1. 1. Production and Cost Anybody can cut prices, but it takes brains to produce a better article -P.D. Armour Slide 1 of 58
2. 2. First, some notes This module is a critical part of this class. The concepts we learn here are a foundation for material we will discuss in each of the next three modulesand in your final project! We are now turning our attention from the behavior of consumers (Modules 4 and 6) to the behavior of producers (Modules 7-11). Slide 2 of 58
3. 3. This module has been divided into three major parts Part 1: Production Relationships Part 2: Short Run Production Costs Part 3: Long Run Production Costs The relationship between the amount of inputs used and the amount of output produced will be explored. One input in particular, labor, will be emphasized. Short run costs are a key part of determining how much a producer will produce. Several short run costs will be discussed Long run costs are key in examining how big your firm should be. Slide 3 of 58
4. 4. Production relationships help show a key microeconomic concept Total Product (TP) This is the total output or total quantity of a particular good or service produced Marginal Product (MP) This is the increase in output associated with adding one more unit of a resource (for example one more unit of labor) Average Product (AP) This is the output per unit of input (for example the amount of output each unit of labor produces) In reference to labor, this is productivity Part 1: Production Relationships Three production relationships will be explored: TP MP AP Slide 4 of 58
5. 5. Total product (TP) describes how much can be produced by a firm In this example, well talk about bricklayers. With no employees, your firm will not produce any brick walls. With the hire of your first employee, your firm may be able to produce 10 feet of brick wall per day. With the hire of your second employee, your firm may be able to produce 25 feet of brick wall per day. Note how two employees are more productive then twice one employee. They are working together and are more efficient. With the hire of your third employee, your firm may be able to produce 45 feet of brick wall per day. Note how three employees are more productive then three times one employee. They are working together and again they are more efficient. Eventually these gains from efficiency start to wear off. If you keep adding employees to the same job, eventually they become increasingly unproductive. In the extreme, production can decline with added employees as the worksite becomes crowded and confused. Part 1: Production Relationships TP Slide 5 of 58
6. 6. Total product, seen graphically This line is referred to as the production function. A producer may produce anywhere up to and including points on this line. But note how the line eventually declines as an increasing number of inputs are added! With one employee, your firm will produce 10 feet of product With two employees, your firm will produce 25 feet of product With three employees, your firm will produce 45 feet of product With four employees, your firm will produce 60 feet of product With five employees, your firm will produce 70 feet of product With six employees, your firm will produce 75 feet of product With seven employees, your firm will still produce 75 feet of product Part 1: Production Relationships TP This is the key lesson in this section: Beyond some point, as extra variable resources are added (in this case, labor), product that can be attributed to each additional unit will decline. With eight employees, your firm will only produce 70 feet of product Slide 6 of 58
7. 7. Marginal product (MP) shows how much can be produced given one more input When we are discussing Marginal Product, we are asking, How much more output will I get if I hire another worker? The technical definition: Marginal product is the extra output associated with adding an extra unit of input such as labor. Part 1: Production Relationships MP Slide 7 of 58
8. 8. Calculating marginal product The first worker produces 10 units. MP =10 The 2nd worker produces 15 units. MP =15 The 3rd worker produces 20 units. MP =20 The 4th worker produces 15 units. MP =15 The 5th worker produces 10 units. MP =10 The 6th worker produces 5 units. MP =5 The 7th worker produces 0 units. MP =0 The 8th worker actually hurts production. The workplace is too crowded. MP =-5 Part 1: Production Relationships MP Slide 8 of 58
9. 9. Note: Increasing MP as a second worker is added Note: MP is increasing at a decreasing rate as more workers are added Note: MP is negative as workers get in each others way This highlights the Law of Diminishing Marginal Returns (see next slide) Marginal product, seen graphically Marginal product is increasing. People are working together and specializing. Added employees are still productive (MP>0) but not as much as the first few. Perhaps they have to wait in line for tools. Part 1: Production Relationships MP Slide 9 of 58
