Chapter 11 - Production and cost analysis I. After reading this chapter, you should be able to: Explain the role of the firm in economic analysis; describe the production process in the short run; calculate fixed costs, variable costs, marginal costs, total costs, average fixed costs, average variable costs, and average total costs; distinguish the various cost curves and describe the relationships among them.
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Production and Cost Analysis I
Production is not the application of tools to materials, but logic to work.
— Peter Drucker
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Chapter Goals
Ø Explain the role of the firm in economic analysis
Ø Calculate fixed costs, variable costs, marginal costs, total costs, average fixed costs, average variable costs, and
average total costs
Ø Describe the production process in the short run
Ø Distinguish the various cost curves and describe the
relationships among them
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The Role of the Firm
Ø Firms transform the factors into goods and services to
consumers
• Production is the transformation of factors into
goods
Ø In the supply process, people offer their factors of
production, such as land, labor, and capital, to the
market
Ø Ultimately, all supply comes from individuals because
they control the factors of production
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The Role of the Firm
1. Organize factors of production and/or
2. Produce goods and services and/or
3. Sell produced goods and services
Ø Some firms don’t have a physical location and don’t
“produce” anything; they simply subcontract out all
production
Ø A firm is an economic institution that transforms factors
of production into goods and services
Ø Many of the organizational structures of business are
being separated from the production process
Firms:
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Firms Maximize Profit
Ø For economists, total cost is explicit payments to the
factors of production plus the opportunity cost of the
factors provided by the owners of the firm
Ø For economists, total revenue is the amount a firm
receives for selling its product or service plus any
increase in the value of the assets owned by the firm
Profit = Total revenue – Total cost
Ø The goal of a firm is to maximize profits
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The Production Process
• A firm chooses from all possible production
techniques
• All inputs are variable
Ø The production process can be divided into the long run
and the short run
Ø The terms long run and short run do not necessarily refer
to specific periods of time, but to the flexibility the firm has
in changing its inputs
• A firm is constrained in
regard to what production
decisions it can make
• Some inputs are fixed
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Production Tables and Production Functions
Ø A production table is a table showing the output
resulting from various combinations of factors of production or inputs
Ø This analysis will concentrate on short run production
in which one of the factors is fixed
Ø Firms combine factors of production to produce
goods and services
Ø Real-world production tables are complicated
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A Production Table
# of
workers OutputTotal Marginal Product Average Product
4 6 7 6 5 3 1 0 -2 -5
Marginal product is the additional output that will
be forthcoming from an additional worker, other
inputs constant
Average product is the output per worker
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Law of Diminishing Marginal Productivity
# of
workers OutputTotal Marginal Product Average Product
4 6 7 6 5 3 1 0 -2
Law of diminishing marginal productivity
states as more of a variable input is added to an existing fixed input, after some point the additional output from the additional input will fall
Increasing marginal productivity
Diminishing marginal productivity
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Fixed Costs, Variable Costs, and Total Costs
TC = FC + VC
Ø Fixed costs (FC) are those that are spent and cannot be
changed in the period of time under consideration
• In the long run, there are no fixed costs since all inputs (and therefore their costs) are variable
• In the short run, a number of inputs and their costs will be fixed
Ø Workers are an example of variable costs (VC) which are
costs that change as output changes
Ø The sum of the variable and fixed costs are total costs (TC)
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Average Costs
Ø Average fixed costs (AFC) equals fixed cost divided
by quantity produced, AFC = FC/Q
Ø Marginal cost (MC) is the increase in total cost when
Ø Average variable costs (AVC) equals variable cost
divided by quantity produced, AVC = VC/Q
Ø Average total costs (ATC) equals total cost divided by
quantity produced, ATC = TC/Q or ATC = AFC + AVC
Marginal Cost
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Costs of Production Table
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Graphing Total Cost Curves
FC
Total Cost
FC curve is constant
TC and VC curves increase as
Q increases
Q
VC
TC
158
108
50
L O M
•
•
•
$450
400
•
•
(TC = FC + VC)
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Graphing Per Unit Output Cost Curves
AVC
MC
ATC
AFC
Q
Cost
AFC curve decreases
MC, ATC, and AVC curves are U-shaped
30
20
10
0
10 20 30
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The Shapes of Cost Curves
Ø The variable and total cost curves are upward sloping
• Increasing output increases VC and TC
Ø The average fixed cost curve is downward sloping
• Increasing output decreases AFC
Ø The fixed cost curve is always constant
• Increasing output doe change FC
Ø The marginal cost, average variable cost, and average
total cost curves are U-shaped
Increasing output initially leads to a decrease in
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Ø If MC > ATC, then ATC is rising
Ø If MC > AVC, then AVC is rising
Ø If MC < ATC, then ATC is falling
Ø If MC < AVC, then AVC is falling
Ø If MC = AVC and MC = ATC, then AVC and ATC
are at their minimum points
The Relationship Between Marginal Cost and Average Cost
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Chapter Summary
Ø Accounting profit is explicit revenue less explicit cost
Ø Economists include implicit revenue and cost in
determining economic profit
Ø Implicit revenue includes the increases in the value of
assets owned by the firm; implicit costs include
opportunity cost of time and capital provided by owners
of the firm
Ø In the long run a firm can choose among all possible
production techniques; in the short run it is constrained
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Chapter Summary
Ø The law of diminishing marginal productivity states that as more of a
variable input is added to a fixed input, the additional output will eventually
be decreasing
Ø TC = FC + VC
Ø MC = ΔTC/ΔQ
Ø AFC = FC/Q
Ø AVC = VC/Q
Ø ATC = AFC + AVC
Ø MC goes through the minimum points of the AVC and ATC
Ø If MC > ATC, then ATC is rising
Ø If MC = ATC, then ATC is constant