Production and Costs

FACTORS THAT AFFECT COSTS

 Students are aware of the differences between
short- and long-run production decision.
Students understand how cost structure may
affect industry structure.
Students are aware of the differences between
Learning outsourcing and vertical integration.

Objectives Key concepts:

◦ Law of diminishing returns
◦ Marginal product
◦ Variable costs, fixed costs, and marginal costs
◦ Economies of scale, economies of scope
◦ Outsourcing and vertical integration
Role of the firms
A firm is an economic institution that transforms factors of
production into goods and services.
◦ Land, labor, capital, entrepreneurial skills

The goal of a firm is to maximize profits.

◦ Profit = Total Revenue – Total Cost

But, economists and accountants measure revenues, costs, and

hence profit differently.
◦ Economists look at both implicit and explicit costs and revenues, and
hence profits
◦ In this course, when we say revenues, costs and profits, we mean
economic revenues, economic costs and economic profits.
 Short-run Long-run

• A period too brief for a firm to alter its plant • A period long enough for the firm to adjust the
capacity, but can change output somewhat by plant size as well as enter or leave the industry.
increasing or decreasing its variable inputs. • A firm chooses from all possible production
• Some inputs are fixed such as fixed plant. techniques
• All inputs are variable.

The terms long run and short run do not necessarily refer to specific periods of time, but to the
flexibility the firm has in changing the level of output.
◦ Short run can be days or weeks for the software industry.
◦ Short run can be years for the automobile industry.

Time horizon affects production

decision
Let’s begin with the
short-run production
SU PPOSE W E H AV E T WO INPUT S: LA B O R A ND C A PITA L ( PLA NT ) .
LA B O R I S O U R VA RI A B LE I NPU T
C A PI TA L I S T H E FI XE D I NPU T ( PLA NT SI ZE I S FI XE D ) .
Q

32
A production
26 function is the

A typical
TP relationship
20 between the
inputs and the
14 outputs
8

2
1 2 3 4 5 6 7 8 9
Number
10 of workers
production function
Increasing Diminishing Negative
marginal marginal marginal
returns returns returns
Total product (TP) is the total quantity produced or the total
output (Q).
Marginal product (MP) is the additional output from additional
unit of (variable) input, other input(s) remain constant.
◦ Labor is the variable input
!"#$%& '$ ()*#+ ,-)./0*
◦ 𝑀𝑃 = = slope of TP
Q !"#$%& '$ 1#-'#2+& '$3/*
8
Marginal
Eventually productivity
marginal
6 returns
first increases
are negative
4
Average product (AP) is the output per unit of input.
2 AP ()*#+ ,-)./0*
◦ 𝐴𝑃 =
0
1 2 3 4 5 6 7 8 9 10 4$'* )5 1#-'#2+& '$3/*
-2 Number of
workers
-4
MP
-6
Increasing Diminishing Negative
marginal marginal marginal
returns returns returns
Q

32
A production
26 function is the
TP relationship

A typical production
20 between the
inputs and the
14 outputs
8

2
1 2 3 4 5 6 7 8 9
Number
10 of workers
function (continued)
Increasing Diminishing Negative
marginal marginal marginal
returns returns returns
Increasing marginal returns (AKA increasing marginal
productivity)
◦ Occur when MP increases as input increases

Diminishing returns (AKA diminishing marginal

productivity)
◦ Occur when MP decreases as input increases
Q
8
6
Marginal
Eventually
returns
productivity
marginal
first increases
are negative Negative marginal returns (AKA diminishing absolute
4 productivity)
AP
2
◦ Occur when MP is negative
0
1 2 3 4 5 6 7 8 9 10
-2 Number of
workers
-4
MP
-6
Increasing Diminishing Negative
marginal marginal marginal
returns returns returns
In the short-run, marginal
product will fall at some
point because of
the law of diminishing
returns.
VARIABLE RESOURCES, SUCH AS LABOR IS ADDED TO PRODUCE
MORE, BUT SOME RESOURCES, SUCH AS NO. OR SIZE OF FACTORY IS
FIXED, AND HENCE NOT OPERATING AT AN OPTIMAL LEVEL.
Q

32
A production
26 function is the
TP relationship

A typical production
20 between the
inputs and the
14 outputs
8

2
1 2 3 4 5 6 7 8 9
Number
10 of workers
function (continued)
Increasing Diminishing Negative
marginal marginal marginal
returns returns returns
When MP = 0, TP is at its highest point.

