Chapter 8:
Production and
Cost Analysis I
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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rights reserved.
1
Introduction

In the supply process, people first offer their
factors of production to the market.

Then the factors are transformed by firms into
goods that consumers want.

Production is the name given to that
transformation of factors into goods.
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2
Role of the Firm

The firm is an economic institution that
transforms factors of production into
consumer goods.



Organizes factors of production.
Produces goods and services.
Sells produced goods and services.
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3
Forms of Business

There are three major types of businesses:



sole proprietorships
partnerships
corporations.
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4
Sole Proprietorship

Businesses that have only one owner.

Advantages:



Minimum bureaucratic hassle.
Direct control by owner.
Disadvantages:


Limited ability to get funds.
Unlimited personal liability.
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5
Partnership

Businesses with two or more owners.

Advantages:



Ability to share work and risks.
Relatively easy to form.
Disadvantages:


Unlimited personal liability (even for partner's
blunder).
Limited ability to get funds.
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6
Corporation

Businesses that are treated as a person and
are legally owned by their stockholders who
are not liable for the actions of the corporate
"person."
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7
Corporation

Advantages:



No personal liability.
Increased ability to get funds.
Ability to shed personal income and gain added
expenses.
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8
Corporation

Disadvantages:



Legal hassle to organize.
Possible double taxation of income.
Monitoring problems.
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9
Forms of Business
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10
The Firm and the Market

A firm operates within the market and,
simultaneously, it abandons the market in the
sense that it replaces the market with
command and control.
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11
The Firm and the Market

How an economy operates depends on
transaction costs — the costs of
undertaking trades through the market.
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12
The Firm and the Market

Firms are the production organizations that
translate factors of production into consumer
goods.

A firm’s goal is to maximize profits.
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13
Firms Maximize Profit

Profit is the difference between total revenue
and total cost.
Profit = total revenue – total cost
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14
Firms Maximize Profit

For an economist,the measure of profit is
revenues minus both implicit costs and
explicit costs.

An accountant will calculate profit by
subtracting explicit costs from the revenue.
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15
Firms Maximize Profit

For an economist, total cost is explicit
payments to factors of production plus the
opportunity cost of the factors provided by the
owners of the firm, which is an implicit cost.
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16
Firms Maximize Profit

For economists:

Economic Profit =
total revenue – (implicit and explicit cost)
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17
Production Process

The production process generally divided into
the long run planning decision and the short
run adjustment decision.
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18
The Long Run and the Short Run

A long-run decision is a decision in which
the firm can choose the least expensive
method of producing from among all possible
production techniques.
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19
The Long Run and the Short Run

A short-run decision is one in which the firm
is constrained by past choices in regard to
what production decision it can make.
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20
The Long Run and the Short Run

The terms long run and short run do not
necessarily refer to specific periods of time.

They refer to the degree of flexibility the firm
has in changing the level of output.
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21
The Long Run and the Short Run

In the long run, all inputs are variable.

In the short run:



Flexibility is limited.
Some factors of production cannot be changed.
Generally, the production facility (“the plant”) is
fixed.
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22
Production Table

A production table shows the output
resulting from various combinations of factors
of production, or inputs.
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23
Production Table

Most of the production decisions firms make
are short run decisions involving changes in
output at a given production facility.

The firm can increase or decrease production
by adjusting the amount of variable inputs,
such as labour or materials.
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24
Production Table

Total product is the number of units of the
good or service produced by different
numbers of workers.
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25
Production

Marginal product is the additional output
that will be forthcoming from an additional
worker, other inputs remaining constant.

