Chapter 9:
Production and
Cost Analysis II
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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1
Long Run Production Decisions

To make their long run decisions:

Firms look at costs of various inputs and the
technologies available for combining these inputs.

Then decide which combination offers the lowest
cost.
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2
Technical Efficiency and Economic
Efficiency

Technical efficiency – as few inputs as
possible are used to produce a given output.

Technical efficiency is efficiency that does not
consider cost of inputs.
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3
Technical Efficiency and Economic
Efficiency

Economic efficiency – the method produces
a given level of output at the lowest possible
cost.

It is the least-cost technically efficient
process.
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4
Long Run Cost Curve

The law of diminishing marginal productivity
does not hold in the long run.

All inputs are variable in the long run.
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5
Long Run Cost Curve

The shape of the long run cost curve is due
to the existence of economies and
diseconomies of scale.
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6
Typical Long Run Average Total Cost
Curve
Costs per unit
$64
62
60
58
56
54
52
50
48
Average
total cost
Minimum efficient
level of production
11 12 13 14 15 16 17 18 19 20 Quantity
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7
Economies of Scale

There are economies of scale in production
when the long run average cost decreases as
output increases.

Economies of scale (increasing returns to
scale) are cost savings associated with larger
scale of production.
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8
Individual Setup Costs

An indivisible setup cost is the cost of an
indivisible input for which a certain minimum
amount of production must be undertaken
before the input becomes economically
feasible to use.
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9
Individual Setup Costs

Indivisible setup costs are the source of many
real-world economies of scale.

The cost of a blast furnace or an oil refinery is
an example of an indivisible setup cost.
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10
Economies of Scale

In the longer run all inputs are variable, so
only economies of scale can influence the
shape of the long run cost curve.
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11
Economies of Scale

Economies of scale occur whenever inputs
do not need to be increased in proportion to
the increase in output.

As output increases, cost per unit falls in the
long run, so this can also be seen as an
increase in productivity.
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12
Economies of Scale

Doubling the inputs more than doubles the
output, when there are economies of scale.

Firms can economize on management cost,
or they can take advantage of specialized
labour and specialized capital.
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13
Economies of Scale

Because of the importance of economies of
scale, business people often talk of a
minimum efficient scale of production.
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14
Minimum Efficient Scale

The minimum efficient scale of production
is the amount of production that spreads
setup costs out sufficiently for firms to
undertake production profitably.
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15
Minimum Efficient Scale

The minimum efficient scale (MES) of
production is reached once the size of the
market expands to a size large enough so
that firms can take advantage of all
economies of scale.
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16
Typical Long Run Average Total Cost
Curve
Costs per unit
$64
Economies
62
of scale
60
58
56
54
52
50
48
Constant
returns
to scale
Diseconomies
of scale
Minimum efficient scale
of production
Long run
average
total cost
11 12 13 14 15 16 17 18 19 20 Quantity
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17
Economies of Scale

The minimum efficient scale of production will
be at the beginning of the constant returns
portion of the average cost curve—where
average total costs are at a minimum.
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18
Economies of Scale

The implication of economies of scale is that
in some industries firms must be of a certain
size to be able to compete successfully.
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19
Increasing Returns to Scale (IRTS)

Increasing returns to scale is where long
run average total costs fall as output
increases.

It is shown by the decreasing portion of the
LRAC curve.
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20
Constant Returns to Scale (CRTS)

Constant returns to scale is where long run
average total costs do not change as output
increases.

It is shown by the flat portion of the LRAC
curve.
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21
Decreasing Returns to Scale (DRTS)

Decreasing returns to scale or
diseconomies of scale refer to decreases in
productivity which occur when there are
equal increases of all inputs.

Decreasing returns to scale occur where the
long run average cost curve is upward
sloping, meaning that average cost is
increasing.
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22
Monitoring Costs

As the size of the firm increases, monitoring
costs generally increase.

