Topic 6: The Cost of Production A fixed input is an input whose quantity cant be changed.

A variable input is an input whose quantity can be changed. In the short run, some inputs are fixed and some inputs are variable. In the long run, all inputs are variable. Adam Smith in The Wealth of Nations(1776) wrote of a factory which made pins. He claimed that labor's marginal physical product would be increasing due to specialization. As more people (laborers) are added to production, each can specialize on a smaller part of the pin production process. With many workers, a firm will be able to take advantage of each worker's specific talents by letting them do what they are best at. By each worker doing only one specific task, tasks will be simplified and work will become less stressful. Tasks will be easier to learn and master. Consider the production function for pins given below where P is output of pins, T is tools used in the production process and L is laborers: P = F(L,T) = TL 2. The following table shows the total product, average product, and marginal product from various combinations of labor and tools. Labor 1 2 3 4 5 Tools 1 1 1 1 1 Total Product Average Product Marginal Product

Specialization is occurring when the marginal product is increasing. This can be seen graphically by plotting the total product, average product, and marginal product curves. Output Total Product 25

Labor Input

Average Product, Marginal Product 5

Marginal Product Average Product

Labor Input

Notice that when marginal product is rising, average product is rising. Similarly, when marginal product is falling, average product is falling. For example, suppose MTSUs football team gives up 50 points to Illinois and 50 points to Florida for an average of 50 points per game. Then, MTSU holds Murry State to 20 points. Consequently, the average becomes 40. Or, suppose your first test score is 80 and your second test score is 80 for an average of 80. Then, you score a 50 on the third test, which lowers your average to 70. Thomas Malthus, a nineteenth century British economist, believed the population of the world would be able to produce just enough to subsist or survive in the long run. Malthus believed land (a necessary input in production) to be forever fixed. In Principles of Political Economy (1820), Malthus explains that as the population of the world grows, more and more laborers will be added to the production process, but the marginal physical product of these workers will be diminishing. In fact, Malthus predicted that the population of the world would grow until the marginal physical product of the last worker was just enough to produce an average physical product which would place everyone just at the brink of starvation. Thus, the decline in the productivity of additional labor would eventually lead to near famine, at which point the world's population size would stop growing and reach equilibrium. Consider the following production function where L equals labor, L equals land and Q equals total production: Q=L L . Malthus believed the world's population would double every twenty-five years until it reached the point of starvation. Let the minimum subsistence level be 0.5 units of food per person.

The following table shows the total product, average product, and marginal product from various combinations of labor and tools. Labor 1 2 3 4 5 Land 1 1 1 1 1 Total Product Average Product Marginal Product

There are 4 laborers at the subsistence level. Diminishing marginal returns are occurring when the marginal product is decreasing. This can be seen graphically by plotting the total product, average product, and marginal product curves. Output Total Product

Labor Input Average Product, Marginal Product

Average Product Marginal Product

Labor Input

Again, when marginal product is falling, average product is falling; when marginal product is rising, average product is rising.

Why hasnt the worlds population stopped growing due to starvation? In some places, it has. Overall, this has not happened because new technology has changed the production function from Q = L L to Q = 3L 2L or Q = 8L L2 . So, which theory is correct, that of specialization or diminishing marginal returns? Economists feel that we often first see specialization, but after a point, we see diminishing marginal returns set in. Now put specialization and diminishing marginal returns together. Total Output (Q)

TP

Specialization Marginal Product Average Product

Diminishing Marginal Returns L

AP MP Specialization Diminishing Marginal Returns (L)

Now define the production process in terms of cost. In this production process, let there be three pieces of equipment or capital (K): riding lawn mower, push mower, and weedeater. Let the capital cost $1000 and each worker cost $40.00 per day. The following table shows total number of lawns mowed (TP), the marginal product (MP), the total cost of production (TC), the total fixed cost of production (TFC), the total variable cost of production (TVC), the total average cost of production (ATC), the average fixed cost of production (AFC), and the average variable cost of production (AVC) for various combinations of labor (L) and equipment (K). Lawns Mowed with Workers and Equipment K L TP MP TC TFC 3 1 2 3 2 6 3 3 12 3 4 16 3 5 18 3 6 19 3 7 19.5 Notice the following relationships (where Q = TP): ATC = AFC + AVC TC = TFC + TVC ATC - AFC = AVC TC - TFC = TVC ATC = TC/Q AFC = TFC/Q AVC = TVC/Q TVC ATC AFC AVC

Now, graph the TP and TC curves to show where there is specialization and diminishing marginal returns.

