Production and Cost
Analysis I
Chapter 9
© 2003 McGraw-Hill Ryerson Limited.
9-2
Introduction

In the supply process, people first offer
the factors of production they control to
the market.
 Then
the factors are transformed by firms
into goods that consumers want.
 Production occurs when factors of
production (inputs) transform into goods
and services.
© 2003 McGraw-Hill Ryerson Limited
9-3
Firms Maximize Profit
Firm’s goal is to maximize profit.
 Profit is the difference between total
revenue and total cost.

Profit = Total revenue – Total cost
© 2003 McGraw-Hill Ryerson Limited
9-4
Firms Maximize Profit
An accountant will calculate profit by
subtracting explicit costs from the
revenue.
 For an economist,the measure of profit
is revenues minus both implicit and
explicit costs.

© 2003 McGraw-Hill Ryerson Limited
9-5
Firms Maximize Profit

Implicit costs include the opportunity
costs of the factors of production.
Economic profit = Revenue – (Implicit
costs +Explicit costs)
© 2003 McGraw-Hill Ryerson Limited
9-6
The Production Process

The production process is generally
divided into a long run planning decision
and the short run adjustment decision.
© 2003 McGraw-Hill Ryerson Limited
9-7
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.
© 2003 McGraw-Hill Ryerson Limited
9-8
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 decisions it
can make.
© 2003 McGraw-Hill Ryerson Limited
9-9
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.
© 2003 McGraw-Hill Ryerson Limited
9 - 10
The Long Run and the Short
Run

In the long run:
 By
definition, the firm can vary the inputs
as much as it wants.
 All inputs are variable.
© 2003 McGraw-Hill Ryerson Limited
9 - 11
The Long Run and the Short
Run

In the short run:
 Flexibility
is limited.
 Some factors of production cannot be
changed.
 Generally, the production facility (“the
plant”) is fixed in the short run.
© 2003 McGraw-Hill Ryerson Limited
9 - 12
Production Tables and
Production Functions
How a firm combines factors of
production to produce consumer goods
can be presented in a production table.
 A production table shows the output
resulting from various combinations of
factors of production or inputs.

© 2003 McGraw-Hill Ryerson Limited
9 - 13
Production Tables and
Production Functions
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.

© 2003 McGraw-Hill Ryerson Limited
9 - 14
Production Tables and
Production Functions

Total product is the number of units of
the good or service produced by a
different number of workers.
© 2003 McGraw-Hill Ryerson Limited
9 - 15
Production Tables and
Production Functions

Marginal product is the additional
output that will result from an additional
worker, other inputs remaining constant.

Average product is calculated by
dividing total output by the number of
workers who produced it.
© 2003 McGraw-Hill Ryerson Limited
9 - 16
Production Tables and
Production Functions

The information in a production table is
often summarized in a production
function – a curve that describes the
relationship between the inputs (factors
of production) and outputs.
© 2003 McGraw-Hill Ryerson Limited
9 - 17
Production Tables and
Production Functions

The production function discloses the
maximum amount of output that can be
derived from a given number of inputs.
© 2003 McGraw-Hill Ryerson Limited
9 - 18
A Production Table, Figure 9-1a, p 203
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
Increasing
marginal
productivity
Diminishing
marginal
productivity
Diminishing
absolute
productivity
© 2003 McGraw-Hill Ryerson Limited
9 - 19
A Production Function, Figure 9-1b
32
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
0
Diminishing
marginal
productivity
Diminishing
absolute 7
productivity
6
TP
Increasing
marginal
productivit
y
Diminishing
marginal
productivity
Diminishing
absolute
productivity
5
Output per worker
Output
and c, p 203
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
8
9
MP
10
© 2003 McGraw-Hill Ryerson Limited
9 - 20
The Law of Diminishing
Marginal Productivity
The law of diminishing marginal
productivity is an important element in
all real-world production processes.
 Both marginal and average
productivities initially increase, but
eventually they both decrease.

