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COSTS OF PRODUCTIONChapters 11
Short-Run vs. Long Run• Firms typically have several types of inputs that they can
adjust to adjust production.• Long-run - When firms are able to adjust all of their inputs
including physical plant.• Short-run – When firms are able to adjust only some of
their inputs (usually energy, labor, and raw material costs).
Productivity• Average Productivity of Labor is output per work.
• Marginal Productivity of Labor is the extra production that is obtained from an extra unit of labor.
Total ProductAPL
Labor
TPMPL
Labor
Short Run Production Function
TPMPL
Labor
ΔLabor
ΔTP
ΔLaborΔTP
Total
Product
Production in the Short-Run• Given a set of fixed inputs (like plant and capital equipment),
a firm can vary other inputs (typically labor) and to vary production.
• Typically, as you add workers, you get more output.
• Up to a point each additional worker adds synergy and adding more workers leads to more and more extra pay-off.
• But at some point, capacity constraints bind, diminishing returns sets in, and the addition of extra workers will generate less and less extra production.
0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 64 68 72 76 80 84 88 92 96 100
0
5
10
15
20
25
30
35
Bakery
Hours
Lo
av
es
Productivity• Labor productivity depends on the number of workers
• First, increasing, then, decreasing• Average product of labor begins decreasing when
marginal product of labor drops below average.
Note: Marginal Product crosses through average product at the peak of average product.
As long as the next worker adds more product than the average worker, they will increase the average.
Once diminishing returns set in, additional workers may add less to output than the average worker, reducing the overall average.
MPL, APL
L
MPLAPL
Small Scale Schedule
Average MarginalHours Loaves Product Product
0 00.10
2 0.20 0.100.32
4 0.83 0.210.58
6 2 0.331
8 4 0.53
10 10 1
Large Scale ScheduleAverage Marginal
Hours Output Product Product0 0
110 10 1
0.33333340 20 0.5
0.290 30 0.333333
0.142857160 40 0.25
0.111111250 50 0.2
0.090909360 60 0.166667
Fixed Costs vs. Variable Costs• In short-run, we distinguish between the costs that are
adjustable as production is adjusted (variable costs) and costs that are unchanged regardless of production (fixed costs).• Variable costs (Wages of production workers, supply and raw
materials costs)• Fixed costs (Depreciation costs, Financial costs, wages of non-
production workers).
Types of Costs• Total Fixed Costs – Invariant to the number of goods
produced (in the short-run)• Average Fixed Costs – Decreasing in the number of goods
produced.
• Total Variable Costs- Increasing in the number of goods produced.
• Total Costs: Fixed Costs + Variable Costs
Bakery: Wages $10 per Worker, $5 Wheat per Loaf
Output Fixed Workers Bakers Wheat Variable Total(Loaves) Costs Wages Costs Costs
2.00 1000 6 60 10.00 70.00 1070.00
10.00 1000 10 100 50.00 150.00 1150.00
20.00 1000 40 400 100.00 500.00 1500.00
30.00 1000 90 900 150.00 1050.00 2050.00
40.00 1000 160 1600 200.00 1800.00 2800.00
50.00 1000 250 2500 250.00 2750.00 3750.00
60.00 1000 360 3600 300.00 3900.00 4900.00
Total Variable Costs are increasing at an accelerating rate.
Reason: Diminishing returns to variable inputs.
2.00 10.00 20.00 30.00 40.00 50.00 60.000
1000
2000
3000
4000
5000
6000
Cost Schedule
Fixed Costs Variable Costs Total Costs
Costs: Average vs. Marginal• Total Costs are the sum of all relevant costs for a firm.• Average Costs: Costs per unit of output.• Marginal Cost: Extra Cost per Extra Unit of Output.
