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Production and Cost
“Anybody can cut prices, but it takes brains to
produce a better article”
-P.D. Armour
Slide 1 of 58
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
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
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
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
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
Slide 6 of 58
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
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
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
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
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
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
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
Slide 13 of 58
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
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
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
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
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
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
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.
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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

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Production and Cost

  • 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 Slide 6 of 58
  • 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 Slide 13 of 58
  • 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