 22 of 58
23. Variable costs include
costs that do change
• Costs that do vary with changes in output
are variable costs
Other examples include:
•Materials
•Fuel
•Power
•Transportation services
TC
Part 2: Short Run
Production Costs
Labor is a great example. As your
output increases, you have to hire more
people and labor costs go up.
Slide 23 of 58
24. An example of variable costs
Which of these costs are variable?
Note: Many other costs such as taxes, insurance, pensions, energy, fuel, and others are ignored
TC
Part 2: Short Run
Production Costs
Hypothetical Costs for a Shipbuilder
Slide 24 of 58
25. Fixed costs, shown in tabular form TC
Part 2: Short Run
Production Costs
Note: fixed costs don’t change with
increases in output.
Slide 25 of 58
26. Fixed costs, shown graphically
Note: There is
no relationship
between fixed
costs and
output
What is the relationship
between fixed costs and
output?
(positive, negative or no relationship)
TC
Part 2: Short Run
Production Costs
Slide 26 of 58
27. Variable costs, shown in tabular form TC
Part 2: Short Run
Production Costs
Note: fixed costs DO change with
increases in output.
Slide 27 of 58
28. Variable costs, shown graphically
The relationship is
positive. As output
increases, variable costs
go up.
TC
Part 2: Short Run
Production Costs
Note: The Law of Diminishing
Marginal Returns is evident in
the shape of this curve! It
increases at an increasing
rate as added employees
become less productive.
What is the relationship
between variable costs and
output?
(positive, negative or no relationship)
Slide 28 of 58
29. Total costs
Please keep in mind that fixed costs
plus variable costs equal total costs
TC
Part 2: Short Run
Production Costs
Slide 29 of 58
30. Total cost, variable cost,
and fixed costs shown graphically
TC
Part 2: Short Run
Production Costs
Notice: the vertical distance
between variable costs and total
costs is constant. Why?
Because the difference between
them is fixed costs, which doesn’t
change as production changes!
Slide 30 of 58
31. Try this total cost exercise
Fill in the empty cells on the table then
graph TFC, TVC, and total costs
TC
Part 2: Short Run
Production Costs
Slide 31 of 58
32. Producer cost concept #2:
Average Total Costs (ATC)
When we are discussing the ATC,
we are asking," How much, on
average, does each unit of
production cost?”
The technical definition:
A firm’s total cost divided by
its output.
Average total costs include:
Average fixed costs
Average variable costs
ATC
Part 2: Short Run
Production Costs
Slide 32 of 58
33. Calculation of Average
Total Costs (ATC)
ATC
Part 2: Short Run
Production Costs
The first cell cannot be filled
out, You can’t divide by zero!
For the first unit, the ATC is
$650. (Total Cost/ Total
Output = $650/1)
For the second unit, the ATC
is $413. (Total Cost/ Total
Output = $825/2)
Costs for a Hypothetical Shipbuilder, in MillionsCosts for a Hypothetical Shipbuilder, in Millions
Slide 33 of 58
34. Average total costs, seen graphically
Note the U-Shape of the ATC!
At lower levels of
production, fixed
costs are spread
over only a few
units making ATC
high
As production
increases, fixed
costs are spread
over more units
and ATC declines
Eventually,
Diminishing
Marginal Returns
sets in and ATC
begins to rise
ATC
Part 2: Short Run
Production Costs
Slide 34 of 58
35. Average total costs, seen graphically
Note the U-Shape of the ATC!
Examine the data: At lower
levels of production, fixed
costs are spread over only a
few units making ATC high
ATC
Part 2: Short Run
Production Costs
Slide 35 of 58
36. Average total costs, seen graphically
Note the U-Shape of the ATC!
Examine the data: At high levels
of production, diminishing
Marginal Returns sets in and the
ATC begins to rise
ATC
Part 2: Short Run
Production Costs
Slide 36 of 58
37. Average total, variable, and fixed
costs, seen graphically
ATC
Part 2: Short Run
Production Costs
This side of the ATC is “held
up” by high fixed costs per
unit (The orange line) This side of the ATC is “held
up” by high variable costs per
unit (The green line)
Among these
curves, this is
the most
important one.
