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ECO 284
College of Business
Northern Arizona University
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ECO 284
Chapter 8 Outline


Chapter 8

Production and Cost

1.  Chapter Summary

Chapter 8 introduces short-run production functions, and variable and fixed costs, explaining  their calculation and how to draw the related curves.  In the short run, marginal costs are expected to be increasing due to diminishing returns, average cost curves are expected to be U-shaped.

In the long run, firms may experience economies of scale due to specialization or spreading of the cost of indivisible inputs, and thus long-run average cost curves will be L-shaped as per-unit costs first decrease and then remain constant.  The minimum efficient scale is reached when economies of scale are exhausted and per-unit costs become constant.  Eventually, the firm may experience diseconomies of scale due to coordination problems or rising input prices, resulting in increasing per-unit costs.

 2.  Learning Objectives

1. If the government breaks up a large aluminum producer into two smaller firms, by how much will the average cost of producing a given quantity of aluminum increase?

As shown in Figure 8.7, the average cost for the large firm is $1.60 per pound (point c), compared to an average cost of $2.10 for each of the small firms.  There is a substantive increase in cost because there are significant economies of scale in aluminum manufacturing.

 2. Are large trucking firms more efficient than smaller trucking firms? If so, how much more efficient?

As shown by Figure 8.8, although a larger trucking firm has lower average costs than a small one, the difference is relatively small, except for very small firms, because there are not significant economies of scale in trucking.

 3. Why is the typical short-run average cost curve shaped like the letter U, while the typical long-run average cost curve is shaped like the letter L?

The short-run curve reflects diminishing returns, which pulls up average cost as output increases.  There are no diminishing returns in the long run; the shape reflects economies of scale.

 4. Suppose that one electric utility has three times as many customers as another electric utility. Which utility has a higher unit cost of electricity, and how large is the cost difference?  

In Figure 8.6, the larger firm (30 billion kWh) has an average cost that is 8% lower than the smaller firm (10 billion kWh).

 3.  Chapter Outline

 I.  Introduction

            A.  Accounting Profit versus Economic Profit

1.  An accountant computes a firm?s explicit costs (actual cash payments for inputs) and calculates profits by subtracting explicit costs from total revenue.

2.  An economist includes the firm?s implicit costs (opportunity costs, including costs of the entrepreneur?s time and/or funds) and calculates profit by subtracting economic cost (explicit plus implicit costs) from total revenue.

            B.  Short- versus Long-Run Decisions

1.  In the short run, with at least one factor of production fixed, a firm with an existing production facility must decide how much output to produce. 

2.  In the long run, a firm must decide what type of production facility to build, because, in the long run, all factors of production can be varied.

II.  Production and Cost in the Short Run

A.  Production and Marginal Product

1.  The firm?s total product curve, or short-run production function, shows the relationship between the quantity of labor employed and the quantity of output produced, holding capital constant (See Table 8.2).

2.  The short-run production function will general increase at an increasing rate initially, due to gains from specialization.  The marginal product of labor is increasing.

3.  Eventually, diminishing returns to the variable factor will cause the production function to increase at a decreasing rate.  The marginal product of labor is decreasing.

B.  Short-Run Total Cost and Short-Run Marginal Cost

1.  Fixed costs do not vary with the level of output and are the cost of any fixed factors of production.

2.  Variable costs change as output increases and represent additional labor and materials required to produce more units.  (Total variable cost is the sum of all variable costs.)

3.  Short-run total cost is the sum of fixed plus variable costs.

4.  Marginal cost is the cost of producing the last unit (the change in total cost divided by the change in output).

1.  The principle of diminishing returns tells us that as more variable inputs are added to fixed inputs, production will increase but at a decreasing rate.

2. Because each additional unit thus requires more variable inputs than the previous unit, in the short run, marginal costs must eventually be increasing as production increases.

C.  Short-Run Average Cost Curves

1.  Average fixed cost (AFC) is fixed cost divided by output produced. 

2. Short-run average variable cost (SAVC) is total variable cost divided by the quantity produced.

3.  Short-run average total cost (SATC) is total cost divided by the quantity produced.  Equivalently, SATCis the sum of AFC plus SAVC.