© 2003 McGraw-Hill Ryerson Limited
9 - 21
The Law of Diminishing
Marginal Productivity

This means that initially the production
function exhibits increasing marginal
productivity.
Then it exhibits diminishing marginal
productivity.
 Eventually, the production function
exhibits negative marginal productivity.

© 2003 McGraw-Hill Ryerson Limited
9 - 22
The Law of Diminishing
Marginal Productivity

The most important part of the
production function is the part exhibiting
diminishing marginal productivity and
falling average product.
© 2003 McGraw-Hill Ryerson Limited
9 - 23
The Law of Diminishing
Marginal Productivity

The law of diminishing marginal
productivity states that as more and
more of a variable input is added to an
existing fixed input, after some point the
additional output obtained from the
additional input will fall.
© 2003 McGraw-Hill Ryerson Limited
9 - 24
The Costs of Production

Costs of production in the short run are:
 Fixed
Costs,
 Variable Costs, and
 Total Costs.
© 2003 McGraw-Hill Ryerson Limited
9 - 25
Fixed Costs, Variable Costs,
and Total Costs
Fixed costs 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 costs are variable.

© 2003 McGraw-Hill Ryerson Limited
9 - 26
Fixed Costs, Variable Costs,
and Total Costs

Variable costs are costs that change
as output changes, such as the costs of
labour and materials.
© 2003 McGraw-Hill Ryerson Limited
9 - 27
Fixed Costs, Variable Costs,
and Total Costs

The sum of the variable and fixed costs
are total costs:
TC = FC + VC
© 2003 McGraw-Hill Ryerson Limited
9 - 28
The Costs of Production
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
© 2003 McGraw-Hill Ryerson Limited
9 - 29
Average Costs

Average total cost (often called
average cost) equals total cost divided
by the quantity produced.
ATC = TC/Q
© 2003 McGraw-Hill Ryerson Limited
9 - 30
Average Costs

Average fixed cost equals fixed cost
divided by quantity produced.
AFC = FC/Q
© 2003 McGraw-Hill Ryerson Limited
9 - 31
Average Costs

Average variable cost equals variable
cost divided by quantity produced.
AVC = VC/Q
© 2003 McGraw-Hill Ryerson Limited
9 - 32
Average Costs
Since total cost is the sum of fixed and
variable costs,
 Average total cost is the sum of average
fixed cost and average variable cost

ATC = AFC + AVC
© 2003 McGraw-Hill Ryerson Limited
9 - 33
Marginal Cost

Marginal cost is the change (increase)
in total cost from a change (increase) in
output by one unit.
MC = TC/Q
© 2003 McGraw-Hill Ryerson Limited
9 - 34
The cost of producing
earrings, Table 9-1, p 205
Q
FC
VC
TC
MC
0
3
4
9
10
16
17
22
23
27
28
50
50
50
50
50
50
50
50
50
50
50
0
38
50
100
108
150
157
200
210
255
270
50
88
100
150
158
200
207
250
260
305
320
—
—
12
—
8
—
7
—
10
—
15
AFC
AVC
ATC
—
—
—
16.67 12.66 29.33
12.50 12.50 25.00
5.56 11.11 16.67
5.00 10.80 15.80
3.13
9.38 12.50
2.94
9.24 12.18
2.27
9.09 11.36
2.17
9.13 11.30
1.85
9.44 11.30
© 2003 McGraw-Hill Ryerson Limited
1.79
9.64 11.42
9 - 35
Graphing Cost Curves
To gain a better understanding of the
costs concepts, we can illustrate them
by drawing a graph.
 Quantity is plotted on the horizontal axis
and a dollar measure of various costs
on the vertical axis.

© 2003 McGraw-Hill Ryerson Limited
9 - 36
Total Cost Curves

The total variable cost curve has the
same shape as the total cost curve—
increasing output increases variable
cost.
© 2003 McGraw-Hill Ryerson Limited
9 - 37
Total Cost Curves, Fig. 9-2a, p 207
Total cost
$400
350
300
250
200
150
100
50
0
TC
VC
TC = (VC + FC)
L
O
M
FC
2 4 6 8 10
20
Quantity of earrings
30
© 2003 McGraw-Hill Ryerson Limited
9 - 38
Average and Marginal Cost
Curves
Marginal cost, average cost and
average variable cost curves are Ushaped.
 The marginal cost curve will intersect
the average total cost curve and the
average variable cost curve at their
minimum points.

