06. costs of production

Costs of

Production

The Meaning of Costs

• Opportunity costs– meaning of opportunity cost

– examples

• Measuring a firm’s opportunity costs– factors not owned by the firm: explicit costs

– factors already owned by the firm: implicit costs

– irrelevance of:• historic costs

• replacement costs

Production in the Short run

• Production functions

– factors of production

• labour

• land and raw materials

• capital

• entrepreneurship

– the relationship between inputs and output

• TPP = ƒ(F1, F2, F3, … Fn)

Production in the Short run

• Long-run and short-run production – fixed and variable factors

– distinction between short run and long run

• The law of diminishing returns

• The short-run production function:– total physical product (TPP)

– average physical product (APP)

– marginal physical product (MPP)

– the graphical relationship between TPP, APP and MPP

0

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Number of farm workers

Wheat production per year from a particular farmT

onne

s o

f wh

eat p

rod

uce

d p

er y

ear

Number of workers

012345678

TPP 0 310243640424240

0

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Number of farm workers

Ton

nes

of w

hea

t pro

du

ced

per

ye

ar

Number of workers

012345678

TPP 0 310243640424240

Wheat production per year from a particular farm

0

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Wheat production per year from a particular farm

Number of farm workers

Ton

nes

of w

hea

t pro

du

ced

per

ye

ar TPP

b

Diminishing returnsset in here

d

Maximum output

-2

0

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Number offarm workers (L)

Ton

nes

of w

heat

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yea

r

TPP

Ton

nes

of w

heat

per

yea

r

Number offarm workers (L)

∆TPP = 7

∆L = 1

MPP = ∆TPP / ∆L = 7

Wheat production per year from a particular farm

0

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0 1 2 3 4 5 6 7 8

0

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-2

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Ton

nes

of w

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yea

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TPP

Ton

nes

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heat

per

yea

r

MPP

Number offarm workers (L)

Number offarm workers (L)

Wheat production per year from a particular farm

0

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30

40

0 1 2 3 4 5 6 7 8

-2

0

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Ton

nes

of w

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TPP

Ton

nes

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yea

r

APP

MPP

APP = TPP / L

Number offarm workers (L)

Number offarm workers (L)

Wheat production per year from a particular farm

0

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30

40

0 1 2 3 4 5 6 7 8

-2

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b

b

Ton

nes

of w

heat

per

yea

r

TPP

Ton

nes

of w

heat

per

yea

r

APP

MPP

Diminishing returnsset in here

Number offarm workers (L)

Number offarm workers (L)

Wheat production per year from a particular farm

0

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30

40

0 1 2 3 4 5 6 7 8

-2

0

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Ton

nes

of w

heat

per

yea

r

TPP

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

d

d

Number offarm workers (L)

Number offarm workers (L)

Maximumoutput

b

Wheat production per year from a particular farm

0

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c

c

-2

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Ton

nes

of w

heat

per

yea

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TPP

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

b

d

d

Number offarm workers (L)

Number offarm workers (L)

Slope = TPP / L= APP

Wheat production per year from a particular farm

Costs in the Short run

• Costs and inputs

– costs and the productivity of factors

– costs and the price of factors

• Fixed costs and variable costs

• Total costs

– total fixed cost (TFC)

– total variable cost (TVC)• TVC and the law of diminishing returns

– total cost (TC = TFC + TVC)

0

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0 1 2 3 4 5 6 7 8

Output(Q)

01234567

TFC(£)

1212121212121212

Total costs for firm X

0

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0 1 2 3 4 5 6 7 8

TFC

Output(Q)

01234567

TFC(£)

1212121212121212

Total costs for firm X

0

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0 1 2 3 4 5 6 7 8

TFC

Total costs for firm XOutput

(Q)

01234567

TFC(£)

1212121212121212

TVC(£)

010162128406091

0

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0 1 2 3 4 5 6 7 8

TVC

Output(Q)

01234567

TFC(£)

1212121212121212

TVC(£)

010162128406091

TFC

Total costs for firm X

0

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0 1 2 3 4 5 6 7 8

TVC

TFC

Total costs for firm XOutput

(Q)

01234567

TFC(£)

1212121212121212

TVC(£)

010162128406091

TC(£)

12222833405272

103

0

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0 1 2 3 4 5 6 7 8

TCOutput

(Q)

01234567

TFC(£)

1212121212121212

TVC(£)

010162128406091

TC(£)

12222833405272

103

TVC

TFC

Total costs for firm X

0

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0 1 2 3 4 5 6 7 8

TC

TVC

TFC

Total costs for firm X

Diminishing marginalreturns set in here

Costs in the Short run

• Marginal cost

– marginal cost (MC) and the law of diminishing returns

Output (Q)

