Economic Question - Economic Costs

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Costs

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CHAPTER 13

Output and Productivity

Costs

Costs of resource services needed to produce output

The more productive the resources

The fewer that are required to produce any given amount of output

Productivity

Output per unit of a resource’s services

Output and Productivity

Labor productivity

Quantity of output divided by the number of hours worked by labor

Everything else held constant

Land productivity

Quantity of output divided by the quantity of land

Everything else held constant

Output and Productivity

Capital productivity

Total output divided by total capital

Total factor productivity

Total output divided by total inputs

Productivity

The efficiency with which inputs are converted into output

Figure 13.1

Productivity growth and economic growth are positively correlated. When productivity rises, so do living standards.

Productivity Growth Has a Big Impact on Living Standards

Output and Productivity

Increases in productivity

From improvements in the quality of resources

Technological change – enables resources to be more efficient

Human capital

From Production to Costs

When productivity is rising

Costs are declining

The same amount of output can be produced using fewer resources

When productivity is falling

Costs are rising

The same amount of output requires more resources

From Production to Costs

Total factor productivity

Measure of the change in output resulting from a change in all resources

Marginal productivity

Change in output that results from a change in just one resource

Everything else held constant

From Production to Costs

Law of diminishing marginal returns

As a variable resource is increased and combined with a fixed quantity of other resources

Marginal productivity will initially rise but eventually will decline

Table 13.1

The combinations of total output (thousands of daily passenger miles) that can be produced by an airline using different combinations of mechanics and airplanes. If one resource is fixed, such as number of airplanes fixed at 10, then increasing the number of mechanics increases output but by decreasing amounts. This is diminishing marginal returns.

Production and Diminishing Marginal Returns

From Production to Costs

Average total cost (ATC)

Cost per unit of output

Total cost divided by quantity of output

Falls initially and then rise as output rises

Law of diminishing marginal returns

Marginal cost (MC)

Change in total cost divided by the change in the quantity of output

Additional cost that comes from producing an additional unit of output

From Production to Costs

Marginal product of labor (MP)

Additional quantity that comes from an additional unit of labor services

Marginal cost of output, MC = W/MP

W – the wage rate

Additional cost of labor

MP – marginal product of labor

Falls initially and then rises as output rises

Law of diminishing marginal returns

From Production to Costs

MC and MP

When marginal productivity (MP) is rising

Fewer additional resources are used to produce a certain amount of additional output

Marginal cost is falling

When marginal productivity is falling

Marginal cost is rising

Table 13.2

a- This is the average of the individual unit marginal cost. The marginal cost of $10 for the first 99 units indicates that the average marginal cost of units 1 through 100 is $101, and so on for units 101–250, units 251–360, etc.

Total, Average, and Marginal costs

Fixed and Variable Costs

Fixed costs, TFC

Costs that do not change as the quantity of output changes

Variable costs, TVC

Costs that depend on the quantity of output

Total costs, TC = TFC + TVC

Table 13.3

This table shows the calculation of the various cost measures. Average costs (average fixed, average variable, average total) are derived by dividing total costs (fixed, variable, total) by output. Marginal cost is the change in total cost divided by the change in output.

Cost Schedules

Fixed and Variable Costs

Average total cost curve

U-shaped

As output rises, per-unit costs initially fall but eventually rise

Law of diminishing marginal returns

Marginal cost curve

U-shaped

As output rises, incremental costs initially fall but eventually rise

Law of diminishing marginal returns

Figure 13.2

The figures in Table 13.3 are plotted. MC, AVC, and ATC all fall initially and then rise. AFC continually falls. MC intersects AVC and ATC at their minimum points.

Average Total Cost (ATC) and Marginal Cost (MC) are U-shaped Due to The Law of Diminishing Marginal Returns

Operating Leverage, Sunk Costs

Operating leverage

Ratio of fixed costs to variable costs

If it is high – the firm has less flexibility

Sunk costs

Costs that have already been incurred and that cannot be recovered

Gone and not retrievable

Should not influence decisions

Operating Leverage, Sunk Costs

Sunk cost fallacy, the Concorde Effect

Sunk costs are used to justify continued action

Sunk costs

Often enter into strategic decisions

Developers - get work underway

Build foundations, clear areas

Once money has been spent - difficult for financiers to do anything except scream and holler

Business Insight
A Builder’s View of Sunk Costs

Jonathan Ward, a remodeler

Humans seem to be the only animals that don’t understand the concept of sunk costs

Waste time trying to find someone to blame

Or someone to sue

Go on TV talk shows to weep about their misfortune

Attempt to “seek closure”

Business Insight
A Builder’s View of Sunk Costs

Jonathan Ward, a remodeler

It is important to know when a situation is untenable

And when to walk away from a project

You must continually ask yourself if, knowing what you know now, you would have funded the venture in the beginning

The Planning Horizon: The Long Run

Short run

Operating period

Fixed costs - firm is constrained

Long run

Planning period

Time period just long enough that everything is variable

No fixed costs

The Planning Horizon: The Long Run

Long run

Manager - can choose any size of plant or building

Any combination of other resources

Planning

Manager compares all short-run situations

Expand, contract, relocate, enter a new business, exit any line of business, or quit doing business altogether

Figure 13.3

The company is currently operating at 5,000 units of output per year. To increase to 100,000 would require an increase in the capacity or scale of the firm.

Morita’s Long-Run Average Total Cost Curve

Figure 13.4

Producing 5,000 units can be done efficiently using the capacity of short-run average total cost (SRATC1). To generate 100,000 units per year would require an increase in scale. But once having increased scale to SRATC2, it would be virtually impossible—very expensive—to move back to 5,000 units.

The Long-Run and Short Run Average Total Cost Curves

Costs in the Long Run

Long run

Is a planning period

Any combination of resources can be selected

A firm can choose to operate at any size

Choose the level of output it wants to produce

Then select the least-cost combination of resources with which to produce the chosen output level

Once it has built that given capacity, then it is constrained to operate at that level

Economies and Diseconomies of Scale

Economies of scale

Cost per unit of output decreases as output rises

Diseconomies of scale

Cost per unit of output increases when the quantity of production increases

Constant returns to scale

Cost per unit of output is constant as output rises

Economies and Diseconomies of Scale

Long-run average total cost curve

Downward sloping

Economies of scale

Constant

Constant returns to scale

Upward sloping

Diseconomies of scale

Economies and Diseconomies of Scale

Economies of scale - result from

Ability to use larger machines that are more efficient than small ones

Specialization

Primary reason for diseconomies of scale

Managerial inefficiencies

Large Scale Is Not Always Best

Efficiency and specialization

Are limited by the size of the market

Larger firm – produce more than what the market can buy

Inefficient

Larger size

Not necessarily beneficial for individual firms

Diseconomies of scale - Bureaucracy, quarterly reporting, rent seeking

Economies of Scope

Economies of scope

Firm obtains a production advantage from producing more than one product

The cost of producing two (or more) products jointly is less than the cost of producing each one alone

Economies of Scope

Economies of scope

Advantages may arise:

Production facility used to make one product - can also be used to make another

By-products of one product - useful in the production of another product

People trained to produce one product - can use their training in the production of another product

The Experience Curve

Experience curve, learning curve

Declining costs as output rises

The result of learning, of gaining experience

Confused with economies of scale

Aircraft manufacturers

Learning curve

Broiler chickens

Misleading learning curve

Better technology

Figure 13.5

If the more experience a firm has in producing a particular good results in lower per-unit costs, then the firm has an experience, or learning curve, that slopes downward. In this diagram, experience curves for two industries are shown, one for aircraft and one for chickens.

The Experience Curve