Production and Cost Analysis

Lecture 5: Production and Cost
Analysis in the Short-Run
Dr. Agyapomaa
Gyeke-Dako
04/11/16
People
buy goods from firms, and people work

for firms as accountants, truck drivers,
teachers etc. Even though we deal with
business firms daily, most of us probably know
little about them. Why do they exist? What do
they try to maximise? How do they produce the
goods & services? What concepts must
organisations concern themselves with?
Dr. Agyapomaa Gyeke-Dako
04/11/16
Firms
produce and sell in order to maximise

Profit = TR- TC
Production is the transformation of resources
or inputs into goods and services or outputs.
Implies production is done using
inputs/resources/factors of production
Inputs can be classified broadly or narrowly
3
04/11/16
Production Function
A production
function describes the
relationship between a
flow of inputs and the
resulting flow of
outputs in a production
process during a given
period of time.
Q = f(L, K, M, )
where
Q = quantity of output
L = quantity of labor input
K = quantity of capital
input
M = quantity of materials
input
04/11/16
Fixed and Variable Inputs

A fixed
input is an
input whose quantity
a manager cannot
change during a
given period of time.
A variable
input is an
input whose quantity
a manager can
change during a
given period of time.
04/11/16
Short-Run vs. Long-Run

The
short-run is a period of time during which

at least one input is fixed, while the long-run is
a period of time during which all inputs are
variable.
04/11/16
Measures of Productivity (ShortRun)

Total
Product or Total Output

Average Product
Marginal Product
04/11/16
Total Product
The
total quantity of
output produced with
given quantities of
fixed and variable
inputs.
TP or Q = f(L, K ), where
TP or Q = total product
or total quantity
produced
L = quantity of labor
input (variable)
K = quantity of capital
(fixed)
04/11/16
Average Product
The
amount of output
per unit of variable
APL = TPL or QL,
input.
where
APL = average product
of labor
04/11/16
Marginal Product
The
additional output
produced with an
additional unit of
variable input.
10
MPL = TPL or
QL
where
MPL = marginal
product of labor
04/11/16
Example: TP=10L+4.5L2 -0.3333L3

K
TP
10
14
10
35
10
62
10
91
10
4.5
106
10
121
10
150
10
6.75
170
10
175
10
197
10
212
10
10
217
1110
11
211
AP
MP
04/11/16
Total Product Curve (Explain this

practically)
12
04/11/16
Average and Marginal Product

Curves
13
04/11/16
Relationship among TP, AP and MP

Stage I: increasing
marginal returns, TP is
is increasing at an increasing
rate
Stage II: MP is falling but
AP is rising, TP is increasing
at a decreasing rate
Stage III: both MP and AP
are falling, but AP>MP
Beyond stage III, there is
negative marginal returns
14
Stage I
Stage II
Stage III
04/11/16
Law of Diminishing Marginal

Returns
The
phenomenon illustrated by that region of

the marginal product curve where the curve is
positive, but decreasing, so that total product is
increasing at a decreasing rate.
As more and more of a variable input is added
to a fixed input, addition to total output
increases, reaches a maximum and begins to
decline
15
04/11/16
Cost Function
A mathematical
or graphical expression that

shows the relationship between the cost of
production and the level of output, all other
factors held constant.
16
04/11/16
Opportunity Cost
The
economic measure of cost that reflects the

use of resources in one activity, such as a
production process by one firm, in terms of the
opportunities forgone in undertaking the next
best alternative activity.
17
04/11/16
Explicit and Implicit Costs
18
A cost is explicit if it is
reflected in a payment
to another individual,
such as a wage paid to
a worker, that is
recorded in a firms
bookkeeping or
accounting system.
A cost that represents

the value of using a
resource that is not
explicitly paid out and
is often difficult to
measure because it is
typically not recorded
in a firms accounting
system.
04/11/16
Profit
The
difference between the total revenue a firm

receives from the sale of its output and the
total cost of producing that output.
= TR - TC
19
04/11/16
Accounting vs. Economic Profit