Cost SchedulesOutput Average Average Average
Total Fixed Variable Total Marginal(Loaves) Costs Costs Costs Costs Costs
2.00 1070.00 500 35 53510.00
10.00 1150.00 100 15 11535.00
20.00 1500.00 50 25 7555.00
30.00 2050.00 33.33333 35 6875.00
40.00 2800.00 25 45 7095.00
50.00 3750.00 20 55 75115.00
60.00 4900.00 16.66667 65 82
Average and Marginal CostsAverage Fixed Costs decreases as production increases
AVC, ATC, MC all increase as diminishing returns kick in
2.00 10.00 20.00 30.00 40.00 50.00 60.00
AFC NaN 100 50 33.33333333333
33
25 20 16.66666666666
67
AVC 35 15 25 35 45 55 65
ATC NaN 115 75 68.33333333333
33
70 75 81.66666666666
67
MC 35 10 35 55 75 95 115
10
30
50
70
90
110
130
Cost Curve
$
MC equals AVC and ATC when each of the latter are at their minimum level.
Long Run Costs• In the short-run, the size of a firms physical plant is a fixed
factor. • Over-time, the plant size can adjust. • In the bakery example, extra ovens can be added.
Minimizing Costs in the Long Run• Consider average total cost schedules at different
numbers of ovens. • Each oven will have a production level that generates the
minimum average total cost. • To minimize average costs in the long-run, choose the
number of ovens which will have the lowest, minimum average total cost.
Average Total Cost Schedules at Different Scales of Production
10
20
30
40
50
60
70
80
90
10
0
11
0
12
0
48
68
88
108
128
148
168
188
208
228
1 Oven
2 Ovens
3 Ovens
4 Ovens
5 Ovens
6 Ovens
7 Ovens
8 Ovens
Output
Minimum of the different cost Schedules
10
20
30
40
50
60
70
80
90
10
0
11
0
12
0
48
68
88
108
128
148
168
188
208
228
1 Oven
2 Ovens
3 Ovens
4 Ovens
5 Ovens
6 Ovens
7 Ovens
8 Ovens
Output
Connect the DotsLong Run Average Total Costs
10
20
30
40
50
60
70
80
90
10
0
11
0
12
048
68
88
108
128
148
168
188
208
228
1 Oven
2 Ovens
3 Ovens
4 Ovens
5 Ovens
6 Ovens
7 Ovens
8 Ovens
Output
If we adjust capital scale continuously, the collection of minimum points is the Long Run Average Total cost cuve
LR ATC
Short-run ATC
Economies of Scale• When firms are able to adjust all of their inputs, they can choose a size that will minimize costs.
• If a firm is able to achieve some economies of scale, increasing size will reduce the average total cost.
• Sources of Economies of Scale• Production requires major expenditure on items needed to
produce even zero products• Ex. Software, pharmaceuticals
• Production requires many specific steps which can be most efficiently done through specialization• Ex. Airplanes, automobiles
Long Run ATC increasing returns to scale.
Output
Costs
LR ATC
Economies of Scale
Returns to Scale• Scale Economies is not always likely to characterize production.
• If each production unit can act autonomously with identical costs then we may experience constant returns to scale.
• Firms at some point experience diseconomies of scale or increasing long run average total costs.
• Sources of diseconomies of scale• Limits of managerial attention. • Limits of some other fixed resource.
Long Run ATC decreasing returns to scale.
Output
Costs
LR ATC
Constant Returns Scale
Diseconomies
Overall Cost Function
LR ATC
Minimum Efficient Scale
MES and Market Structure• If MES is relatively large in comparison with the market
demand:
$
Q
D
LRAC
The market is most efficiently served by a single firm---natural monopoly!
MES and Market Structure• If MES is relatively small in comparison with market
demand:
$
Q
Many “small” firms in the market.
Learning OutcomesStudents should be able to • Define and calculate various types of economic costs.• Fixed, variable, total, average, marginal.
• Describe the shape of various relevant cost curves• Average Total (in LR and SR), Average Fixed, Marginal Costs
• Describe the relationship between production, productivity (marginal and average) and the law of diminishing returns.
