INTRODUCTION THE COSTS OF PRODUCTION THE PRODUCTION FUNCTION VARYING INPUT LEVELS A PRODUCTION FUNCTION

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1 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? THE COSTS OF PRODUCTION Chapter 6 2 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. Factors of production costs something to produce a good. The limits to the production of any good are reflected in the production function. The production function is the technological relationship expressing the maximum quantity of a good attainable from different combinations of factor inputs. 3 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? The purpose of a production function is to tell us just how much output we can produce with varying amounts of factor inputs 4 VARYING INPUT LEVELS The productivity of any factor of production depends on the amount of other resources available to it. A PRODUCTION FUNCTION Productivity - Output per unit of input, for example, output per labor hour. 5 6

2 EFFICIENCY The production function represents the maximum technical efficiency. Efficiency (technical) is the maximum output of a good from the resources used in production. There is an opportunity cost to inefficiency. 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. 7 8 SHORT-RUN CONSTRAINTS SHORT-RUN PRODUCTION FUNCTION 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. Labor is the variable input that determines how much output we get from our fixed inputs (land and capital). 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. 9 Jeans Output (pairs per day) B 1 5 A Total output (per day) C D E Labor Input (machine operators per day) F G H Output rates depend on input levels I 1 MARGINAL PRODUCTIVITY A short-run production function shows how much each additional worker contributes to output. MARGINAL PRODUCTIVITY Marginal physical product (MPP) is the change in total output that results from employment of one additional unit of input. 11 When the MPP of labor (MPP L >), then total output increases. Improving the ratio of labor to other factors increases the MPP of labor. 12

3 MARGINAL PHYSICAL PRODUCT MARGINAL PHYSICAL PRODUCT 13 Jeans Output (pairs per day) A a Total output (per day) C D Third worker E + 1 jeans B Marginal physical product c b d (per worker) e f g h i Labor Input (machine operators per day) F G H I 14 DIMINISHING MARGINAL RETURNS 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. 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. As more labor is hired, each unit of labor has less capital and land to work with. 15 Jeans Output (pairs per day) A a Total output (per day) C D E B Marginal physical product c b d (per worker) e f g h i Labor Input (machine operators per day) F G H I 16 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. The economic cost of a product is measured by the value of the resources needed to produce it. MARGINAL RESOURCE COST Marginal cost (MC) is the increase in total costs associated with a one unit increase in production. 17 Whenever MPP is increasing, the marginal cost of producing a good must be falling. If marginal physical product declines, marginal cost increases. 18

4 FALLING MPP IMPLIES RISING MARGINAL COST Diminishing marginal productivity implies... Rising marginal cost Marginal Physical Product c 16 b 12 d 8 e 4 f /e g. h 1/b 1/c 1/d Additional Labor Cost 1/g 1/f Labor Input i Labor Input 19 DOLLAR COSTS The dollar costs of production are directly related to the underlying production function. Total cost is the market value of all the resources used to produce a good or service. 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. Variable costs are the costs of production that change when the rate of output is altered, such as labor and material costs. TOTAL COST 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 TOTAL COST OF PRODUCTION THE COST OF JEANS PRODUCTION 23 Production Costs (dollars per day) $1, 1,1 1, Total cost include variable and fixed costs A B Total cost Fixed costs Rate of Output (pairs of jeans per day) G Variable costs 24

5 AVERAGE COSTS One of the most common cost is average, or perunit, cost. Average total cost (ATC) is total cost divided by the quantity produced in a given time period. AVERAGE COSTS Average fixed cost (AFC) is total fixed cost divided by the quantity produced in a given time period AVERAGE COSTS Average variable cost (AVC) is total variable cost divided by the quantity produced in a given time period. AVERAGE COSTS Average total cost is the sum of average fixed and average variable cost. ATC = AFC + AVC AVERAGE COSTS AVERAGE COSTS Costs (dollars per pair) $ I J K L M ATC N O AVC AFC Rate of Output (pairs per day) 3

