The Costs of Production

Chapter 21

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Inc., 2003
 Introduction
■ The key questions addressed in this
chapter are:
● How much output can a firm produce?
● How do the costs of production vary
with the rate of output?
● Do larger firms have a cost advantage
over smaller firms?

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 The Production Function
■ It takes factors of production to produce a
good or service – no matter what the good
is.
● Factors of production – Resource
inputs used to produce goods and
services, such as land, labor, capital,
entrepreneurship.

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 The Production Function
■ Factors of production costs something to
produce a good.
■ The limits to the production of any good
are reflected in the production function.

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 The Production Function
■ The production function is the
technological relationship expressing the
maximum quantity of a good attainable
from different combinations of factor
inputs.

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 Varying Input Levels
■ What we really want to know is how best to
produce.
● What is the smallest amount of
resources needed to produce a specific
product?
● What is the maximum amount of output
attainable from a given quantity of
resources?

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 Varying Input Levels
■ The purpose of a production function is to
tell us just how much output we can
produce with varying amounts of factor
inputs

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 Varying Input Levels
■ The productivity of any factor of production
depends on the amount of other resources
available to it.
● Productivity - Output per unit of input,
for example, output per labor hour.

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 A Production Function

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 Efficiency
■ The production function represents the
maximum technical efficiency.
■ Efficiency (technical) is the maximum
output of a good from the resources used
in production.

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 Efficiency
■ There is an opportunity cost to inefficiency.
● Opportunity cost - The most desired
goods and services that are foregone in
order to obtain something else.

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 Efficiency
■ If production is not efficient, society either:
● Gets fewer goods than it should, or
● Gives up too many other goods and
services in order to get the good.

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 Short-Run Constraints
■ When there are fixed inputs, we’re dealing
with a short run production condition.
■ The short-run is the period in which the
quantity (and quality) of some inputs
cannot be changed.

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 Short-Run Constraints
■ Labor is the variable input that determines
how much output we get from our fixed
inputs (land and capital).

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 Short-Run Constraints
■ The general assumption is that, in the
short-run labor can change while capital is
held constant.
■ In general, as the amount of labor used
increases the output will also increase.

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 Short-Run Production
Function
55 F G H
50 E I
Jeans Output (pairs per day)

Total output
45 (per day) D
40
35 C
30
25
20 Output rates depend
15 B on input levels
10
5
0
A 1 2 3 4 5 6 7 8
Labor Input (machine operators per day)

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 Marginal Productivity
■ A short-run production function shows how
much each additional worker contributes to
output.

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 Marginal Productivity
■ Marginal physical product (MPP) is the
change in total output that results from
employment of one additional unit of input.

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 Marginal Productivity
■ When the MPP of labor (MPPL >0), then
total output increases.
■ Improving the ratio of labor to other factors
increases the MPP of labor.

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 Marginal Physical
Product

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 Marginal Physical
Product
55 F G H
50 Total output E I
Jeans Output (pairs per day)

45 (per day) D
40 + 10 jeans
35 C
30 Third worker
25
20 Marginal physical product
15 B c
b d (per worker)
10
e
5 f g
A h
0
a 1 2 3 4 5 6 7 8
i
Labor Input (machine operators per day)

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 Diminishing Marginal
Returns
■ At some point, the ratio of labor to other
factors decreases.
■ Output begins to rise more and more
slowly as more workers are hired.

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 Law of Diminishing
Returns
■ According to the law of diminishing
returns, the marginal physical product of a
variable input declines as more of it is
employed with a given quantity of other
(fixed) inputs.

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 Law of Diminishing
Returns
■ As more labor is hired, each unit of labor
has less capital and land to work with.

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 Diminishing Marginal
Returns
55 F G H
50 Total output E I
Jeans Output (pairs per day)

45 (per day) D
40
35 C
30
25
20 Marginal physical product
15 B c
b d (per worker)
10
e
5 f g
A h
0
a 1 2 3 4 5 6 7 8
i
Labor Input (machine operators per day)

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 Resource Costs
■ A production function tells us how much a
firm can produce but not how much it
should produce.

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 Resource Costs
■ The most desirable rate of output is the
one that maximizes total profit.
● Profit - The difference between total
revenue and total cost.

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 Resource Costs
■ The economic cost of a product is
measured by the value of the resources
needed to produce it.

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 Marginal Resource Cost
■ Marginal cost (MC) is the increase in total
costs associated with a one unit increase
in production.

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 Marginal Resource Cost
■ Whenever MPP is increasing, the marginal
cost of producing a good must be falling.
■ If marginal physical product declines,
marginal cost increases.