Do Microsoft Excel example. See the Cost of Production excel file. The Production of Lawn Mowings Lawns Mowed TC TFC TVC 1 2500 2000 2 2800 3 3000 4 3160 5 3340 6 3540 7 3780 8 4080 9 4410 10 4770 11 5190 12 5760 13 6630 14 7800 15 9800 ATC AFC AVC MC

However, typically, we wont be able to use Microsoft excel to graph our cost curves. Here is how we will graph short-run cost curves by hand: $ AVC MC ATC

AFC Quantity Note the following relationships. The AFC curve asymptotically approaches zero. The AVC and ATC get closer and closer together as output increases because youre adding a smaller and smaller AFC to AVC to get ATC. ATC and AVC are shaped like a bowl because specialization initially lowers these average costs but as diminishing marginal returns set in, these cost curves are pulled up again. In the long run, we examine returns to scale, which describes how output changes when the inputs change. When doubling the amount of inputs used in the production process, if

output more than doubles, then the production process exhibits increasing returns to scale, if output less than doubles, then the production process exhibits decreasing returns to scale, and if output exactly doubles, then the production process exhibits constant returns to scale. Now, some examples where the inputs are doubled. Q = L2K : (1)2(1) = 1; (2)2(2) = 8; (4)2(4) = 64; increasing returns to scale because output more than doubles. Q = K L : (1)(1)1/2 = 1; (2)(2)1/2 = 2.82; (4)(4)1/2 = 8; increasing returns to scale because output more than doubles. Q=K+ L : 1 + 1 = 2; 2 + 1.41 = 3.41; 4 + 2 = 6; decreasing returns to scale because output less than doubles. In the long run, we can change the amount of the fixed input that were using you can change your scale of production. This means that there are different scales of production in the long run because capital becomes variable. $ MC(M) MC(S) ATC(S) ATC(M) MC(L) ATC(L) LRAC

q1

q2

q3 Quantity

Farmer A goes into production on the small scale (S). Farmer B goes into production on the medium scale (M), and farmer C goes into production on the large scale (L). If you wanted to produce q1, then you would go into production on the small scale because that is the scale on which q1 can be produced at lowest average total cost. Similarly, if you wanted to produce q2, then you would go into production on the medium scale and if you wanted to produce q3, then you would go into production on the large scale. The long run average cost (LRAC) curve connects the lowest possible average cost of producing each level of output in the long run.

Having graphed the LRAC curve, we can now identify the areas of increasing and decreasing returns to scale and economies and diseconomies of scale. When doubling output, if the total cost of production less than doubles, then the production process exhibits economies of scale and the long run average cost of production is decreasing. However, when doubling output, if the total cost of production more than doubles, then the production process exhibits diseconomies of scale and the long run average cost of production is increasing. If the long run total cost of production exactly doubles when output doubles, then there are constant returns to scale. Incidentally, economies of scale occur where there are increasing returns to scale. Similarly, diseconomies of scale occur where there are decreasing returns to scale. This is because returns to scale and economies of scale describe the same thing the returns to scale definitions use production language (inputs and output) and economies of scale use cost of production language (output and total cost of production). In other words, increasing returns to scale means economies of scale and decreasing returns to scale means diseconomies of scale.

Economies of Scale : Diseconomies of Scale Increasing Returns to Scale: Decreasing Returns to Scale $

Quantity

Problem Set 6: The Cost of Production 1. Adam Smith in The Wealth of Nations (1776) wrote of a factory which made pins. He claimed that labor's marginal physical product would be increasing due to specialization. As more people (laborers) are added to production, each can specialize on a smaller part of the pin production process. With many workers, a firm will be able to take advantage of each worker's specific talents by letting them do what they are best at. By each worker doing only one specific task, tasks will be simplified and work will become less stressful. Tasks will be easier to learn and master. Consider the production function for pins given below where P is output of pins, T is tools used in the production process and L is laborers: P = F(L,T) = TL 2. a) Fill in the following chart using the production function given above. The chart represents a short run situation where labor is a variable input but tools are fixed. Labor 1 2 3 4 5 Tools 1 1 1 1 1 Total Product Average Product Marginal Product