The MP curve goes through the maximum point of the

AP curves
◦ Think of MP as your course grade and AP as your GPA.
When course grade > GPA, GPA will rise. Therefore, when
Q
8
Marginal
Eventually productivity
marginal
MP > AP, AP will rise and when MP < AP, AP will fall.
6 returns
first increases
are negative
4
2 AP

0
1 2 3 4 5 6 7 8 9 10
-2 Number of
workers
-4
MP
-6
Increasing Diminishing Negative
marginal marginal marginal
returns returns returns
Now let’s move on to
short-run costs
SU PPOSE W E H AV E T WO INPUT S: LA B O R A ND C A PITA L ( PLA NT ) .
LA B O R I S O U R VA RI A B LE I NPU T
C A PI TA L I S T H E FI XE D I NPU T ( PLA NT SI ZE I S FI XE D ) .
 $200

MC MC, ATC,
150 and AVC
curves are
U-shaped
ATC
Costs

100 AVC

Production costs
AFC

50
AVC
AFC curve
AFC decreases
0 1 2 3 4 5 6 7 8 9 10 Q
Total costs (TC) = fixed costs (FC) + variable costs (VC).
Fixed costs (FC) 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 inputs (and
therefore their costs) are variable.
◦ In the short run, a number of inputs and their costs will be fixed,
regardless of the level of production.
TC and VC
Total Cost curves
500 TC increase as
Q increases
Variable costs (VC) are costs that change as output changes.
VC
400 TC and VC ◦ VC is zero when there is no production.
are parallel.
300 Their ◦ Example: Wages
vertical
200 difference
is FC
100 FC curve is
FC constant
0 Q
4 8 12 16 20 24 28 32
 $200

MC MC, ATC,
150

Production costs
and AVC
curves are
U-shaped
ATC
Costs

100 AVC

(continued)
AFC

50
AVC
AFC curve
AFC decreases
0 1 2 3 4 5 6 7 8 9 10 Q
Average fixed costs (AFC) equals fixed cost divided by
FC is spread quantity produced, AFC = FC/Q
over larger Q Average variable costs (AVC) equals variable cost divided
by quantity produced, AVC = VC/Q

Average total costs (ATC) equals total cost divided by

TC and VC
quantity produced, ATC = TC/Q or ATC = AFC + AVC
Total Cost curves
500 TC increase as
Q increases Marginal cost (MC) is the increase in total cost when
VC
400 TC and VC output increases by one unit, MC = ΔTC/ΔQ where Δ
300
are parallel.
Their means change.
vertical
200 difference
is FC
100 FC curve is
FC constant
0 Q
4 8 12 16 20 24 28 32
Costs
per unit
MC
AVC

Production costs
If marginal productivity
is rising, marginal
costs are falling
Q

(continued)
Output If average productivity
per worker is falling, average
variable costs are
rising

AP of workers
MP of workers
L
Increasing output initially leads to a decrease in MC,
AVC, and ATC but eventually they increase.

When output is increased in the short run, it can only

be done by increasing the variable input
◦ The law of diminishing productivity causes marginal and
Costs average productivities to fall
per unit
The marginal cost curve goes
through the minimum point of ◦ As average and marginal productivities fall, average and
MC
both the ATC and AVC curves marginal costs rise. (Productivity and cost has negative
ATC
Intuition: Think of MC as
relationship.)
AVC your course grade and ATC
as your GPA. When course
grade > GPA, GPA will rise.
Therefore, when MC > ATC,
ATC will rise and when MC <
Q ATC, ATC will fall.
 $200

MC MC, ATC,
150

Cost curves can

and AVC
curves are
U-shaped
ATC
Costs

100 AVC

shift
AFC

50
AVC
AFC curve
AFC decreases
0 1 2 3 4 5 6 7 8 9 10 Q Shifts in the curves will occur if either resource
prices or technology change.

For example, if fixed costs decrease, TC, AFC and

ATC shift down.
TC and VC
Total Cost
500 TC
curves
increase as
If labor costs (or some other variable input
400
VC
Q increases
TC and VC
costs) rise, then TC, VC, AVC, ATC, and MC would
shift up.
are parallel.
300 Their
vertical
200 difference
is FC
100 FC curve is
FC constant
0 Q
4 8 12 16 20 24 28 32
Firms have more options in the long run.
◦ They can change any input they want (more flexible).
◦ That is, the firm can change all input amounts, including plant size or no. of plants.
◦ The firm can also choose any technology.
◦ They choose the combination of inputs and technology that offers the lowest cost.

All costs are variable in the long run.

◦ No fixed costs in the long run.

No diminishing returns in the long run because diminishing returns are due to fixed inputs which
we do not have in the long run.

What happens in the long-run?

Average Total Costs ATC-1
ATC-5
ATC-2
ATC-3 ATC-4
A firm’s plant
capacity decision
Output Since all costs are variable in the long run, the focus is
on average total cost.

The long-run ATC curve is made up of segments of the

short-run cost curves of the various-size plants from
which the firm might choose.
Average Total Costs

Long-run ATC just “envelopes” short run ATCs.

