1909 system 4 accout ology is your friend Be soci

Production and Cost

“Anybody can cut prices, but it takes brains to produce a better article”

-P.D. ArmourSlide 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


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.


TP

Slide 5 of 58

Total product, seen graphicallyThis 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


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.


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


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.


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


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 m

arginal returns occurs


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


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.


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


AP =15


AP =15


AP=14


AP =12.5


AP =10.7


AP =8.8


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?


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.


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 variableIn 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.


Slide 17 of 58

Opportunities to change production differ in the short run versus the long run


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”


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


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


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


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


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


Hypothetical Costs for a Shipbuilder

Slide 24 of 58

Fixed costs, shown in tabular form TC


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


Slide 26 of 58

Variable costs, shown in tabular form TC


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


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


Slide 29 of 58

Total cost, variable cost, and fixed costs shown graphically

TC


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


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 costsAverage variable costs

ATC


Slide 32 of 58

Calculation of Average Total Costs (ATC)

ATC


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


Slide 34 of 58



Examine the data: At lower levels of production, fixed costs

are spread over only a few units making ATC high

ATC


Slide 35 of 58



Examine the data: At high levels of production, diminishing

Marginal Returns sets in and the ATC begins to rise

ATC


Slide 36 of 58

Average total, variable, and fixed costs, seen graphically

ATC


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


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.


MC

Slide 39 of 58

Marginal cost (MC)

Note: When adding the 1st unit of production, costs go

up by $250

MC


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


Slide 41 of 58

Try this marginal cost exercise MC


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


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?


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?


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


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


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


Your ATC = $0.50/sfHis 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.


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!


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


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?


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.


Average costs per unit for these

firms are here.

Smaller companies have relatively higher costsCompanies 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

decreasingCompanies here are bigger still.

Perhaps there are a few layers of management and making big decisions

becomes more difficult.


firms are here.


firms are here.

Slide 53 of 58

Costs behave differently along different portions of the LRATC


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”.


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”.


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’sPart 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


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 examplesPart 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:_____________


Slide 58 of 58

1909 system 4 accout ology is your friend Be soci

Food

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