b) Is the marginal physical product of labor increasing as Adam Smith asserts? Show your answer by first graphing the total production curve that corresponds to Smith's pin production function. Then graph the average and marginal product curves derived from your total product curve. c) In the long run both inputs are variable. Does the pin production function given above exhibit increasing, decreasing or constant returns to scale? Describe what 'returns to scale' means intuitively and show how you arrived at your answer below. 2. Thomas Malthus, a nineteenth century British economist, believed the population of the world would be able to produce just enough to subsist or survive in the long run. Malthus believed land (a necessary input in production) to be forever fixed. In Principles of Political Economy (1820), Malthus explains that as the population of the world grows, more and more laborers will be added to the production process, but the marginal physical product of these workers will be diminishing. In fact, Malthus predicted that the population of the world would grow until the marginal physical product of the last worker was just enough to produce an average physical product that would place everyone just at the brink of starvation. Thus, the decline in the productivity of additional labor would eventually lead to near famine, at which point the world's population size would stop growing and reach equilibrium. Consider the following production function where L equals labor, L equals land and Q equals total production: Q=L L. a) Assume the average physical product required for each worker to subsist is 0.5 units of Q, and that land is forever fixed to be 1. At first, labor is sufficiently productive. 9

Calculate for each level of labor total product (TP), marginal product (MP) and average product (AP). Labor 1 2 3 4 5 Land 1 1 1 1 1 Total Product Average Product Marginal Product

b) How many laborers will there be at the subsistence level? c) Graph the total product curve assuming labor is variable but land is fixed in the short run. d) Using your total product curve, graph the average and marginal product of labor curves. e) Malthus' dismal theory appears to be incorrect when compared to the real world: in general, the population of the world taken as a whole has not stopped growing. One explanation for why the population growth of the world has not stopped is that land in the new world was discovered. Assuming land is not forever fixed, check to see if the production function given above exhibits increasing, decreasing or constant returns to scale in the long run by doubling the inputs used in production. f) What other reason can be given to explain why the world's population has not yet stopped growing? 3. A commercial fisherman notices the following relationship between hours spent fishing and the quantity of fish caught: Hours Quantity of Fish in Pounds 0 0 1 10 2 18 3 24 4 28 5 30 a) What is the marginal product of each hour spent fishing? b) Use these data to graph the fisherman's production function. Explain its shape. c) The fisherman has a fixed cost of $10.00 (his pole). The opportunity cost of his time is $5.00 per hour. Graph the fisherman's total cost curve. Explain its shape. 4. You are thinking about setting up a lemonade stand. The stand itself costs $200. The ingredients for each cup of lemonade cost $.50. a) What is your fixed cost of doing business? What is your variable cost per cup? b) Construct a table showing your total cost, average total cost, and marginal cost for output levels varying from 0 to 10 gallons where there are 16 cups in a gallon. Draw the three cost curves.

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5. Floyd owns a painting company with a total fixed cost of $200.00 and the following schedule for total variable cost: Quantity of housed painted per Month Total Variable Cost 1 $10.00 2 $20.00 3 $40.00 4 $80.00 5 $160.00 6 $320.00 7 $640.00 Calculate average fixed cost, average variable cost, and average total cost for each quantity. What is the efficient scale of the painting company? 6. Healthy Harry's Juice Bar has the following cost schedules: Quantity (vats) Variable Cost Total Cost 0 $0 $ 30 1 10 40 2 25 55 3 45 75 4 70 100 5 100 130 6 135 165 a) Calculate average variable cost, average total cost and marginal cost for each quantity. b) Which curves are falling when marginal cost is below them and rising when marginal cost is above them? c) What kind of cost does not depend on the quantity of output produced? d) What is the cost of producing an extra unit of output called? e) Graph the three curves. What is the relationship between the marginal cost curve and the average total cost curve? What is the relationship between the marginal cost curve and the average variable cost curve? Explain. 7. Consider the following table of long run total cost for three different firms. State whether each of these firms experiences economies of scale or diseconomies of scale. Quantity 1 2 3 4 5 6 7 Cost for Firm A 60 70 80 90 100 110 120 Cost for Firm B 11 24 39 56 75 96 119 Cost for Firm C 21 34 49 66 85 106 129