ATC-1 ATC-5 ◦ If the number of possible plant sizes is very large, the
ATC-2
ATC-3 ATC-4 Long-run long-run ATC curve approximates a smooth curve.
ATC

Output
Envelope
relationship Costs
between long-run per unit

and short-run ATC LRATC

SRATC1 The long-run average
SRMC1
Each short-run cost curve touches the SRATC3 total cost curve (LRATC)
long-run cost curve at only one point. SRMC3 is an envelope of the
short-run average total
Long-run costs are always less than or cost curves (SRATC1-4)
equal to short-run costs because:
◦ In the short run all expansion must
proceed by increasing only the
Q Q
variable input.
◦ This constraint increases cost in
SRMC curve intersects both LRATC and SRATC only at the Minimum
the short run.
point of the LRATC curve (where SRATC tangents to LRATC)
◦ In the long run, all inputs are
flexible, and hence no such a cost
constraint.
Long-run ATC is U-
shape because of
economies and
diseconomies of scale
NOT BECAUSE OF DIMINISHING RETURNS LIKE THE SHORT-RUN
ATC WHERE SOME INPUTS ARE FIXED
 $60
Long-run
average total

Costs per unit

Minimum
cost (LRATC)
efficient
$55 scale

$50

Q
11 14 17 20
ATC falls because of Constant ATC ATC rises because of
economies of scale because of constant diseconomies of scale
returns to scale

It is the amount of production that spreads setup costs out sufficiently for firms to undertake
production profitably.

It is the smallest level of output that yield the lowest long run unit cost (LRATC).

Minimum efficient scale or

minimum efficient level of production
 Labor Managerial
specialization specialization Efficient capital Other factors

• Makes use of • Managers can • High volume • Costs such as

special skills manage more production design,
• Proficiency is workers with no warrants the development,
gained as the increased cost. expensive large- and advertising
worker • Managers can scale equipment. are spread out
concentrates on also specialize in over larger
one task and their respective quantities.
time is saved. area of expertise.

Sources of economies of scale

 Production techniques can be replicated
again and again to increase output.

Sources of constant returns to scale

 Control and Communication
Loss of team
coordination problems
problems spirit (bureaucracy)

Shirking
Worker (avoiding work is
alienation easier in larger
firms)

Sources of diseconomies of scale

Minimum efficient scale
(MES) can determine
the structure of the
industry.
THERE WILL BE MANY OR FEW PRODUCERS
WHETHER THEY WILL BE LARGE, SMALL, OR DIFFERENT SIZES
 Average Total Costs

Average Total Costs

Constant Returns
Average Total Costs
Economies Diseconomies
To Scale Economies Of Scale Of Scale
Of Scale LRATC

LRATC
LRATC

q1 q2 Output
Output Output

Industries whose economies of

Industries with an extended range Industries with economies of scale scale exist, but are exhausted
of constant returns to scale. over a wide range of outputs quickly, and turn back up
substantially.
•Will be populated by firms of •Will lead to a few large-scale •MES occurs at a very low level of
many different sizes. firms. output.
•Small- and large-scale producers •LRATC curve is lowest only when •This yields a large number of
will coexist and be equally there is a large output. small producers.
successful.

MES and industry structure

 Learning by
Many dimensions
Economies of doing and
technological in decision-
scope making
change

Unmeasured
Joint costs Indivisible costs
costs

Limitations of using cost analysis

The cost of production of one product often depends on what other products a firm is producing.

There are economies of scope 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

Firms look for both economies of scope and economies of scale.

Economies of scope
Most decisions that firms make involve more than one dimension, including:
◦ Quality: Should we improve our quality?
◦ Packaging: Should we change the wrapper?
◦ Shipping: Should we change the shipping speed?

So, there are just not one MC but many of them.

The level of output is the only dimension in the standard model.

Many dimensions in decision-making

Cases
A P P LY I N G T H E C O N C E P T S
I N B U S I N E S S S I T UAT I O N S
Cost of
production in
decision making
Read the case here.
Cost reduction
through supply
chain
Read the cases here.
Cost reduction
through outsourcing
Hire someone else outside the firm to do the job that is normally
done in-house, e.g. customer service call center.
◦ Areas firms often outsource can be found here.
◦ Cases from well known companies here.

Rationale:
◦ Cut labor costs (lower compensation structure for certain tasks)
◦ Focus on core functions to increase overall efficiency and productivity
◦ Time saving (sometimes cannot complete the contract on time)

Concerns:
◦ Communication difficulties
◦ Security threat (and leaked trade secret)
Cost reduction through
vertical integration
Taking direct ownership of key components in the supply chain
(can be upstream and downstream), doing things in-house as
opposed to outsourcing,
◦ e.g. DeBeers owns diamond mines.
◦ Cases from well known companies here.

Rationale:
◦ Greater efficiency (through economies of scale) and reduce costs
◦ Competitive advantage or barriers to entry (owning key resources)

Concerns:
◦ Require huge investment
◦ Make firms less flexible in the long run
◦ Lose focus on core functions
◦ May create diseconomies of scale
But not the
same as
horizontal
integration
Horizontal integration is taking
direct ownership of similar level
in the supply chain
◦ Example: Dtac and True

Rationale:
◦ Efficiency through economies of scale
◦ Reduce competition

Concerns:
◦ Inflexibility
◦ Antitrust investigation