The Costs of Production

1. The Costs of Production Chapter 21

2. The Production Function • No matter what is being produced, it takes factors of production to produce a good or service. • Factors of production – Resource inputs used to produce goods and services, such as land, labor, capital, entrepreneurship. LO1

3. The Production Function • The production function is the technological relationship expressing the maximum quantity of a good attainable from different combinations of factor inputs. LO1

4. Varying Input Levels • The purpose of a production function is to tell us how much output we can produce with varying amounts of factor inputs. LO1

5. 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. LO1

6. A Production Function LO1

7. Efficiency • The production function represents maximum technical efficiency. • Efficiency (technical) is the maximum output of a good from the resources used in production. LO1

8. Efficiency • There is an opportunity cost to inefficiency, society either: • Gets fewer goods than it should, or • Gives up too many other goods and services in order to get the good. LO1

9. Short-Run Constraints • We’re dealing with a short run production condition when there are fixed inputs. • Theshort-run is the period in which the quantity (and quality) of some inputs cannot be changed. LO1

10. Short-Run Constraints • Labor is the variable input that determines how much output we get from our fixed inputs (land and capital). In general, as the amount of labor used increases, output also increases. LO1

11. Short-Run Production Function LO1

12. Short-Run Production Function 55 G H F E I 50 D 45 40 35 C 30 Jeans Output (pairs per day) 25 20 B 15 10 5 0 A 1 2 3 4 5 6 7 8 Labor Input (machine operators per day) Total output (per day) Output rates depend on input levels LO1

13. Marginal Productivity change in total output Marginal physical product (MPP) = change in input quantity • Marginal physical product(MPP) is the change in total output that results from employment of one additional unit of input. LO1

14. 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. LO1

15. Marginal Physical Product LO1

16. Marginal Physical Product G H F E I D C B c d b e g f h A a i 55 Total output (per day) 50 45 40 + 10 jeans 35 30 Third worker Jeans Output (pairs per day) 25 20 Marginal physical product (per worker) 15 10 5 0 3 4 5 1 2 6 7 8 Labor Input (machine operators per day) LO1

17. Diminishing Marginal Returns • At some point, the ratio of labor to other factors decreases. • As more labor is hired, each unit of labor has less capital and land to work with. • Output begins to rise more and more slowly as more workers are hired. LO2

18. Law of Diminishing Returns • According to thelaw 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. LO2

19. Law of Diminishing Returns 55 G H F E I 50 D 45 40 C 35 30 25 20 B c 15 d b 10 e 5 g f h A 0 3 4 5 1 2 6 7 8 a i Total output (per day) Jeans Output (pairs per day) Marginal physical product (per worker) Labor Input (machine operators per day) LO2

20. Resource Costs • A production function tells us how much a firm can produce but not how much it should produce. • The most desirable rate of output is the one that maximizes total profit. • Profit - The difference between total revenue and total cost. LO2

21. Marginal Resource Cost • Marginal cost(MC) is the increase in total costs associated with a one unit increase in production. LO3

22. 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. LO3

23. Falling MPP Implies Rising Marginal Cost 24 1.20 c 1/g 1.00 20 16 0.80 b Diminishing marginal physical product Rising marginal cost 12 0.60 Marginal Physical Product Additional Labor Cost d 1/f 8 0.40 1/e e 4 0.20 1/d f 1/b 1/c g h 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 i Labor Input Labor Input Diminishing marginal productivity implies . . . Rising marginal cost LO3

24. Dollar Costs • The dollar costs of production are directly related to the underlying production function. LO3

25. Total Cost • Total cost is the market value of all the resources used to produce a good or service. LO3

26. Fixed Cost • Fixed costs are the costs of production that do not change when the rate of output is altered • Example – the cost of basic plant and equipment. LO3

27. Variable Cost • Variable costs are the costs of production that change when the rate of output is altered. • Example – labor and material costs. LO3

28. 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. LO3

29. Total Cost LO3

30. The Cost of Jeans Production LO3

31. The Cost of Jeans Production $1,200 1,100 1,000 900 800 700 G 600 Production Costs (dollars per day) 500 400 B 300 A 200 100 0 15 30 45 60 75 Rate of Output (pairs of jeans per day) Total cost include variable and fixed costs Total cost Variable costs Variable costs Fixed costs LO3

32. Average Costs • One of the most common cost is average, or per-unit, cost. LO3

33. Average Costs • Average total cost(ATC) is total cost divided by the quantity produced in a given time period. LO3

34. Average Costs • Average fixed cost(AFC) is total fixed cost divided by the quantity produced in a given time period. LO3

35. Average Costs • Average variable cost(AVC) is total variable cost divided by the quantity produced in a given time period. LO3

36. Average Costs • Average total cost is the sum of average fixed and average variable cost. ATC = AFC + AVC LO3

37. Average Costs LO3

38. Average Costs $24 I 20 ATC J 16 O K N L M Costs (dollars per pair) 12 8 AVC 4 AFC 0 10 20 30 40 50 Rate of Output (pairs per day) LO3

39. 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. LO3

40. Rising AVC • AVC will eventually rise as the rate of output increases. • AVC rises because of diminishing returns in the production process. LO3

41. 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. LO3

42. 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. • Profit aren’t necessarily maximized where average total costs are minimized. LO3

43. Marginal Cost • Marginal cost refers to the change in total costs associated with one more unit of output. LO3

44. Marginal Cost LO3

45. Marginal Cost v u t s q r p $35 30 Added output is increasingly expensive 25 20 15 10 5 10 20 30 40 50 Rate of Output (pairs per day) LO3

46. Marginal Cost • Diminishing returns in production cause marginal costs to increase as the rate of output is expanded. LO3

47. 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). LO3

48. A Cost Summary • The marginal cost curve always intersects the ATC curve at its lowest point. If MC > ATC, ATC is increasing If MC < ATC, ATC is decreasing If MC = ATC, ATC at minimum LO3

49. Basic Cost Curves LO3

50. Basic Cost Curves $32 28 24 20 16 Cost (dollars per unit) 12 8 4 0 1 2 3 4 5 6 7 8 9 Rate of Output (units per time period) MC ATC AVC m AFC n LO3