10. 10. Eventually the MP curve turns downward and becomes negative This idea is embodied in the Law of Diminishing Marginal Return: As successive units of variable resources (such as labor) are added to a fixed resource (such as a factory), beyond some point, the added product (i.e. marginal product) that can be attributed to each additional unit of the variable resource will decline Part 1: Production Relationships In common language: As you continually hire more employees without increasing your factory size, eventually each one will produce less than the last. MP Slide 10 of 58
11. 11. There is a relationship between the production function and MP Early in production, we observe increasing marginal returns At some point, diminishing marginal returns sets in Eventually,negative marginalreturnsoccurs Part 1: Production Relationships MP Slide 11 of 58
12. 12. To make sure you understand, try this exercise At what point does diminishing marginal returns set in? ____________ At what point does negative MP occur? ____________ Please fill in the blank cells and answer the questions below. Click to see the answers. 4th employee 7th employee Part 1: Production Relationships MP Slide 12 of 58
13. 13. Average product (AP) describes output per unit of labor When we are discussing Marginal Product, we are asking, How much does the average employee produce? The technical definition: Average product is the total output produced per unit of resource employed. Part 1: Production Relationships AP Slide 13 of 58
14. 14. Calculating average product The first worker produces 10 units. AP =10 The first 2 workers produce 25 units. AP =12.5 The first 3 workers produce 45 units. AP =15 The first 4 workers produce 60 units. AP =15 The first 5 workers produce 70 units. AP=14 The first 6 workers produce 75 units. AP =12.5 The first 7 workers produce 75 units. AP =10.7 The first 8 workers produce 70 units. AP =8.8 Part 1: Production Relationships AP Slide 14 of 58
15. 15. AP and MP, seen graphically Diminishing Marginal Returns is evident in both these measures: Eventually, the curves slope downward. When does diminishing marginal returns set in? Part 1: Production Relationships AP When does diminishing marginal returns set in? With the fourth worker. Slide 15 of 58
16. 16. Part 2: Short run costs of production Lets turn our attention from production to producer costs Well use the shipbuilding industry as an example. Part 2: Short Run Production Costs Slide 16 of 58
17. 17. First, a clarification about time When analyzing production costs, we must first differentiate between the short run and the long run. In the short run, the plant is fixed plant capacity cant be altered, but the intensity with which that plant is used can be altered. For example, you can hire a night shift. In the long run, the plant is variable In the long run, the producer can alter plant capacity and any other resource. For example, you can add another dry dock. But you cant do that in the short run. Part 2: Short Run Production Costs Slide 17 of 58
18. 18. Opportunities to change production differ in the short run versus the long run Part 2: Short Run Production Costs Assume you own a farm and decided to plant corn last spring. It is time to harvest. You are now reading in the paper that corn prices are falling and soybean prices are rising. In the long run, you can change your crop to soybean (i.e. next year). In the short run, you are going to harvest corn. Slide 18 of 58
19. 19. Short run costs are a major factor in deciding how much to produce Total Costs (TC) It is the sum of all producers costs It includes fixed and variable costs Average Total Costs (ATC) It is the average cost per unit of production Includes average fixed and average variable costs Marginal Costs (MC) It is change in costs associated with a one unit change in production Remember: marginal means additional Part 2: Short Run Production Costs Three short run producer costs will be explored: TC ATC MC Slide 19 of 58
20. 20. Producer cost concept #1: Total Costs (TC) Total costs of production include the value of all resources used in the production process Total costs include: Fixed costs Variable costs TC Part 2: Short Run Production Costs Slide 20 of 58 These (and other) relationships are a key learning outcome. Each cost has a special, but different relationship with output. Understanding the producer costs outlined from here forward will be critical in your success in this class.