Average product is calculated by dividing
total output by the number of workers who
produced it.
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26
Production Functions

Production function – a curve that
describes the relationship between the inputs
(factors of production) and output.
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27
Production Functions

The production function tells the maximum
amount of output that can be derived from a
given number of inputs.
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28
Production Table
Number of
workers
Total output
Marginal
product
Average
product
0
1
2
3
4
5
6
7
8
9
10
0
4
10
17
23
28
31
32
32
30
25
4
6
7
6
5
3
1
0
2
5
—
4
5
5.7
5.8
5.6
5.2
4.6
4.0
3.3
2.5
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29
32
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
0
7
6
TP
5
Output per worker
Output
Production Function
4
3
2
AP
1
1
2
(a) Total product
3 4 5 6 7
Number of workers
8
9
10
0
1
2
3 4 5 6 7
Number of workers
(b) Marginal and average product
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8
9
MP
10
30
Diminishing Marginal Productivity

Both marginal and average productivities
initially increase, but eventually they both
decrease.
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31
Diminishing Marginal Productivity

This means that initially the production
function exhibits increasing marginal
productivity.

Then it exhibits diminishing marginal
productivity.

Finally, it exhibits negative marginal
productivity.
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32
Diminishing Marginal Productivity

The most relevant part of the production
function is that part exhibiting diminishing
marginal productivity.
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33
Diminishing Marginal Productivity

Law of diminishing marginal productivity
– as more and more of a variable input is
added to an existing fixed input, after some
point the additional output one gets from the
additional input will fall.
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34
Diminishing Marginal Productivity
Number of
workers
Total
output
Marginal
product
Average
product
0
1
2
3
4
5
6
7
8
9
10
0
4
10
17
23
28
31
32
32
30
25
4
6
7
6
5
3
1
0
2
5
—
4
5
5.7
5.8
5.6
5.2
4.6
4.0
3.3
2.5
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Increasing
marginal returns
Diminishing
marginal returns
Diminishing
absolute returns
35
Diminishing Marginal Productivity
Diminishing
absolute
returns
32
30
28
26
24
22
20 Increasing
18
16 marginal
returns
14
12
10
8
6
4
2
0
1 2 3 4 5 6 7
Number of workers
(a) Total product
Diminishing
marginal
returns
7
Diminishing
absolute
returns
6
TP
5
Output per worker
Output
Diminishing
marginal
returns
4
3
2 Increasing
1
8
9
10
0
AP
marginal
returns
1
2
3 4 5 6 7
Number of workers
(b) Marginal and average product
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8
9
MP
10
36
Diminishing Marginal Productivity

This law is sometimes called the flowerpot
law.

If it did not hold true, the world’s entire food
supply could be grown in a single flower pot.
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37
Costs of Production

Costs of production in the short run are:



Fixed Costs,
Variable Costs, and
Total Costs.
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38
Fixed Costs

Fixed costs are those that cannot be
changed in the period of time under
consideration regardless of output.


In the long run there are no fixed costs since all
costs are variable.
In the short run, a number of costs will be fixed.
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39
Variable Costs

Variable costs are costs that change as
output changes, such as the costs of labour
and materials.
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40
Fixed Costs, Variable Costs, and Total
Costs

The sum of the fixed costs and variable costs
are total costs.
TC = FC + VC
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41
Average Costs

Besides total costs, firms are concerned with
their costs per unit of output.

Per unit costs are



Average Total Cost,
Average Fixed Cost, and
Average Variable Cost
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42
Average Costs

Average total cost (often called average
cost) equals total cost divided by the quantity
produced.
ATC = TC/Q
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43
Average Costs

Average fixed cost equals fixed cost divided
by quantity produced.
AFC = FC/Q
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44
Average Costs

Average variable cost equals variable cost
divided by quantity produced.
AVC = VC/Q
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45
Average Costs

Average total cost can also be thought of as
the sum of average fixed cost and average
variable cost.
ATC = AFC + AVC
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46
Marginal Cost

Marginal cost is the increase in total cost of
increasing the level of output by one unit,
MC = TC/Q

In deciding how many units to produce, the
most important variable is marginal cost.
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47
The Cost of Producing Earrings
Output
FC
VC
TC
MC
AFC
AVC
ATC
3
4
9
10
16
17
22
23
27
28
50
50
50
50
50
50
50
50
50
50
38
50
100
108
150
157
200
210
255
270
88
100
150
158
200
207
250
260
305
320
—
12
—
8
—
7
—
10
—
15
16.67
12.50
5.56
5.00
3.13
2.94
2.27
2.17
1.85
1.79
12.66
12.50
11.11
10.80
9.38
9.24
9.09
9.13
9.44
9.64
29.33
25.00
16.67
15.80
12.50
12.18
11.36
11.30
11.30
11.42
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48
Graphing Cost Curves

To gain a greater understanding of these
concepts, it is a good idea to draw a graph.