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 Falling MPP Implies
Rising Marginal Cost
Diminishing marginal productivity implies .Rising
.. marginal cost
24 1.20
Marginal Physical Product

c 1.00 1/g

st
20
ma

Additional Labor Cost

l co
rgi
Dimphy

16 0.80
na

na
b
l

rgi
ini sica

12 0.60

ma
sh l p

d
ing ro

1/f

in g
8 0.40

Ris
e 1/e
du

4 0.20 1/b 1/c 1/d

ct

f
g h
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7
Labor Input i Labor Input

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 Dollar Costs
■ The dollar costs of production are directly
related to the underlying production
function.

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 Total Cost
■ Total cost is the market value of all the
resources used to produce a good or
service.

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 Fixed Cost
■ Fixed costs are the costs of production
that do not change when the rate of output
is altered, such as the cost of basic plant
and equipment.

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 Variable Cost
■ Variable costs are the costs of production
that change when the rate of output is
altered, such as labor and material costs.

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 Total Cost
Rate of Fixed Variable Total Cost
Output Cost Cost (FC +VC)
0 $120 $ 0 $120
10 120 85 205
15 120 125 245
20 120 150 270
30 120 240 360
40 120 350 470
50 120 550 670
51 120 633 753

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 Total Cost
■ How fast total costs rise depends on
variable costs only.
■ Total cost is equal to the fixed costs when
output is zero.
■ There is no way to avoid fixed costs in the
short run.

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 Total Cost of Production

Resource Input X Unit Price = Total Cost

1 factory $100 per day $100
1 sewing m achine 20 per day 20
1 operator 80 per day 80
1.5 bolts of denim 30 per bolt 45
Total cost $245

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 The Cost of Jeans
Production
$1,200
Production Costs (dollars per day)

1,100 Total cost include variable

1,000 and fixed costs
900
800
700
G
600
500 Total cost
400
300 B
A Variable costs
200
100 Fixed costs
0 15 30 45 60 75
Rate of Output (pairs of jeans per day)

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 Average Costs
■ One of the most common cost is average,
or per-unit, cost.

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 Average Costs
■ Average total cost (ATC) is total cost
divided by the quantity produced in a given
time period.

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 Average Costs
■ Average fixed cost (AFC) is total fixed
cost divided by the quantity produced in a
given time period.

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 Average Costs
■ Average variable cost (AVC) is total
variable cost divided by the quantity
produced in a given time period.

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 Average Costs
■ Average total cost is the sum of average
fixed and average variable cost.
ATC = AFC + AVC

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Average Costs
Rate of Average Average Average
Total Cost Variable Total Cost
Output Fixed Cost
Cost AFC +AVC
0 $120 —
10 205 $12.00 $ 8.50 $20.50
15 245 8.00 8.33 16.33
20 270 6.00 7.50 13.50
30 360 4.00 8.00 12.00
40 470 3.00 8.75 11.75
50 670 2.40 11.00 13.40
51 753 2.35 12.41 14.76
 Average Costs
$24
I
20
Costs (dollars per pair)

J ATC
16 O
K
L M N
12

8 AVC

4 AFC

0 10 20 30 40 50
Rate of Output (pairs per day)

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 Falling AFC
■ As the rate of output increases, AFC
decreases as the fixed cost is spread over
more output.
■ Any increase in output lowers average
fixed cost.

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 Rising AVC
■ AVC will eventually rise as the rate of
output increases.
■ AVC rises because of diminishing returns
in the production process.

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 U-Shaped ATC
■ The initial dominance of falling AFC,
combined with the later resurgence of
rising AVC, is what gives the ATC curve its
characteristic U shape.

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 Minimum Average Cost
■ The bottom of the U-shaped average total
cost curve represents the minimum
average total costs.
■ It identifies the lowest possible opportunity
costs to produce the product.

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 Minimum Average Cost
■ Profit aren’t necessarily maximized where
average total costs are minimized.

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 Marginal Cost
■ Marginal cost refers to the change in total
costs associated with one more unit of
output.

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 Marginal Cost

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 Marginal Cost
v
$35
30
Added output is increasingly expensive
25
20 u

15
s t
10 q
p r
5

10 20 30 40 50
Rate of Output (pairs per day)

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 Marginal Cost
■ Diminishing returns in production cause
marginal costs to increase as the rate of
output is expanded.

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 A Cost Summary
■ The output decision has to be based not
only on the capacity to produce – the
production function.
■ It also depends on the costs of production
– the cost functions.

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 A Cost Summary
■ The output decision has to be based not
only on the capacity to produce (the
production function) but also on the costs
of production (the cost functions).

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 A Cost Summary
■ The marginal cost curve always intersects
the ATC curve at its lowest point.