© 2003 McGraw-Hill Ryerson Limited
9 - 39
Average and Marginal Cost
Curves

The average fixed cost curve slopes
down continuously.
© 2003 McGraw-Hill Ryerson Limited
9 - 40
Downward-Sloping Shape of
the 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.

© 2003 McGraw-Hill Ryerson Limited
9 - 41
The U Shape of the Average
and Marginal Cost Curves

In the short-run, output can only be
increased by increasing the variable
input.
© 2003 McGraw-Hill Ryerson Limited
9 - 42
The U Shape of the Average
and Marginal Cost Curves

As more and more variable input is
added to a fixed input, the law of
diminishing marginal productivity sets
in.

Marginal and average productivities fall
and marginal costs rise.
© 2003 McGraw-Hill Ryerson Limited
9 - 43
The U Shape of the Average
and Marginal Cost Curves

And when average productivity of the
variable input falls, average variable
costs rise.
© 2003 McGraw-Hill Ryerson Limited
9 - 44
The U Shape of the Average
and Marginal Cost Curves

The average total cost curve is the
vertical summation of the average fixed
cost curve and the average variable
cost curve, so it is always higher than
both of them.
© 2003 McGraw-Hill Ryerson Limited
9 - 45
The U Shape of the Average
and Marginal Cost Curves

If the firm increased output enormously,
the average variable cost curve and the
average total cost curve would almost
meet.
© 2003 McGraw-Hill Ryerson Limited
9 - 46
Per Unit Cost Curves, Figure 9-2b,
p207
Cost
$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
© 2003 McGraw-Hill Ryerson Limited
9 - 47
The Relationship Between
Productivity and Costs

The shapes of the cost curves are
mirror-image reflections of the shapes
of the corresponding productivity
curves.
© 2003 McGraw-Hill Ryerson Limited
9 - 48
The 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.

© 2003 McGraw-Hill Ryerson Limited
9 - 49
The Relationship Between
Productivity and Costs,Fig. 9-3, p208
Output per worker
Costs per unit
$18
16
14
12
10
8
6
4
2
0
a)
MC
AVC
12
21
Output
9
8
7
6
5
4
3
2
1
0
A
AP
MP
21/2
4
Labour
b)
© 2003 McGraw-Hill Ryerson Limited
9 - 50
Relationship Between
Marginal and Average Costs

The marginal cost and average cost
curves are related.
 When
marginal cost exceeds average cost,
average cost is rising.
 When marginal cost is less than average
cost, average cost is falling.
© 2003 McGraw-Hill Ryerson Limited
9 - 51
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.
© 2003 McGraw-Hill Ryerson Limited
9 - 52
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.
© 2003 McGraw-Hill Ryerson Limited
9 - 53
Relationship Between
Marginal and Average Costs

To summarize:
If MC < ATC, then ATC is falling.
If MC = ATC, then ATC is at its low point.
If MC > ATC, then ATC is rising.
© 2003 McGraw-Hill Ryerson Limited
9 - 54
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 falling.
If MC = AVC, then AVC is at its low point.
If MC > AVC, then AVC is rising.
© 2003 McGraw-Hill Ryerson Limited
9 - 55
Relationship Between
Marginal and Average Costs

Average total cost will fall when
marginal cost is above average variable
cost, so long as average variable cost
does not rise by more than average
fixed cost falls.
© 2003 McGraw-Hill Ryerson Limited
9 - 56
Relationship Between Marginal
and Average Costs,Fig 9-4, p209
$90
80
70
60
50
40
30
20
10
0
MC
Area A
Area C
Area B
ATC
AVC
B
MC
1
2
3
A
Q0 Q1
4 5 6
Quantity of output
7
8
9
© 2003 McGraw-Hill Ryerson Limited
Production and Cost
Analysis I
End of Chapter 9
© 2003 McGraw-Hill Ryerson Limited.