Quantity is plotted on the horizontal axis and
a dollar measure of various costs on the
vertical axis.
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49
Total Cost Curves

Total cost rises with output.

The total variable cost curve has the same
shape as the total cost curve—increasing
output increases variable cost.
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50
Total cost
Total Cost Curves
$400
350
300
250
200
150
100
50
0
TC
VC
TC = (VC + FC)
L
O
M
2 4 6 8 10
FC
20
Quantity of earrings
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30
51
Average Fixed Cost Curve

The average fixed cost curve slopes down
continuously.
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52
Average Fixed Cost Curve

The average fixed cost curve looks like a
child’s slide – it starts out with a steep
decline, then it becomes flatter and flatter.

It tells us that as output increases, the same
fixed cost can be spread out over a wider
range of output.
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53
Increasing Output in the Short Run

In the short run, output can only be increased
by increasing the variable input.
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54
U-Shaped Cost Curves

The law of diminishing marginal productivity
sets in as more and more of a variable input
is added to a fixed input.

Marginal and average productivities fall and
marginal costs rise.
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55
U-Shaped Cost Curves

And when average productivity of the variable
input falls, average variable cost rises.
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56
U-Shaped Cost Curves

The average total cost curve is the vertical
summation of the average fixed cost curve
and the average variable cost curve.
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57
U-Shaped Cost Curves

If the firm increased output enormously, the
average variable cost curve and the average
total cost curve would almost meet.
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58
Cost
Per Unit Cost Curves
$30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
0
MC
ATC
AVC
AFC
2 4 6 8 10 12 14 16 18 20 22 2426 28 30 32
Quantity of earrings
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59
Relationship Between Productivity and
Costs

The shapes of the cost curves are mirrorimage reflections of the shapes of the
corresponding productivity curves.
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60
Relationship Between Productivity and
Costs

When one is increasing, the other is
decreasing.

When one is at a maximum, the other is at a
minimum.
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61
Relationship Between Productivity and
Costs
Costs per unit
$18
16
14
12
10
8
6
4
2
0
MC
AVC
18
21
Output
9
8
7
6
5
4
3
2
1
Output per worker
0
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AP
MP
21/2
4
Labour
62
Relationship Between Marginal and
Average Costs

The marginal cost and average cost curves
are related.

When marginal cost exceeds average cost,
average cost must be rising.

When marginal cost is less than average cost,
average cost must be falling.
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63
Relationship Between Marginal and
Average Costs

This relationship explains why marginal cost
curves always intersect average cost curves
at the minimum of the average cost curve.
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64
Relationship Between Marginal and
Average Costs

The position of the marginal cost relative to
average total cost tells us whether average
total cost is rising or falling.
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65
Relationship Between Marginal and
Average Costs

To summarize:
If MC > ATC, then ATC is rising.
If MC = ATC, then ATC is at its minimum.
If MC < ATC, then ATC is falling.
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66
Relationship Between Marginal and
Average Costs

Marginal and average total cost reflect a
general relationship that also holds for
marginal cost and average variable cost.
If MC > AVC, then AVC is rising.
If MC = AVC, then AVC is at its minimum.
If MC < AVC, then AVC is falling.
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67
Relationship Between Marginal and
Average Costs

As long as average variable cost does not
rise by more than average fixed cost falls,
average total cost will fall when marginal cost
is above average variable cost.
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68
Relationship Between Marginal and
Average Costs
$90
80
70
60
50
40
30
20
10
0
MC
Area A
Area C
Area B
ATC
AVC
B
1
2
3
A
Q0 Q1
4 5 6
7
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8
9 Quantity
69
Production and
Cost Analysis I
End of Chapter 8
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70