21. 21. Fixed costs include costs that dont change Costs that do not vary with changes in output are fixed costs Examples include: Rental payments Interest on a firms debt Depreciation on equipment Insurance premiums TC Part 2: Short Run Production Costs Rent is a great example. It doesnt matter how many units of output you produce your rent is the same. Interest on debt is another example. Do you think these guys care how much output you produced? Slide 21 of 58
22. 22. An example of fixed costs Which of these costs are fixed? Note: Many other costs such as taxes, insurance, pensions, energy, fuel, and others are ignored. TC Part 2: Short Run Production Costs Hypothetical Costs for a Shipbuilder Slide 22 of 58
23. 23. Variable costs include costs that do change Costs that do vary with changes in output are variable costs Other examples include: Materials Fuel Power Transportation services TC Part 2: Short Run Production Costs Labor is a great example. As your output increases, you have to hire more people and labor costs go up. Slide 23 of 58
24. 24. An example of variable costs Which of these costs are variable? Note: Many other costs such as taxes, insurance, pensions, energy, fuel, and others are ignored TC Part 2: Short Run Production Costs Hypothetical Costs for a Shipbuilder Slide 24 of 58
25. 25. Fixed costs, shown in tabular form TC Part 2: Short Run Production Costs Note: fixed costs dont change with increases in output. Slide 25 of 58
26. 26. Fixed costs, shown graphically Note: There is no relationship between fixed costs and output What is the relationship between fixed costs and output? (positive, negative or no relationship) TC Part 2: Short Run Production Costs Slide 26 of 58
27. 27. Variable costs, shown in tabular form TC Part 2: Short Run Production Costs Note: fixed costs DO change with increases in output. Slide 27 of 58
28. 28. Variable costs, shown graphically The relationship is positive. As output increases, variable costs go up. TC Part 2: Short Run Production Costs Note: The Law of Diminishing Marginal Returns is evident in the shape of this curve! It increases at an increasing rate as added employees become less productive. What is the relationship between variable costs and output? (positive, negative or no relationship) Slide 28 of 58
29. 29. Total costs Please keep in mind that fixed costs plus variable costs equal total costs TC Part 2: Short Run Production Costs Slide 29 of 58
30. 30. Total cost, variable cost, and fixed costs shown graphically TC Part 2: Short Run Production Costs Notice: the vertical distance between variable costs and total costs is constant. Why? Because the difference between them is fixed costs, which doesnt change as production changes! Slide 30 of 58
31. 31. Try this total cost exercise Fill in the empty cells on the table then graph TFC, TVC, and total costs TC Part 2: Short Run Production Costs Slide 31 of 58
32. 32. Producer cost concept #2: Average Total Costs (ATC) When we are discussing the ATC, we are asking," How much, on average, does each unit of production cost? The technical definition: A firms total cost divided by its output. Average total costs include: Average fixed costs Average variable costs ATC Part 2: Short Run Production Costs Slide 32 of 58
33. 33. Calculation of Average Total Costs (ATC) ATC Part 2: Short Run Production Costs The first cell cannot be filled out, You cant divide by zero! For the first unit, the ATC is $650. (Total Cost/ Total Output = $650/1) For the second unit, the ATC is $413. (Total Cost/ Total Output = $825/2) Costs for a Hypothetical Shipbuilder, in MillionsCosts for a Hypothetical Shipbuilder, in Millions Slide 33 of 58
34. 34. Average total costs, seen graphically Note the U-Shape of the ATC! At lower levels of production, fixed costs are spread over only a few units making ATC high As production increases, fixed costs are spread over more units and ATC declines Eventually, Diminishing Marginal Returns sets in and ATC begins to rise ATC Part 2: Short Run Production Costs Slide 34 of 58
35. 35. Average total costs, seen graphically Note the U-Shape of the ATC! Examine the data: At lower levels of production, fixed costs are spread over only a few units making ATC high ATC Part 2: Short Run Production Costs Slide 35 of 58