4.  Short-run average total cost will be U-shaped because:

a.  Initially, fixed cost per unit decreases as the total fixed cost is spread over a larger number of units.

b.  However, as marginal costs per unit are increasing due to diminishing returns, eventually the higher costs of variable inputs per unit will outweigh the gains from spreading fixed costs.  At that point, average total costs will begin to increase.

D.  The Relationship Between Marginal and Average Curves

1.  If marginal costs are less than average costs, average costs are decreasing.
2.  If marginal costs are greater than average cost, average costs are rising.

3.  Marginal costs and average costs are equal at the minimum point on the average total cost curve.

E.  Economic Detective?The Cost of Pencils
Two pencil firms, Sharp, Inc. and Pointy, Inc., have identical factories, pay the same wage to their workers, and pay the same prices for inputs.  Although Sharp produces 1,000 pencils per minute and Pointy produces 2,000 pencils per minute, they each have a short-run average total cost of $0.10 per pencil.  A third firm builds an identical factory, hires equivalent workers (at the same wage), and pays the same price for materials.  Based on the experience of the other two firms, it expected to produce 2,500 pencils at an average cost of $0.10 per pencil, but found that SATC was actually $0.14 per pencil.  Why?  Sharp produces on the negatively-sloped portion of the SATC curve.  Pointy produces on the positively-sloped portion.  The third firm is farther along the positively-sloped portion of the curve, and thus its per-unit costs are higher.

III.  Production and Cost in the Long-Run

            A.  Expansion and Replication

1.  The long-run total cost is defined as the cost of production when the firm is fully flexible in its choice of all inputs.

2.  The firm?s long-run average cost of production (LAC)  is defined as long-run total cost divided by the quantity of output produced.

B.  Decrease in Output and Indivisible Inputs

1. An input is indivisible if it cannot be scaled down to produce a small quantity of output.  For example, a railroad must lay the same amount of track between two cities whether one train or many trains use it.

2.  If there are indivisible inputs, cutting output in half will not cut costs in half, and thus the LAC curve is negatively sloped.

C.  Decrease in Output and Labor Specialization

1. Specialization may initially make additional workers more productive, as less time is spent switching between tasks and specific skills are improved; thus per-unit costs fall as quantity increases.

2.  If there are gains from specialization inputs, cutting output in half will not cut costs in half, because less specialization causes workers to be less productive, and thus the LAC curve is negatively sloped.

D.  Economies of Scale:

A firm experiences economies of scale if the LAC curve is negatively sloped.

IV.  Actual Long-Run Average Cost Curves

A.  Actual long-run average cost curves tend to be L-shaped.

B.  Minimum Efficient Scale:  The minimum efficient scale (MES) for a firm is defined as the output at which the long-run average cost curve becomes horizontal, and thus scale economies are exhausted.  Beyond this point, a firm will not have lower per-unit costs if it produces more.

C. Diseconomies of scale exist when increasing output causes per-unit costs to rise.  Diseconomies often occur due to:

1.  Coordination problems:  Larger firms are more difficult to coordinate and may require several layers of management, increasing per-unit costs.

2.  Increasing input costs:  As a firm expands, it increases its demand for inputs.  At some point, this demand may be sufficiently large to drive up input prices and thus raise input costs.

            D.  Application?Hospital Services:

An administrator claims that the average cost per bed in an 800-bed hospital would be one-third of the cost per bed in a 400-bed hospital.  However, examination of cost curve in this industry (Figure 8-7) suggests that this estimate overstates the amount of scale economies.  The average cost for the 400-bed hospital is $11,000 per bed, compared with $15,000 per bed for the larger hospital.  The larger hospital is more efficient, but by a lesser amount than expected.

E.  Short-Run Versus Long-Run Costs:  Why are SATC curves U-shaped while LATC curves are L-shaped?  Each curve reflects the fact that initial production increases allow firms to spread some type of costs (fixed costs or indivisibilities) over more units.  However, in the short-run case, the inability of the firm to adjust the size of the production facility eventually causes diminishing returns to occur. This need not be the case in the long run when all factors are variable. 

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Copyright 2001NAU and CBA
Dr. James V. Pinto