Accounting
profit is
the difference
between total
revenue and total
cost where cost
includes only the
explicit costs of
production.
20
Economic
profit is the
difference between
total revenue and
total cost where cost
includes both the
explicit and any
implicit costs of
production.
04/11/16
Short Run Cost Function

A cost
function for a short-run production

process is one in which there is at least one
fixed input of production.
21
04/11/16
Fixed vs. Variable Costs

Fixed
cost is the total

cost of using the
fixed input, which
remains constant
regardless of the
amount of output
produced.
22
Variable
cost is the
total cost of using
the variable input,
which increases as
more output is
produced.
04/11/16
Short Run Costs

COST FUNCTION
23
DEFINITION
Total fixed cost
TFC = (PK) x (K)
Total variable cost
TVC = (PL) x (L)
Total cost
Average fixed cost
Average variable cost
Average total cost
TC = TFC + TVC
AFC = TFC Q
AVC = TVC Q
ATC = TC Q = AFC + AVC
Marginal cost
MC = TC Q = TVC Q
04/11/16
Example
PK = 50 and PL = 100
24
TP =
Q
10
10
14
10
35
10
62
10
91
10
121
10
150
10
175
10
197
10
212
10
10
217
TFC
TVC
TC
AFC
AVC
ATC
MC
04/11/16
Total Cost Curves
25
04/11/16
Average and Marginal Cost Curves
26
04/11/16
Relationship Between Short Run

Production and Cost
TC PL L
TC TVC
MC
Q
Q
PL L
L
PL
Q
Q
PL
PL
Q
MPL
L
27
TVC PL L
AVC
Q
Q
PL
APL
04/11/16
Relationship Between Short Run

Production and Cost
MC
AC
Q1
28
Q2
04/11/16
Revenue
TR P Q
dTR
MR
dQ
TR P Q
AR
P
Q
Q
Draw the curves
29
04/11/16
REVENUE
Defining
total, average and marginal revenue
Revenue
curves when firms are price takers

(horizontal demand curve)
average revenue (AR)
marginal revenue (MR)
total revenue (TR)
REVENUE
Revenue
curves when price varies with output

(downward-sloping demand curve)
average revenue (AR)
marginal revenue (MR)
total revenue (TR)
revenue curves and price elasticity of demand
Shifts
in revenue curves
PROFIT MAXIMISATION
Using total curves
maximising difference between TR and TC
the total profit curve
Using marginal and average curves
stage 1:
profit maximised where MR = MC
stage 2:
using AR and AC curves to measure maximum profit
PROFIT MAXIMISATION
Some
qualifications
long-run profit maximisation
the meaning of profit
What
if a loss is made?
loss minimising:
still produce where MR = MC
short-run shut-down point:
P = AVC
long-run shut-down point:
P = LRAC
Profit Maximization
TR TC
d
0
dQ
d dTR dTC
0
dQ dQ dQ
MR MC 0
MR MC
34
04/11/16
Profit Maximization
35
Profit-maximising output
04/11/16
The profit maximization rule

Profits are maximized where marginal cost (MC) equals
marginal revenue (MR).
It is possible that over the firms full potential range of
outputs there are two points where MC = MR
Producing at point X would not profit maximize because
outputs up to X are produced where MC > MR.
Technically, profits are maximized where MC = MR and
the MC curve is rising (not falling), as at q* output
36
04/11/16
Normal and Supernormal Profit

Normal
profit is the minimum profit which must

be earned to ensure that a firm will continue to
supply the existing good or service.
Supernormal profit is any profit earned above
normal profit and is a form of economic rent.
These are measured relative to ATC
37
04/11/16
Long Run Production Function
38
A production function
showing the relationship
between a flow of inputs
and the resulting flow of
output, where all inputs
are variable.
Q = f(L, K)
where
Q = quantity of output
L = quantity of labor input
(variable)
K = quantity of capital input
(variable)
04/11/16
Input Substitution
choice
39
of inputs will be influenced by:
The technology of the production process

The prices of the inputs of production
The set of incentives facing the given producer
04/11/16
Technology of the Production

