ECONOMICS
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cm08_production.pptxMicroeconomics
Costs of Production
Production
Transformation of resources (inputs) into goods and services (output)
Fixed Inputs
Quantity does not change as output changes
For example: capital (K)
Variable Inputs
Quantity changes as output changes
For example: labor (L)
Production Process
LABOR ( L )
CAPITAL ( K )
OUTPUT ( Q )
Production: Short vs Long
Output
Total Physical Product (TPP)
aka Quantity (Q)
Production in the short run
Fixed Inputs + Variable Inputs
Production in the long run
Variable Inputs (no fixed inputs)
Example Production Functions
with K = 1
Output
Total Physical Product (TPP or Q)
The quantity of goods that are produced for a given set of inputs.
For example:
L=3, K=1 330 units
Marginal Physical Product (MPP)
The additional quantity that is produced by increasing the variable input by one unit, holding all other inputs constant.
MPP Example
Total Fixed and Variable Costs
TFC: Total Fixed Cost
Cost associated with fixed inputs (short term production)
Does not vary with the level of output
TVC: Total Variable Cost
Cost associated with variable inputs
Varies with the level of output
TC: Total Cost = TFC + TVC
Total Fixed and Variable Costs
FIXED COST
$400 per unit of capital
VARIABLE COST
$24 per unit of labor
Total Fixed and Variable Costs
FIXED COST
$400 per unit of capital
VARIABLE COST
$24 per unit of labor
Total Cost
FIXED COST
$400 per unit of capital
VARIABLE COST
$24 per unit of labor
Average Productivity
Average Productivity (AP)
=
Q / L
“A study released earlier this year examining stable scheduling practices at Gap Inc. stores found that labor productivity increased 5% and sales rose 7% when managers did things such as keep the days and times of workers’ shifts consistent from week to week.”
Average Costs
AFC: Average Fixed Cost = TFC / Q
AVC: Average Variable Cost = TVC / Q
ATC: Average Total Cost = TC / TPP
= AFC + AVC
Average Fixed Cost = Total Fixed Cost / Quantity
Average Variable Cost = Total Variable Cost / Quantity
ATC = AFC + AVC = 3.33 + 0.20 = 3.53
MARGINAL COST
CHANGE IN TOTAL COST WITH RESPECT TO CHANGE IN OUTPUT
Marginal Cost
Equal to change in total cost divided by change in output:
or…
Equal to wage rate divided by MPP:
Marginal Cost
of 1st unit of labor
Marginal Cost
of 1st unit of labor
MC=?=ATC
1. AFC is falling
2a. When MC < AVC
AVC is falling
2b. When MC > AVC
AVC is rising
1. AFC is falling
2a. When MC < AVC
AVC is falling
2b. When MC > AVC
AVC is rising
3a. When MC < ATC
ATC is falling
3b. When MC > AVC
ATC is rising
Exercise #1 (1 of 3)
At 3 units of labor, what is the marginal physical product?
At 4 units of labor, what is the quantity produced?
Exercise #1 (2 of 3)
At 3 units of labor, the marginal physical product is 35
At 4 units of labor, what is the quantity produced?
Exercise #1 (3 of 3)
At 3 units of labor, the marginal physical product is 35
At 4 units of labor, 60 units are produced
Exercise #2 (1 of 5)
Assume that the cost of labor is $240, and the cost of capital is $1200
At 4 units of labor calculate AFC, AVC, TC, and MC
Exercise #2 (2 of 5)
Cost of labor = $240 per unit
Cost of capital = $1200 per unit
At 4 labor and 2 capital Q=600 units, MPP=20
Exercise #2 (3 of 5)
Cost of labor = $240 per unit
Cost of capital = $1200 per unit
At 4 labor and 2 capital Q=600 units, MPP=20
Exercise #2 (4 of 5)
Cost of labor = $240 per unit
Cost of capital = $1200 per unit
At 4 labor and 2 capital Q=600 units, MPP=20
Exercise #2 (5 of 5)
Cost of labor = $240 per unit
Cost of capital = $1200 per unit
At 4 labor and 2 capital Q=600 units, MPP=20
Microeconomics
Long Run Costs, Economies of Scale, & Sunk Cost
SRATC = AFC + AVC
MC = ATC
SRATC = min{SRATC}
Q < MCO:
MC < SRATC
and ↓ SRATC
Q > MCO:
MC > SRATC
and ↑ SRATC
Industry Analysis – An Example
4 Firms
Each firm has fixed and variable inputs
Each firm produces quantity that minimizes average total cost (MCO)
Industry output = Sum of firm output: QTY = Q1 + Q2 + Q3 + Q4
In the Long Run
There are no fixed inputs in the production process
NO FIXED INPUTS
NO FIXED COSTS
TOTAL COST = VARIABLE COST
LRATC = Long Run Average Total Cost
The relationship between output (TPP) and average total cost (ATC) when fixed cost has been chosen to minimize average total cost for each level of output.