We will
continue to
discuss the
ATC for the
next several
weeks.
Slide 37 of 58
38. Try this average total cost exercise ATC
Part 2: Short Run
Production Costs
Fill in the empty cells on
the table then graph ATC
Slide 38 of 58
39. Producer cost concept #3:
Marginal Costs (MC)
When discussing the MC, we are asking
the question, " How much would it cost
to produce one more unit?”
The technical definition:
A firm’s total cost divided by
its output.
Part 2: Short Run
Production Costs
MC
Slide 39 of 58
40. Marginal cost (MC)
Note: When adding the 1st
unit of production, costs go
up by $250
MC
Part 2: Short Run
Production Costs
MC for the first unit = ($650-
$400)/(1-0)
Costs for a Hypothetical Shipbuilder, in MillionsCosts for a Hypothetical Shipbuilder, in Millions
Note: When adding the 2nd
unit of production, costs go
up by $175
MC for the second unit =
($825-$650)/(2-1)
Slide 40 of 58
41. Marginal cost, seen graphically
Note the “J-Curve Shape”.
MC decreases as
efficiency is improved
(Increasing Marginal Product)
MC slowly rises as
Diminishing Marginal
Returns sets in
(Decreasing Marginal Product)
MC increases
rapidly as
Marginal
Product
approaches
(and falls
below) zero
(Negative Marginal
Product)
MC
Part 2: Short Run
Production Costs
Slide 41 of 58
42. Try this marginal cost exercise MC
Part 2: Short Run
Production Costs
Fill in the empty cells on
the table then graph MC
Slide 42 of 58
43. Long run producer costs
impact the size of the company
Part 3: Long Run
Production Costs
In the long run, a shipbuilder can add
another dry dock
In the long run, a farmer can farm
additional land
Slide 43 of 58
44. In the long run, if a firm is
successful it will likely expand
The question is, what happens to its average
total costs (ATC) as it expands?
Part 3: Long Run
Production Costs
Slide 44 of 58
45. As a firm expands, economies
of scale may occur
Please note: “scale” is a
fancy word for “size”
The issue: can this big factory produce a good at a lower
average cost than this little factory?
Part 3: Long Run
Production Costs
The technical definition of economies of scale:
Reductions in the average total cost of
producing a product as the firm expands the
size of its plant
Slide 45 of 58
46. Recall: in the long run an industry
(and the individual firms it includes) can adjust all resources
– Farmers can add to farmed land
– Manufacturers can add an assembly line
– Shipbuilders can add a dry dock
Part 3: Long Run
Production Costs
Slide 46 of 58
47. As an example: assume that you run a
transportation company moving containers
Your current fleet is comprised of containers
measuring 10’X10’ X 30’
10’
10’
30’
3,000 ft3
Total costs to transport one container (fuel, driver, taxes,
tariffs, storage) = $1,500
Average total costs (ATC) are $0.50 per cubic foot
i.e. $1,500 / 3,000 ft3
Part 3: Long Run
Production Costs
Slide 47 of 58
48. One of your competitors is
operating with larger containers
10’
12’
60’
7,200 ft3
Total costs to transport one container (fuel, driver, taxes,
tariffs, storage) = $2,600
Average total costs (ATC) are $0.36 per cubic foot
Clearly, your competitor
has a cost advantage
on you !
i.e. $2,600 / 7,200 ft3
Part 3: Long Run
Production Costs
Your ATC = $0.50/sf
His ATC=$0.36/sf
Slide 48 of 58
49. Long run versus short run
In the long run, you could upgrade your
fleet to include the larger containers.
You realize that you should probably adjust your fleet
to compete, but you look at the number of containers
you have and sigh…
In the short run, you are stuck with the
containers you have.
Part 3: Long Run
Production Costs
Slide 49 of 58
50. Short run ATC for individual firms
$0.50
200
$0.50
$0.36
200 500
Your ATC
Your Competitors
ATC
ATC3
Perhaps there is another firm
with even bigger containers
ATC4
Eventually, however, containers
may become so big, that it takes
specialized equipment to pick
them up, overwhelming any cost
savings.
ATC5
Here average costs per
unit have increased
again as containers
become even bigger!