36. 36. Average total costs, seen graphically Note the U-Shape of the ATC! Examine the data: At high levels of production, diminishing Marginal Returns sets in and the ATC begins to rise ATC Part 2: Short Run Production Costs Slide 36 of 58
37. 37. Average total, variable, and fixed costs, seen graphically ATC Part 2: Short Run Production Costs This side of the ATC is held up by high fixed costs per unit (The orange line) This side of the ATC is held up by high variable costs per unit (The green line) Among these curves, this is the most important one. We will continue to discuss the ATC for the next several weeks. Slide 37 of 58
38. 38. Try this average total cost exercise ATC Part 2: Short Run Production Costs Fill in the empty cells on the table then graph ATC Slide 38 of 58
39. 39. Producer cost concept #3: Marginal Costs (MC) When discussing the MC, we are asking the question, " How much would it cost to produce one more unit? The technical definition: A firms total cost divided by its output. Part 2: Short Run Production Costs MC Slide 39 of 58
40. 40. Marginal cost (MC) Note: When adding the 1st unit of production, costs go up by $250 MC Part 2: Short Run Production Costs MC for the first unit = ($650- $400)/(1-0) Costs for a Hypothetical Shipbuilder, in MillionsCosts for a Hypothetical Shipbuilder, in Millions Note: When adding the 2nd unit of production, costs go up by $175 MC for the second unit = ($825-$650)/(2-1) Slide 40 of 58
41. 41. Marginal cost, seen graphically Note the J-Curve Shape. MC decreases as efficiency is improved (Increasing Marginal Product) MC slowly rises as Diminishing Marginal Returns sets in (Decreasing Marginal Product) MC increases rapidly as Marginal Product approaches (and falls below) zero (Negative Marginal Product) MC Part 2: Short Run Production Costs Slide 41 of 58
42. 42. Try this marginal cost exercise MC Part 2: Short Run Production Costs Fill in the empty cells on the table then graph MC Slide 42 of 58
43. 43. Long run producer costs impact the size of the company Part 3: Long Run Production Costs In the long run, a shipbuilder can add another dry dock In the long run, a farmer can farm additional land Slide 43 of 58
44. 44. In the long run, if a firm is successful it will likely expand The question is, what happens to its average total costs (ATC) as it expands? Part 3: Long Run Production Costs Slide 44 of 58
45. 45. As a firm expands, economies of scale may occur Please note: scale is a fancy word for size The issue: can this big factory produce a good at a lower average cost than this little factory? Part 3: Long Run Production Costs The technical definition of economies of scale: Reductions in the average total cost of producing a product as the firm expands the size of its plant Slide 45 of 58
46. 46. Recall: in the long run an industry (and the individual firms it includes) can adjust all resources Farmers can add to farmed land Manufacturers can add an assembly line Shipbuilders can add a dry dock Part 3: Long Run Production Costs Slide 46 of 58
47. 47. As an example: assume that you run a transportation company moving containers Your current fleet is comprised of containers measuring 10X10 X 30 10 10 30 3,000 ft3 Total costs to transport one container (fuel, driver, taxes, tariffs, storage) = $1,500 Average total costs (ATC) are $0.50 per cubic foot i.e. $1,500 / 3,000 ft3 Part 3: Long Run Production Costs Slide 47 of 58
48. 48. One of your competitors is operating with larger containers 10 12 60 7,200 ft3 Total costs to transport one container (fuel, driver, taxes, tariffs, storage) = $2,600 Average total costs (ATC) are $0.36 per cubic foot Clearly, your competitor has a cost advantage on you ! i.e. $2,600 / 7,200 ft3 Part 3: Long Run Production Costs Your ATC = $0.50/sf His ATC=$0.36/sf Slide 48 of 58
49. 49. Long run versus short run In the long run, you could upgrade your fleet to include the larger containers. You realize that you should probably adjust your fleet to compete, but you look at the number of containers you have and sigh In the short run, you are stuck with the containers you have. Part 3: Long Run Production Costs Slide 49 of 58
50. 50. Short run ATC for individual firms $0.50 200 $0.50 $0.36 200 500 Your ATC Your Competitors ATC ATC3 Perhaps there is another firm with even bigger containers ATC4 Eventually, however, containers may become so big, that it takes specialized equipment to pick them up, overwhelming any cost savings. ATC5 Here average costs per unit have increased again as containers become even bigger! Part 3: Long Run Production Costs Slide 50 of 58