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 A Cost Summary
If MC > ATC, ATC is increasing
If MC < ATC, ATC is decreasing
If MC = ATC, ATC at minimum

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 Basic Cost Curves
$32
MC
28
Cost (dollars per unit)

24
20
16
12 ATC
AVC
8 m
4
n AFC
0 1 2 3 4 5 6 7 8 9
Rate of Output (units per time period)

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 Economic vs. Accounting
Costs
■ Accountants typically count dollar costs
only and ignore any resource use that
doesn’t result in an explicit dollar cost.

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 Economic vs. Accounting
Cost
■ The essential economic question is how
many resources are used in production.
■ As such, economists consider implicit
costs as well as explicit costs to be part of
the total costs of production.

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 Economic vs. Accounting
Cost
■ Explicit costs are the payments made for
the use of a resource.
■ Implicit costs are the value of resources
used, even when no direct payment is
made.

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 Economic vs. Accounting
Cost
■ Economic cost represents he value of all
resources used to produce a good or
service; opportunity cost.

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 Economic vs. Accounting
Cost
■ The accounting costs are all of the costs
that have an explicit dollar cost attached to
them.

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 Economic vs. Accounting
Cost
■ Economic and accounting costs will
diverge whenever any factor of production
is not paid an explicit wage, or rent, etc.

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 Long-Run Costs
■ The short-run is characterized by fixed
costs.
■ These costs (factory, equipment, etc.)
cannot be changed in the short-run.

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 Long-Run Costs
■ In the long-run, new sites can be leased.
■ Consequently, there are no fixed costs in
the long-run.
■ The long run is a period of time long
enough for all inputs to be varied (no fixed
costs).

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 Long-Run Average Costs
■ The long-run cost curve is a summary of
our best short-run cost possibilities.

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 Long-Run Average Costs
Costs (dollars per pair)

ATC1
ATC2
ATC3

Long-run average
total cost (LATC)
0 40 a 60 b c
Rate of Output (pairs of jeans per day)

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 Long-Run Marginal Costs
■ The long-run marginal costs curve
intersects our long-run cost curve at its
lowest point.

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 Long-Run Costs with
Unlimited Options
LMC
Costs (dollars per pair)

ATC2

LATC

m2

0 q2
Rate of Output (jeans per day)

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 Economies of Scale
■ There are many optional plant sizes
available in long-run production.

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 Economies of Scale
■ One option is the decision to use one large
plant or several smaller plants to produce
a given amount of output.

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 Economies of Scale
■ Economies of scale are reductions in
minimum average costs that come about
through increases in the size (scale) of
plant and equipment.

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 Economies of Scale
■ Constant returns to scale are increases
in plant size do not affect minimum
average cost – minimum per-unit costs are
identical for small plants and large plants.

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 Economies of Scale
■ Efficiency and size do not necessarily go
hand in hand.
■ Diseconomies of scale occur when an
increase in plant size results in reducing
operating efficiency.

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 Economies of Scale
Constant returns to scale Economies of scale Diseconomies of scale
COST (dollars per unit)

ATC3
ATC1
ATCS ATCS ATC2 ATCS m3
m1
m2
c c c

0 QM 0 QM 0 QM
RATE OF OUTPUT RATE OF OUTPUT RATE OF OUTPUT
(units per period) (units per period) (units per period)

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 Global Competitiveness
■ Global competitiveness ultimately depends
on the costs of production.

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 Cheap Foreign Labor?
■ Low wages are not a reliable measure of
global competitiveness.

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 Cheap Foreign Labor?
■ A worker’s productivity (MPP) depends on
the quantity and quality of other resources
in the production process.

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 Unit Labor Costs
■ A true measure of global competitiveness
must take into account both factor costs
and productivity.

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 Unit Labor Costs
■ Unit labor cost is a true measure of global
competitiveness.

wage rate
Unit labor cost =
MPP

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 Productivity Advance
■ American productivity must increase as
fast as other nations in order for America
to stay competitive in global markets.

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 Productivity Advance
■ Productivity advances and lower wage
growth increase America’s
competitiveness in world markets.

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 Productivity Advance
■ Unit labor costs in the U.S. increased by
1.0 percent between 1982 and 1994, far
less than most other industrialized nations.

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 Improvements in
Productivity Reduce
Costs
When the production Cost curves shift
function shifts up down

COST (dollars per unit)

ATC1
(units per time period)
TOTAL OUTPUT

ATC2

MC1
MC2

Resource Inputs Rate of Output

(dollars per unit) (units per time period)

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 The Costs of Production

End of Chapter 21

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Inc., 2003