Economies of Scale
LRATC FALLS => ECONOMIES OF SCALE
Produce more output at lower unit costs
For example, a 5% increase in inputs leads to 8% increase in output
Economies of Scale
Internal Economies of Scale
External Economies of Scale
Technical Economies of Scale
Economies of Scale
Internal Economies of Scale
Specialization of Operations
Production – people become expert performing certain tasks
Administration – management philosophies, sophisticated accounting strategies
Distribution – modernized supply chain, just-in-time strategies
Economies of Scale
Internal Economies of Scale
Specialization of Operations
Production – people become expert performing certain tasks
Administration – management philosophies, sophisticated accounting strategies
Distribution – modernized supply chain, just-in-time strategies
External Economies of Scale
Creation of positive externalities (e.g., Internet) benefits industry or economy
Lower interest rates make it cheaper for firms to invest in new projects
Economies of Scale
Internal Economies of Scale
Specialization of Operations
Production – people become expert performing certain tasks
Administration – management philosophies, sophisticated accounting strategies
Distribution – modernized supply chain, just-in-time strategies
External Economies of Scale
Creation of positive externalities (e.g., Internet) benefits industry or economy
Lower interest rates make it cheaper for firms to invest in new projects
Technical Economies of Scale
Improvements to capital and production processes (e.g., assembly lines)
LRATC Long Run Average Total Cost
Constant Returns to Scale
Average total cost unchanged as production is increased.
A coffee shop with 10 employees can produce 400 cups per day; if they open another coffee shop with 10 employees they can produce another 400 cups.
Smaller firms operating in this region can compete with larger firms
For example, a 5% increase in inputs leads to 5% increase in output
LRATC constant
Diseconomies of Scale
Firms grow to point that causes problems:
Manager coordination of work activities
Timely communication of work directives
Effective monitoring of personnel
Overcrowding effects are often the cause of diseconomies of scale
For example, a 5% increase in inputs leads to 2% decrease in output
LRATC rising
Only relevant in the long run!
A Tale of Three Grinders
$25 $55 $625
#1 #2 #3
#1 Manual
OUTPUT: 50 UNITS
TOTAL COST: $350
#2 Electric
OUTPUT: 150 UNITS
TOTAL COST: $450
#3 Industrial
OUTPUT: 300 UNITS
TOTAL COST: $600
Economies of Scale
Sunk Costs
?
I might as well keep eating because I already bought the food.
?
Well I’m going to keep watching this terrible movie because I have already watched an hour of it already.
?
I might as well continue dating someone bad for me because I’ve already invested so much in them.
SUNK COST
Cost that been paid and cannot be recovered
Decisions that are constrained by consideration of sunk costs are irrational
Thank you!
On your own…
EXERCISE
PK = 240
PL = 16
L
K
Q
0
1
0
1
1
120
2
1
230
3
1
330
4
1
420
5
1
500
6
1
570
7
1
630
8
1
680
9
1
720
L
K
Q
MPP
0
1
0
1
1
120
120
2
1
230
110
3
1
330
100
4
1
420
90
5
1
500
80
6
1
570
70
7
1
630
60
8
1
680
50
9
1
720
40