6 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. AVC will eventually rise as the rate of output increases. AVC rises because of diminishing returns in the production process. 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. 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 MINIMUM AVERAGE COST MARGINAL COST Profit aren t necessarily maximized where average total costs are minimized. Marginal cost refers to the change in total costs associated with one more unit of output MARGINAL COST MARGINAL COST $ Added output is increasingly expensive u s t q p r v Diminishing returns in production cause marginal costs to increase as the rate of output is expanded. 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. 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). Rate of Output (pairs per day) 35 36

7 A COST SUMMARY BASIC COST CURVES 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 37 Cost (dollars per unit) $32 MC ATC AVC 8 m 4 n AFC Rate of Output (units per time period) 38 ECONOMIC VS. ACCOUNTING COSTS ECONOMIC VS. ACCOUNTING COST Accountants typically count dollar costs only and ignore any resource use that doesn t result in an explicit dollar 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. 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 ECONOMIC VS. ACCOUNTING COST ECONOMIC VS. ACCOUNTING COST Economic cost represents he value of all resources used to produce a good or service; opportunity cost. The accounting costs are all of the costs that have an explicit dollar cost attached to them. Economic and accounting costs will diverge whenever any factor of production is not paid an explicit wage, or rent, etc

8 q 2 Rate of Output (jeans per day) LONG-RUN COSTS The short-run is characterized by fixed costs. These costs (factory, equipment, etc.) cannot be changed in the short-run. In the long-run, new sites can be leased. Consequently, there are no fixed costs in the longrun. The long run is a period of time long enough for all inputs to be varied (no fixed costs). LONG-RUN AVERAGE COSTS The long-run cost curve is a summary of our best short-run cost possibilities LONG-RUN AVERAGE COSTS LONG-RUN MARGINAL COSTS The long-run marginal costs curve intersects our long-run cost curve at its lowest point. Costs (dollars per pair) ATC 1 ATC 2 ATC 3 Long-run average total cost (LATC) 4 a 6 b c Rate of Output (pairs of jeans per day) LONG-RUN COSTS WITH UNLIMITED OPTIONS ECONOMIES OF SCALE Costs (dollars per pair) ATC 2 m 2 LMC LATC There are many optional plant sizes available in long-run production. One option is the decision to use one large plant or several smaller plants to produce a given amount of output. Economies of scale are reductions in minimum average costs that come about through increases in the size (scale) of plant and equipment

9 ECONOMIES OF SCALE 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. 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. COST (dollars per unit) Constant returns to scale ATC S c m 1 ATC 1 Q M RATE OF OUTPUT (units per period) Economies of scale ATC S c m 2 ATC 2 Q M RATE OF OUTPUT (units per period) Diseconomies of scale ATC S c m 3 ATC 3 Q M RATE OF OUTPUT (units per period) 49 5 GLOBAL COMPETITIVENESS Global competitiveness ultimately depends on the costs of production. Low wages are not a reliable measure of global competitiveness. A worker s productivity (MPP) depends on the quantity and quality of other resources in the production process. UNIT LABOR COSTS A true measure of global competitiveness must take into account both factor costs and productivity. Unit labor cost is a true measure of global competitiveness PRODUCTIVITY ADVANCE IMPROVEMENTS IN PRODUCTIVITY REDUCE COSTS American productivity must increase as fast as other nations in order for America to stay competitive in global markets. Productivity advances and lower wage growth increase America s competitiveness in world markets. Unit labor costs in the U.S. increased by 1. percent between 1982 and 1994, far less than most other industrialized nations. TOTAL OUTPUT (units per time period) When the production function shifts up COST (dollars per unit) Cost curves shift down MC 1 MC 2 ATC 1 ATC 2 53 Resource Inputs (dollars per unit) Rate of Output (units per time period) 54

10 THE COSTS OF PRODUCTION End of Chapter 6