Malla, ma. luisa

Production and Cost Analysis I 1

2

Production, Cost and the Business

Organization

1


2The Role of the Firm

• Firms transform the factors into goods for consumers

• Production is the transformation of factors into goods

• In the supply process, people offer their factors of production, such as land, labor, and capital, to the market

• Ultimately, all supply comes from individuals because control the factors of production

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2The Role of the Firm

1. Organize factors of production and/or2. Produce goods and services and/or3. Sell produced goods and services

• A virtual firm organizes production and subcontracts out all work

• A firm is an economic institution that transforms factors of production into goods and services

• Many of the organizational structures of business are being separated from the production process

Firms

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2The Production Process

• A firm chooses from all possible production techniques

• All inputs are variable

• The production process can be divided into the long run and the short run

• 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 the level of output

Short run Long run• A firm is constrained in

regard to what production decisions it can make

• Some inputs are fixed

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2Production Function

• Production function States the relationship between inputs and outputs

• Inputs – the factors of production classified as:• Land – all natural resources of the earth – not just ‘terra firma’!

• Price paid to acquire land = Rent• Labour – all physical and mental human effort involved in

production• Price paid to labour = Wages

• Capital – buildings, machinery and equipment not used for its own sake but for the contribution it makes to production

• Price paid for capital = Interest

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2Production Function

Inputs Process Output

Land

Labour

Capital

Product or service

generated– value added


2Analysis of Production Function:

Short RunIn times of rising sales (demand) firms can increase labour and capital but only up to a certain level – they will be limited by the amount of space. In this example, land is the fixed factor which cannot be altered in the short run.



Short Run

If demand slows down, the firm can reduce its variable factors – in this example it reduces its labour and capital but again, land is the factor which stays fixed.



Short Run

If demand slows down, the firm can reduce its variable factors – in this example, it reduces its labour and capital but again, land is the factor which stays fixed.


2Production Tables and Production Functions

• A production table is a table showing the output resulting from various combinations of factors of production or inputs

• This analysis will concentrate on short run production when in which one of the factors is fixed

• Firms combine factors of production to produce goods and services

• Real-world production tables are complicated

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2A Production Table

# of workers

Total Output

Marginal Product

Average Product

0 04

6

7

6

5

3

1

0

-2

-5

---

1 4 4

2 10 5

3 17 5.7

4 23 5.8

5 28 5.6

6 31 5.2

7 32 4.6

8 32 4.0

9 30 3.3

10 25 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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2Graphing a Production Function Q

Increasing marginal

productivity

Diminishingmarginal

productivity

DiminishingAbsolute

productivity

Number of workers

TP

A production function is the relationship between the

inputs and the outputs

32

26

20

14

8

2

1 2 3 4 5 6 7 8 9 10

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2Graphing Marginal and Average Productivity

Increasing marginal

productivity

Diminishingmarginal

productivity

DiminishingAbsolute

productivity

Number of workers

AP

MP

QMarginal productivity

first increasesThen marginal

productivity declines

Eventually marginal productivity is

negative

8

6

4

2

0

-2

-4

-6

1 2 3 4 5 6 7 8 9 10

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2Law of Diminishing Marginal Productivity

# of workers

Total Output

Marginal Product

Average Product

0 04

6

7

6

5

3

1

0

-2

-5

---

1 4 4

2 10 5

3 17 5.7

4 23 5.8

5 28 5.6

6 31 5.2

7 32 4.6

8 32 4.0

9 30 3.3

10 25 2.5

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

Diminishingmarginal productivity

DiminishingAbsolute productivity

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2The Costs of Production

TC = FC + VC

• 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

• Workers are an example of variable costs (VC) which are costs that change as output changes

• The sum of the variable and fixed costs are total costs (TC)

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2The Costs of Production

• Average fixed costs (AFC) equals fixed cost divided by quantity produced, AFC = FC/Q

• Marginal cost (MC) is the increase in total cost when output increases by one unit, MC = ΔTC/ΔQ

• Average variable costs (AVC) equals variable cost divided by quantity produced, AVC = VC/Q

• Average total costs (ATC) equals total cost divided by quantity produced, ATC = TC/Q or ATC = AFC + AVC

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2Costs of Production Table

Output FC ($) VC ($) TC ($) MC ($) AFC ($) AVC ($) ATC ($)3 50 38 88

1216.67 12.66 29.33

4 50 50 100 12.50 12.50 25.00

9 50 100 1508

5.56 11.11 16.67

10 50 108 158 5.00 10.80 15.80

16 50 150 2007

3.13 9.38 12.51

17 50 157 207 2.94 9.24 12.18

22 50 200 25010

2.27 9.09 11.36

23 50 210 260 2.17 9.13 11.30

27 50 255 30515

1.85 9.44 11.29

28 50 270 320 1.79 9.64 11.43

32 50 400 450 1.56 12.50 14.06

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2Graphing Total Cost Curves

FC

Total Cost

FC curve is constant

TC and VC curves

increase as Q increases

Q

500

400

300

200

100

04 8 12 16 20 24 28 32

VC

TC

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2Graphing Per Unit Output Cost Curves

AVC

MC

ATC

AFCQ

Cost

AFC curve decreases

MC, ATC, and AVC

curves are U-shaped

35

30

25

20

15

10

5

04 8 12 16 20 24 28 32

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2The Shapes of Cost Curves

• The variable and total cost curves have the same shape• Increasing output increases VC and TC

• The average fixed cost curve is downward sloping• Increasing output decreases AFC

• The fixed cost curve is always constant• Increasing output doesn’t change FC

• The marginal cost, average variable cost, and average total cost curves are U-shaped

• Increasing output initially leads to a decrease in MC, AVC, and ATC but eventually they increase

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2The Shapes of Cost Curves

• The marginal cost curve goes through the minimum points of the ATC and AVC curves

• The U-shape of ATC and AVC curves is due to:• When output is increased in the short run, it can

only be done by increasing the variable input• The law of diminishing productivity causes

marginal and average productivities to fall• As average and marginal productivities fall,

average and marginal costs rise

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2 The Relationship Between

Marginal Productivity and Marginal Costs

AVC

Q

MC

Q

Output per worker

Costs per unit

If marginal productivity is rising, marginal costs are falling

If average productivity is falling, average costs are rising

MP of workersAP of workers

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2

• If MC > ATC, then ATC is rising

• If MC > AVC, then AVC is rising

• If MC < ATC, then ATC is falling

• If MC < AVC, then AVC is falling

• 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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2The Relationship Between

Marginal Cost and Average Cost

AVC

MC

Q

Costs per unit

ATCThe marginal cost curve

goes through the minimum point of both the ATC and AVC curves

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Malla, ma. luisa

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