Monitoring costs are those incurred by the
organizer of production in seeing to it that the
employees do what they are supposed to do.
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23
Decreasing Returns to Scale

Diseconomies occur for a number of reasons
as the firm increases its size




Coordination of a large firm is more difficult
Information costs and communication costs
increase as firm increases
Monitoring costs increase
Team spirit may decrease
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24
Decreasing Returns to Scale

Team spirit is the feelings of friendship and
being part of a team that brings out people’s
best effort.
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25
Summary of Returns to Scale
Returns to scale
Doubling inputs
results in:
Slope of the LRAC
Increasing returns to
scale (IRTS;
economies of scale)
Output more than
doubles.
downward
Constant returns to
scale (CRTS)
Output exactly
doubles.
horizontal
Decreasing returns to Output less than
scale (DRTS;
doubles.
diseconomies of
scale)
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upward
26
Economies and Diseconomies of Scale
Costs per unit
$64
62
60
58
56
54
52
50
48
Increasing
Returns to
Scale
Constant
returns
to Scale
Decreasing
Returns to
Scale
Long run
average
total cost
11 12 13 14 15 16 17 18 19 20 Quantity
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27
Importance of Economies of Scale

Economies and diseconomies of scale play
important roles in real-world long run
production decisions.
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28
Importance of Economies of Scale

The long run and the short run average cost
curves have the same U-shape, but the
underlying causes of these shapes differ.
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29
Short Run Average Cost Curves

Initially increasing and then eventually
diminishing marginal productivity (as a
variable input is added to a fixed input)
accounts for the shape of the short run
average cost curve.
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30
Long Run Average Cost Curve

Economies and diseconomies of scale
account for the shape of the long run total
cost curve.
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31
Envelope Relationship

In the long run all inputs are flexible, while in
the short run some inputs are not flexible.

As a result, long run cost will always be less
than or equal to short run cost.
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32
Envelope Relationship

In the short run the firm faces an additional
constraint – all expansion must proceed
using only the variable input.

These additional constraints increase cost.
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33
Envelope Relationship

The envelope relationship explains that:


At the planned output level, short run average
total cost equals long run average total cost.
At all other levels of output, short run average
total cost is higher than long run average total
cost.
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34
Envelope of Short Run Average Total
Cost Curves
Costs per unit
LRATC
0
SRMC1
SRATC4
SRATC1
SRMC2
SRMC4
SRATC2 SRATC3
SRMC3
Q*
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Quantity
35
Industry with Strong Economies of Scale
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36
Entrepreneurial Activity and the
Supply Decision

Profit is what underlies the dynamics of
production in a market economy.

The expected price must exceed the
opportunity cost of supplying the good for a
good to be supplied.
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37
Entrepreneurial Activity and the
Supply Decision

The greater the difference between price and
average total cost, the greater the
entrepreneur’s incentive to tackle the
organizational problems and supply the good.
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38
Entrepreneurial Activity and the
Supply Decision

An entrepreneur is an individual who sees
an opportunity to sell an item at a price higher
than the average cost of producing it.
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39
Entrepreneurial Activity and the
Supply Decision

Entrepreneurs organize production.

They visualize the demand and convince the
individuals who own the factors of production
that they want to produce those goods.
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40
Using Cost Analysis in the Real World

Some of the problems of using cost analysis
in the real world include the following:




Economies of scope.
Learning by doing and technological change.
Many dimensions.
Unmeasured costs.
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41
Economies of Scope

The cost of production of one product often
depends on what other products a firm is
producing.
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42
Economies of Scope

There are economies of scope in production
when the costs of producing goods are
interdependent so that it is less costly for a
firm to produce one good when it is already
producing another.
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43
Economies of Scope

Firms look for both economies of scope and
economies of scale.

Economies of scope play an important role in
firms’ decisions of what combination of goods
to produce.
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44
Economies of Scope

Globalization has made economies of scope
even more important to firms in their
production decisions.
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45
Learning by Doing and Technological
Change

Production techniques available to real-world
firms are constantly changing because of
learning by doing and technological change.

These changes occur over time and cannot
be accurately predicted.
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46
Learning by Doing and Technological
Change

Learning by doing means that as we do
something, we learn what works and doesn’t,
and over time we become more proficient at
it.
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47
Learning by Doing and Technological
Change

The concept of learning by doing emphasizes
the importance of the past effort in
developing cost advantages.

Many firms estimate worker productivity to
grow 1 to 2 percent a year because of
learning by doing.
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48
Learning by Doing and Technological
Change

External economies are present in all
industries – those are the external forces at
work which are capable of reducing costs for
all firms belonging to the industry
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49
Learning by Doing and Technological
Change

Technological change is an increase in the
range of production techniques that provides
new ways of producing goods.
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50
Learning by Doing and Technological
Change

Technological change offers an increase in
the known range of production.
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51
Learning by Doing and Technological
Change

Whenever learning by doing or technological
change occurs, the cost curve shifts down
since the same output can be produced at a
lower cost.
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52
Learning by Doing and Technological
Change

In some industries such as the computer
business, technological change is occurring
so fast that it overwhelms all other cost
components.
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53
Learning by Doing and Technological
Change

Technological change and learning by doing
are intricately related.
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54
Many Dimensions

Most decisions that firms make involve more
than one dimension.