Part 3: Long Run
Production Costs
Slide 50 of 58
51. Short run ATC for individual firms and
long run ATC for industry
$0.50
200
$0.50
$0.36
200 500
Your ATC
Your Competitors
ATC
ATC3
ATC4
ATC5
These are the short run ATC
curves for individual firms.
In the long run, any firm could
move to any other curve with an
investment in new containers.
Therefore, in the long run, the
Long Run Average Total Cost
curve (LRATC) curve is
determined by connecting all the
short run ATC curves.
LR ATC
Part 3: Long Run
Production Costs
Slide 51 of 58
52. Lets return to the original question
This questions refers to economies of scale
and is asking about the shape of an
industry’s Long Run Average Total Cost
Curves (LRATC).
The issue: can this big factory produce a good at a lower
average cost than this little factory?
Part 3: Long Run
Production Costs
Slide 52 of 58
53. Assume we are discussing
a hypothetical industry and
this is that industry’s
LRATC
Each industry has it’s
own unique LRATC
Companies operating at
this point on the LRATC
are relatively small as can
be seen by their low
output
Eventually,
costs start to
increase.
Companies here are
getting very big. There
are numerous layers of
management and
changes are
implemented only very
slowly.
Part 3: Long Run
Production Costs
Average
costs per
unit for
these
firms are
here.
Smaller companies have
relatively higher costs
Companies on this portion of the
LRATC are relatively small. Perhaps
these small companies do not have the
largest most efficient equipment
available.
As output increases, the
LRATC declines
Companies here are getting bigger as
can be seen by their output. Perhaps
labor specialization occurs or capital is
used more efficiently.
Average
costs per
unit for
these
firms are
here.
At some point, average
costs per unit stop
decreasing
Companies here are bigger still.
Perhaps there are a few layers of
management and making big decisions
becomes more difficult.
Average
costs per
unit for
these
firms are
here.
Average
costs per
unit for
these
firms are
here.
Slide 53 of 58
54. Costs behave differently along
different portions of the LRATC
Part 3: Long Run
Production Costs
Along this portion
of the LRATC,
average total
costs are falling.
As a firm’s size
gets bigger costs
per unit fall.
This is referred
to as
“Economies of
scale”.
Along this portion
of the LRATC,
average total
costs are
constant.
As a firm’s size
gets bigger costs
per unit don’t
change.
This is referred
to as “Constant
returns to scale”.
Along this portion
of the LRATC,
average total
costs increase.
As a firm’s size
gets bigger costs
per unit increase.
This is referred
to as
“Diseconomies of
scale”.
Remember that scale means size!
Slide 54 of 58
55. Some industries have flat LRATC’s
Part 3: Long Run
Production Costs
In this industry, a long
“constant returns to scale”
segment exists
In an industry with an ATC
like this, large and small
firms may coexist. Neither
would have a cost
advantage on the other.
Examples could
include food or
apparel.
For example, Tom’s
Two Table Taco’s can
operate right next to
Jimmy’s Giant Buffet.
Average costs per unit are the same
for these different sized firms.
Output for
Firm #1
Output for
Firm #2
Slide 55 of 58
56. Some industries have downward
sloped LRATC’s
Part 3: Long Run
Production Costs
In this industry, economies
of scale prevail through a
wide range of outputs
Large firms will
dominate this
industry. Firms must
“Get big or go home.”
Auto makers are huge.
You cannot produce
one or two cars per
year and coexist with
them. Your costs
would be outrageous
and you’d have to sell
cars at ridiculously high
prices.
Examples include:
•Auto Industry
•Steel Industry
•Shipbuilding
•Farm Equipment
Slide 56 of 58
57. Industrial examples
Part 3: Long Run
Production Costs
In this industry,
economies of scale
are quickly
exhausted
Small firms will
dominate this
industry.
Why isn’t there one
large concrete
production plant in the
center of the U.S?
Transportation costs
would be extreme. It is
more efficient to have
many plants all over
the country.
Examples include:
•Concrete production
•Pizza delivery
Slide 57 of 58
58. Individual exercise
Try to think of an industry that would fit each
of these LRATC’s
Industry:_____________ Industry:_____________ Industry:_____________
Part 3: Long Run
Production Costs
Slide 58 of 58