51. 51. Short run ATC for individual firms and long run ATC for industry $0.50 200 $0.50 $0.36 200 500 Your ATC Your Competitors ATC ATC3 ATC4 ATC5 These are the short run ATC curves for individual firms. In the long run, any firm could move to any other curve with an investment in new containers. Therefore, in the long run, the Long Run Average Total Cost curve (LRATC) curve is determined by connecting all the short run ATC curves. LR ATC Part 3: Long Run Production Costs Slide 51 of 58
52. 52. Lets return to the original question This questions refers to economies of scale and is asking about the shape of an industrys Long Run Average Total Cost Curves (LRATC). The issue: can this big factory produce a good at a lower average cost than this little factory? Part 3: Long Run Production Costs Slide 52 of 58
53. 53. Assume we are discussing a hypothetical industry and this is that industrys LRATC Each industry has its own unique LRATC Companies operating at this point on the LRATC are relatively small as can be seen by their low output Eventually, costs start to increase. Companies here are getting very big. There are numerous layers of management and changes are implemented only very slowly. Part 3: Long Run Production Costs Average costs per unit for these firms are here. Smaller companies have relatively higher costs Companies on this portion of the LRATC are relatively small. Perhaps these small companies do not have the largest most efficient equipment available. As output increases, the LRATC declines Companies here are getting bigger as can be seen by their output. Perhaps labor specialization occurs or capital is used more efficiently. Average costs per unit for these firms are here. At some point, average costs per unit stop decreasing Companies here are bigger still. Perhaps there are a few layers of management and making big decisions becomes more difficult. Average costs per unit for these firms are here. Average costs per unit for these firms are here. Slide 53 of 58
54. 54. Costs behave differently along different portions of the LRATC Part 3: Long Run Production Costs Along this portion of the LRATC, average total costs are falling. As a firms size gets bigger costs per unit fall. This is referred to as Economies of scale. Along this portion of the LRATC, average total costs are constant. As a firms size gets bigger costs per unit dont change. This is referred to as Constant returns to scale. Along this portion of the LRATC, average total costs increase. As a firms size gets bigger costs per unit increase. This is referred to as Diseconomies of scale. Remember that scale means size! Slide 54 of 58
55. 55. Some industries have flat LRATCs Part 3: Long Run Production Costs In this industry, a long constant returns to scale segment exists In an industry with an ATC like this, large and small firms may coexist. Neither would have a cost advantage on the other. Examples could include food or apparel. For example, Toms Two Table Tacos can operate right next to Jimmys Giant Buffet. Average costs per unit are the same for these different sized firms. Output for Firm #1 Output for Firm #2 Slide 55 of 58
56. 56. Some industries have downward sloped LRATCs Part 3: Long Run Production Costs In this industry, economies of scale prevail through a wide range of outputs Large firms will dominate this industry. Firms must Get big or go home. Auto makers are huge. You cannot produce one or two cars per year and coexist with them. Your costs would be outrageous and youd have to sell cars at ridiculously high prices. Examples include: Auto Industry Steel Industry Shipbuilding Farm Equipment Slide 56 of 58
57. 57. Industrial examples Part 3: Long Run Production Costs In this industry, economies of scale are quickly exhausted Small firms will dominate this industry. Why isnt there one large concrete production plant in the center of the U.S? Transportation costs would be extreme. It is more efficient to have many plants all over the country. Examples include: Concrete production Pizza delivery Slide 57 of 58
58. 58. Individual exercise Try to think of an industry that would fit each of these LRATCs Industry:_____________ Industry:_____________ Industry:_____________ Part 3: Long Run Production Costs Slide 58 of 58