Co

sts

(£)

MC

x

Average and marginal costs

Diminishing marginalreturns set in here

Costs in the Short run

• Marginal cost

– marginal cost (MC) and the law of diminishing returns

– the relationship between MC and TC curves

Output (Q)

Co

sts

(£)

MC

x

Average and marginal costs

Costs in the Short run

• Average cost

– average fixed cost (AFC)

– average variable cost (AVC)

– average (total) cost (AC)

• Relationship between average and marginal cost

Output (Q)

Co

sts

(£)

AFC

AVC

MC

x

AC

z

y

Average and marginal costs

Production in the Long run

• All factors variable in long run

• The scale of production:

– constant returns to scale

– increasing returns to scale

Short-run and long-run increases in output

Short-run and long-run increases in output

Short-run and long-run increases in output

Short-run and long-run increases in output

Production in the Long run

• All factors variable in long run

• The scale of production:

– constant returns to scale

– increasing returns to scale

– decreasing returns to scale

Production in the Long run

• All factors variable in long run

• The scale of production:

– constant returns to scale

– increasing returns to scale

– decreasing returns to scale

• Returns to scale and economies and diseconomies of scale

Production in the Long run

• Economies of scale– specialisation & division of labour

– indivisibilities

– container principle

– greater efficiency of large machines

– by-products

–multi-stage production

– organisational & administrative economies

– financial economies

• Economies of scope

Production in the Long run

• Diseconomies of scale–managerial diseconomies

– effects of workers and industrial relations

– risks of interdependencies

• External economies of scale

• External diseconomies of scale

• Location– balancing the distance from suppliers and

consumers

– importance of transport costs

Production in the Long run

• Optimum combination of factors

–MPPa/Pa = MPPb/Pb ... = MPPn/Pn

• Decision making in different time periods– very short run

– short run

– long run

– very long run

– decisions can be made for all time periods at the same time

Costs in the Long run

• Long-run average costs– shape of the LRAC curve

– assumptions behind the curve

Alternative long-run average cost curves

OutputO

Costs

LRAC

Economies of Scale

OutputO

Costs

LRAC

Alternative long-run average cost curves

Diseconomies of Scale

OutputO

Costs

LRAC

Alternative long-run average cost curves

Constant costs

A typical long-run average cost curve

OutputO

Costs

LRAC

A typical long-run average cost curve

OutputO

Costs

LRACEconomiesof scale

Constantcosts

Diseconomiesof scale

Costs in the Long run

• Long-run average costs

– shape of the LRAC curve

– assumptions behind the curve

• Long-run marginal costs

Long-run average and marginal costs

OutputO

Costs

LRAC

LRMC

Economies of Scale

OutputO

Costs

LRAC

Long-run average and marginal costs

LRMC

Diseconomies of Scale

OutputO

Costs

LRAC

Long-run average and marginal costs

= LRMC

Constant costs

OutputO

Costs

Long-run average and marginal costs

LRMC

LRAC

Initial economies of scale,then diseconomies of scale

Costs in the Long run

• Long-run average costs– shape of the LRAC curve

– assumptions behind the curve

• Long-run marginal costs

• Relationship between long-run and short-run average costs

Costs in the Long run

• Long-run average costs– shape of the LRAC curve

– assumptions behind the curve

• Long-run marginal costs

• Relationship between long-run and short-run average costs– the envelope curve

Deriving long-run average cost curves: factories of fixed size

SRAC3

Costs

OutputO

SRAC4

SRAC5

5 factories

4 factories3 factories2 factories

1 factory

SRAC1 SRAC2

SRAC1SRAC3

SRAC2 SRAC4

SRAC5

LRAC

Costs

OutputO

Deriving long-run average cost curves: factories of fixed size

Deriving a long-run average cost curve: choice of factory sizeCosts

OutputO

Examples of short-runaverage cost curves

LRAC

Costs

OutputO

Deriving a long-run average cost curve: choice of factory size

Costs in the Long run

• Long-run average costs– shape of the LRAC curve

– assumptions behind the curve

• Long-run marginal costs

• Relationship between long-run and short-run average costs– the envelope curve

• Long-run cost curves in practice

Costs in the Long run

• Long-run average costs– shape of the LRAC curve

– assumptions behind the curve

• Long-run marginal costs

• Relationship between long-run and short-run average costs– the envelope curve

• Long-run cost curves in practice– the evidence

Costs in the Long run

• Long-run average costs– shape of the LRAC curve

– assumptions behind the curve

• Long-run marginal costs

• Relationship between long-run and short-run average costs– the envelope curve

• Long-run cost curves in practice– the evidence

–minimum efficient plant size