The only dimension in the standard model is
the level of output.

Good economic decisions take all relevant
marginal costs and benefits into account.
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55
Many Dimensions

The important thing to remember in using the
standard model is the reasoning, not the
specific model.
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56
Unmeasured Costs

The relevant costs as defined by economists
are not the costs found in a firm’s books.

Economists include opportunity costs while
accountants use explicit costs that can be
measured.
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57
Economists Include Opportunity Cost

Economists include the business owner’s
opportunity cost.

The business owner’s opportunity cost
includes forgone income that the owner could
have earned by spending his or her time in
another job.
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58
The Standard Model as a Framework

Despite its limitations, the standard model
provides a good framework for cost analysis.

It can be expanded to include real-world
complications.
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59
Production and
Cost Analysis II
End of Chapter 9
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60
Isocost/Isoquant Analysis
Chapter 9 Appendix
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61
Isocost/Isoquant Analysis

In the long run, a firm can vary all of the
factors of production.

One important decision in the long run is
which combination of factors to use.

Economic efficiency involves choosing the
factors so that the cost of production is at the
minimum.
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62
Isocost/Isoquant Analysis

A graphical tool used in economics to
analyze the long run choice of factors of
production is the isocost/isoquant analysis.
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63
Isocost/Isoquant Graph

The analyst creates a graph showing various
combinations of factors of production that can
produce a certain amount of output.
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64
Isocost/Isoquant Graph
More than 3 units of
machinery and more
than 4 units of labour
Less than 3 units
of machinery and
less than 4 units
of labour
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65
Isoquant Curve

Isoquant curve –An isoquant curve (equal
quantity) represents combinations of factors
of production that result in equal amounts of
output.

A point on the isoquant curve is technically
efficient.
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66
Isoquant Curve for 60 Earrings
Labour
Machines Pairs of Earrings
A
3
20
60
B
4
15
60
C
6
10
60
D
10
6
60
E
15
4
60
F
20
3
60
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67
Isoquant Curve for 60 Earrings
Machines
A
B
G
C
D
E
F Q60
Units of labour
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68
Isoquant Curve

The isoquant curve is bowed inward because
of the law of diminishing marginal
productivity.
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69
Isoquant Curve

Marginal rate of technical substitution –
the rate at which one factor must be added to
compensate for the loss of another factor, to
keep output constant.

It is the slope of the isoquant curve.
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70
Isoquant Curve

The absolute value of the slope at a point on
the isoquant curve equals the ratio of the
marginal productivity of labour to the marginal
productivity of machines.
MPlabour
Slope 
MPmachine
 Marginal rate of substituti on
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71
Isoquant Curve

Isoquant map – a set of isoquant curves that
show technically efficient combinations of
inputs that can produce different levels of
output.
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72
Isoquant Map
Q100
Q60
Q40
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73
The Isocost line

The isocost line (equal cost) represents
alternative combinations of factors of
production that have the same cost.

The slope of the isocost line equals the ratio
of prices of the factors of production.
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74
The Isocost Line

The slope of the isocost curve:
Slope = Plabour/Pmachines
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75
The Isocost Lines
Machines
20
C
Slope = -Plabour/Pmachines
=-5/3
D
6
A
12
18
Units of labour
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76
Choosing the Economically Efficient
Point of Production

The least cost combination of inputs for a
given output occurs where the isocost curve
is tangent to the isoquant curve for that
output.
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77
Choosing the Economically Efficient
Point of Production

The slopes of the two curves are equal at that
point of tangency.
– MPlabour – Plabour
MPlabour MPmachines

so that

MPmachines Pmachines
Plabour
Pmachines
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78
Choosing the Economically Efficient
Point of Production

The firm is operating efficiently when an
additional output per dollar spent on labour
equals the additional output per dollar spent
on machines.
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79
Combining Isoquant and Isocost
Curves
Machines
20
B
A
MPlabour/MPmachines =Plabour/Pmachines
C
Q2
Q1
12
Units of labour
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80
Isocost/Isoquant Analysis
End of Chapter 9 Appendix
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81