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Answer Key 6: The Cost of Production Answer to question 1: a) Labor 1 2 3 4 5 b) Tools 1 1 1 1 1 Total Product 1 4 9 16 25 Average Product 1 2 3 4 5 Marginal Product 3 5 7 9

The marginal product is increasing; specialization is occurring. Output Total Product 25

6 Average Product, Marginal Product 5

Labor Input

Marginal Product Average Product

c)

5 Labor Input Returns to scale indicate what happens to output when the inputs are doubled. Here, there are increasing returns to scale because output more than doubles when inputs are doubled. For example, suppose L = 1 and T = 1. Then Q = (1) (1)2 = 1. Now suppose that L = 2 and T = 2. Then, Q = (2) (2)2 = 8. Now suppose L = 4 and T = 4. Then, Q = (4) (4)2 = 64.

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Answer to question 2: a) Labor Land 1 1 2 1 3 1 4 1 5 1 b) c)

Total Product 1 1.41 1.73 2 2.23

Average Product 1 0.705 0.576 0.500 0.446

Marginal Product 0.41 0.33 0.27 0.23

4 workers at the subsistence level. Output Total Product

Labor Input This shows diminishing returns to scale. d) Average Product, Marginal Product

Average Product Marginal Product Labor Input

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e) If labor = 1 and land = 1 then Q = 1. If labor = 2 and land = 2 then Q = 2.82. If labor = 4 and land = 4 then Q = 8. When inputs are doubled, output more than doubles, so there are increasing returns to scale. f) Technology has actually changed the production function. With new farming techniques, the production function may have changed from Q = L L to Q = L L or Q = 8L (L)2 . Answer to question 3: a) Hours Quantity Marginal Product 0 0 1 10 10 2 18 8 3 24 6 4 28 4 5 30 2 The production function shows that output increases as hours increase, but at a decreasing rate. Diminishing marginal returns are present. b) Output Total Product

Labor Input c) Quantity Fixed Costs Variable Costs Total Costs 0 10 0 10 10 10 5 15 18 10 10 20 24 10 15 25 28 10 20 30 30 10 25 35 The total cost of production is increasing with output at an increasing rate. When there are diminishing marginal returns, the total cost of production increases at an increasing rate.

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Total Cost

10 Output Answer to question 4: a) The fixed cost of doing business is $200; the variable cost per cup is $0.50. b) Gallons Total Average Total Marginal Cost Cost Cost 0 200 infinity 1 208 208 8 2 216 108 8 3 224 74.6 8 4 232 58 8 5 240 48 8 6 248 41.333 8 7 256 36.5 8 8 264 33 8 9 272 30.222 8 10 280 28 8 Cost, $ Total Cost

200

Average Total Cost 8 Marginal Cost Gallons

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Answer to question 5: Quantity 1 2 3 4 5 6 7 Total Variable Cost 10 20 40 80 160 320 640 Average Fixed Costs 200 100 66.666 50 40 33.333 28.5 Average Variable Cost 10 10 13.3 20 32 53.333 91.4 Average Total Cost 210 110 80 70 72 86.666 119.9

The efficient scale for the painting company is where average total cost (ATC) is lowest, which occurs at 4 houses painted per month. Answer to question 6: a) Quantity Variable Cost 0 0 1 10 2 25 3 45 4 70 5 100 6 135

Total Cost 30 40 55 75 100 130 165

Average Variable Cost 10 12.5 15 17.5 20 22.5

Average Total Cost 40 27.5 25 25 26 27.7

Marginal Cost 10 15 20 25 30 35

b) The average total cost curve (ATC) and the average variable cost curve (AVC). c) Fixed costs, which are constant across levels of output. d) Marginal Cost. e) When the marginal cost curve is above the ATC, the ATC curve is rising. When the marginal cost curve is below the ATC, the ATC curve is falling. The relationship is the same for the marginal cost curve and the AVC curve. So, the marginal cost curve cuts through the bottom of both the ATC and the AVC curves.

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$ Average Total Cost (ATC) Marginal Cost (MC)

Average Variable Cost (AVC)

Quantity Answer to question 7: Firm A exhibits economies of scale because when output doubles, cost less than double. Firm B exhibits diseconomies of scale because costs more than double when output doubles. Firm C exhibits economies of scale at first, but diseconomies of scale eventually set in.

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