Process
40
Capital-intensive method
of production is a
process that uses large
amounts of capital
equipment relative to the
other inputs to produce
the firms output.
Labor-intensive method
of production is a
process that uses large
amounts of labor relative
to the other inputs to
produce the firms
output.
04/11/16
Long Run Average Cost Function

This
is defined as the minimum average or unit

cost of producing any level of output when all
inputs are variable.
42
04/11/16
Long Run Average Cost Curve

$
SRAC1
SRAC2
SRAC4
SRAC3
LRAC
43
04/11/16
Economies and Diseconomies of

Scale
44
Economies of scale
exist when the firm can
achieve lower unit costs
of production by
adopting a larger scale
of production,
represented by the
downward sloping
portion of along-run
average cost curve.
Diseconomies of scale
exist when the firm
incurs higher unit costs
of production by
adopting a larger scale
of production,
represented by the
upward sloping portion
of a long-run average
cost curve.
04/11/16
Economies and Diseconomies of

Scale - Graphical
$
SATC3
SATC1
LRAC
SATC2
Diseconomies of scale
Increasing LRAC
Economies of scale
Declining LRAC
Q1
45
Q
04/11/16
Factors Creating Economies of

Scale
Specialization
and division of labor

Technological factors
The use of automation devices
Quantity discounts
The spreading of advertising costs
Financial factors
46
04/11/16
Factors Creating Diseconomies of

Scale
The
inefficiencies of managing large-scale

operations.
The increased transportation costs that result
from concentrating production in a small
number of very large plants.
47
04/11/16
Learning By Doing
The
drop in unit costs as total cumulative

production increases because workers become
more efficient as they repeat their assigned
tasks.
48
04/11/16
Minimum Efficient Scale
That scale of operation $

at which the long-run
average cost curve stops
declining or at which
economies of scale are
exhausted.
LRAC
MES
49
Q
04/11/16

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Lecture 5: Production and Cost

Analysis in the Short-Run

buy goods from firms, and people work

Dr. Agyapomaa Gyeke-Dako

produce and sell in order to maximise

Dr. Agyapomaa Gyeke-Dako

Fixed and Variable Inputs

Short-Run vs. Long-Run

short-run is a period of time during which

Dr. Agyapomaa Gyeke-Dako

Measures of Productivity (ShortRun)

Product or Total Output

Dr. Agyapomaa Gyeke-Dako

Example: TP=10L+4.5L2 -0.3333L3

Total Product Curve (Explain this

Dr. Agyapomaa Gyeke-Dako

Average and Marginal Product

Dr. Agyapomaa Gyeke-Dako

Relationship among TP, AP and MP

Dr. Agyapomaa Gyeke-Dako

Law of Diminishing Marginal

phenomenon illustrated by that region of

Dr. Agyapomaa Gyeke-Dako

or graphical expression that

Dr. Agyapomaa Gyeke-Dako

economic measure of cost that reflects the

Dr. Agyapomaa Gyeke-Dako

Explicit and Implicit Costs

A cost that represents

difference between the total revenue a firm

Dr. Agyapomaa Gyeke-Dako

Accounting vs. Economic Profit

Short Run Cost Function

function for a short-run production

Dr. Agyapomaa Gyeke-Dako

Fixed vs. Variable Costs

cost is the total

Short Run Costs

Total fixed cost

TFC = (PK) x (K)

Total variable cost

TVC = (PL) x (L)

Dr. Agyapomaa Gyeke-Dako

Total Cost Curves

Dr. Agyapomaa Gyeke-Dako

Average and Marginal Cost Curves

Dr. Agyapomaa Gyeke-Dako

Relationship Between Short Run

Dr. Agyapomaa Gyeke-Dako

Relationship Between Short Run

Dr. Agyapomaa Gyeke-Dako

total, average and marginal revenue

curves when firms are price takers

average revenue (AR)

marginal revenue (MR)

total revenue (TR)

curves when price varies with output

average revenue (AR)

marginal revenue (MR)

total revenue (TR)

revenue curves and price elasticity of demand

Using total curves

maximising difference between TR and TC

the total profit curve