Chapter 8:

Production and

Cost Analysis I

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Chapter Objectives

 1. Summarize briefly the advantages and

disadvantages of three types of businesses.

 2. Differentiate between economic profit and

accounting profit.

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Chapter Objectives
 3.a. Distinguish between long-run and short-
run production.
3.b. State the law of diminishing marginal
productivity.

 4. Calculate fixed costs, variable costs, total

costs, average fixed costs, average variable
costs, and average total costs, given the
appropriate information.

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Chapter Objectives

 5.a Distinguish the various kinds of cost

curves and describe the relationships among
them.
5.b Explain why the marginal and average
cost curves are U-shaped.
5.c Explain why the marginal cost curve
always goes through the minimum point of the
average cost curve.

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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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Forms of Business

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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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Firms Maximize Profit

 Profit is the difference between total revenue

and total cost.

Profit = total revenue – total cost

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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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Firms Maximize Profit

 For economists:

 Economic Profit =
total revenue – (implicit and explicit cost)

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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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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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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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Production Table

 Total product is the number of units of the

good or service produced by different
numbers of workers.

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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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Production Functions

 Production function – a curve that

describes the relationship between the inputs
(factors of production) and output.

 The production function tells the maximum

amount of output that can be derived from a
given number of inputs.

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Production Table

Number of Total output Marginal Average

workers product product

0 0 4 —
1 4 6 4
2 10 5
3 7
17 6 5.7
4 23 5.8
5
5 28 3 5.6
6 31 1 5.2
7 32 0 4.6
8 32 2 4.0
9 30 5 3.3
10 25 2.5

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Production Function

32
30 7
28
26 6
24
22 TP 5
20

Output per worker

Output

18 4
16
14 3
12
10
8 2
AP
6
4 1
2
0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Number of workers Number of workers MP
(a) Total product (b) Marginal and average product

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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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Diminishing Marginal Productivity

Diminishing Diminishing
Diminishing Diminishing
32 marginal absolute
7 marginal absolute
30 returns returns
returns returns
28
26 6
24
22 TP 5
20 Increasing

Output per worker

Output

18 4
16 marginal
14 returns
3
12
10
8 2 Increasing
marginal AP
6
4 1 returns
2
0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Number of workers Number of workers MP
(a) Total product (b) Marginal and average product

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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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Variable Costs

 Variable costs are costs that change as

output changes, such as the costs of labour
and materials.

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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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Average Costs

 Average total cost (often called average

cost) equals total cost divided by the quantity
produced.

ATC = TC/Q

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Average Costs

 Average fixed cost equals fixed cost divided

by quantity produced.

AFC = FC/Q

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Average Costs

 Average variable cost equals variable cost

divided by quantity produced.

AVC = VC/Q

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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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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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Total Cost Curves

TC
$400 VC
350
300
TC = (VC + FC)
Total cost

250
200 L
150
100 O
M
50 FC
0
2 4 6 8 10 20 30
Quantity of earrings
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Per Unit Cost Curves

$30
28
26
24
22
20
18
16 MC
14
Cost

12 ATC
10 AVC
8
6
4
2 AFC
0 2 4 6 8 10 12 14 16 18 20 22 2426 28 30 32
Quantity of earrings
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Relationship Between Productivity
and Costs
 The shapes of the cost curves are mirror-
image reflections of the shapes of the
corresponding productivity curves.

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 Relationship Between Productivity
and Costs
Costs per unit Output per worker
$18 9
16 MC 8
14 7
12 AVC 6
10 5
8 4
6 3 AP
4 2
2 1 MP
0 18 21 Output 0 21/2 4 Labour

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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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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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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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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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Relationship Between Marginal and
Average Costs
$90
80 MC
70 Area A Area C
60 Area B
Costs per unit

50 ATC
40 AVC
30 B
20
A
10 Q0 Q1
0
1 2 3 4 5 6 7 8 9 Quantity
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Production and
Cost Analysis I

End of Chapter 8

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