Microeconomics Set 5 - Production, Business Organization and Economic Analysis of Costs

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Theory of Production Productivity Business Organizations Cost Concepts Production and Costs Opportunity Costs
Economics 1
Set 5: Production, Business Organization and Economic
Analysis of Costs
Nordhaus and Samuelson, Economics 19e, Chapter 6 & 7
Dr. Christoph Bierbrauer

Professorship for Economics
Cologne Business School
Summer Term 2016
Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

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Review of Central Concepts: Consumer Behavior

Characterize the following concepts in your own words:
Substitution effect
Income effect
Indifference curve
Elasticity
Total utility and Marginal utility
Consumer surplus
State the properties we refer to when two goods are either
Substitutes
Complements
Independent
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Production and Business Organization
A discussion of the fundamentals of the Production Theory
Productive capacity determines the ability of an economy to

provide goods and services, it depends on the quantity and quality
of the
Labor force
Capital stock
Available technology
Production is executed by specialized organizations: Firms

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Production Function
The production function specifies the maximum output that can
be produced, given a certain quantity of inputs and the
technological standard
The concept describes the productive capabilities of a firm

or economy
By definition, producers will always try to achieve efficiency
in production
Any particular production function is subject to changes, it may

become obsolete with the occurrence of technological progress

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Example: A Cobb-Douglas Production Function

The Cobb-Douglas production function is commonly used in
macroeconomic models
Y = Lα K β (1)
where Y is the total production, L labor input, K capital input

and α, β are the output elasticities of capital and labor
If β = 0.55, a 1% increase in capital usage will lead to

approximately a 0.55% increase in production
Empirically, we observe capital-intensive as well as labor-intensive

sectors of the economy. The required elasticities are estimated for
a wide range of countries/industries
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Total and Marginal Product

The production of wheat: c.p. the number of workers is increased
The total product curve rises with the addition of each worker
The increment (marginal product) declines (diminishing returns of
labor) and adds up to the total amount produced
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Production Concepts
Total physical product or total product; based on the
production function, the total product designates the total amount
of output produced in physical units (e.g. cars or DVDs), for given
inputs and technology
Marginal product; is the extra output produced by one additional

unit of that input while other inputs are held constant
The marginal product is crucial for understanding how wages and

other factor prices are determined (similar to the concept of
marginal utility which determines market prices)
Average product; total output divided by total units of input

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Law of Diminishing Returns
The addition of one unit of a particular productive input yields

diminishing increments to total production which implies a
concave total product curve
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Law of Diminishing Returns, cont.
Law of diminishing returs; a firm will get less and less extra
output when it adds additional units of a specific input while
holding all other inputs fixed
Diminishing returns are an empirical regularity, they prevail

in most cases
Any type of output tends to show the law of diminishing
returns

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Returns to Scale
Returns to Scale - A concept for the long run
The concepts of diminishing returns and marginal product

characterize the response of output to an c.p. increase in a single
productive input
In many cases we are interested in the effect of a proportional

increase in all productive inputs on output
Returns to scale describe the effect of a scale increase of inputs

on the quantity produced

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Returns to Scale
Returns to Scale, cont.
Increasing returns to scale or economies of scale; an increase

in all inputs leads to a more-than-proportional increase in the level
of output
Constant returns to scale; an increase in all inputs leads to a

proportional increase in the level of output
Decreasing returns to scale; a balanced increase of all inputs

leads to a less-than-proportional increase in total output

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Returns to Scale
Production Concepts

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Returns to Scale
Short-run and Long-run
Time is a crucial requirement for the adjustment of production

capacities, we distinguish between two different time periods:
Short-run; the time period in which all variable factors of
production such as the utilization of installed capital or the
employed labor force (e.g. by overtime) can be adjusted
Long-run; the time period in which any production factor can
be adjusted, including fixed factors such as the amount and
type of capital installed

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Technological Change
Technology determines the amount of output that can be

produced using a certain amount of productive inputs
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Technological Change: Innovation
We distinguish between two different types of technological

change:
i. Process innovation; improved production techniques for
existing products, i.e. a shift in the production function
ii. Product innovation; new or improved products, i.e. a new
kind of production function

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Productivity
Productivity measures the ratio of total output to a weighted

average of all inputs
Total factor productivity; output divided by an index of all inputs
Labor productivity; output per unit of labor
Productivity growth; when output grows faster than the

respective amount of inputs, we speak of productivity growth

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Sources of Productivity growth
Technological advances; the introduction of process

innovations
Economies of scale; e.g. mass production
Economies of scope; combinations of goods that can be
produced more efficiently than each single product

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Business Firms
Production is executed by specialized organizations, firms, these
generate:
Economies of specialization; e.g. by the use of specialized
labor inputs and machinery (capital) and the division of
production in small oversee-able operations
Raising resources; e.g. by utilizing financial markets (issuing
of stocks or bonds), firms have their own legal personality and
allow their owners to limit individual risk
Manage and coordinate the production process; by
monitoring the production process, evaluating reorganization
possibilities as well as the identification of potential areas of
research
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Total costs
Fixed and Variable Costs
We are interested in the analysis of costs as these form the

foundation of the supply decisions of producers
Two components of total cost (TC):
Fixed costs or sunk costs (FC) are expenses that must be paid
even when the firm produces no output, e.g. rents, debt services,
salaries
Variable costs (VC) depend on the amount of output produced,

e.g. raw materials, electricity
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Total costs
Example

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Total costs
Total Costs
Total cost (TC) are the lowest total expenses needed to produce a
certain quantity q of output
TC = VC + FC (2)
fixed FC and variable costs VC represent the sunk costs, even

present at q = 0 and the additional costs of actually starting and
increasing production, respectively

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Total costs
Total Costs, cont.
Total costs TC increase as production is initiated

Fixed costs FC are constant and independent of q
Variable costs VC depend on the actual quantity q produced
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Marginal Costs
Marginal Cost Diagram

Marginal costs (mc) are the extra or additional costs of producing one
extra unit of output
Total costs are related to marginal costs in the same way as the total
product/utility is related to the marginal product/utility
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Unit cost
Average Costs
Average costs are of crucial importance when making real world

business decisions
The comparison of average costs and average revenue yield
the actual profitability of a business firm
Depending on the complexity of the production process it
might be an onerous task to identify the average costs of a
particular product
Average costs consist of two components

Average fixed costs
Average variable costs

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Unit cost
Calculation of the Average Costs

Average costs (AC):
TC
AC = (3)
q
Average fixed costs (AFC):

FC
AFC = (4)
q
Average variable costs (AVC):

VC
AVC = (5)
q

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Unit cost
Cost Concepts

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Unit cost
Average and Marginal costs

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Unit cost
Average and Marginal costs: Summary
If the marginal cost curve is below the average cost curve, the
average cost curve must be falling
By contrast, if marginal costs are above average costs, the average

cost curve is rising
When marginal costs are just equal to the average costs, the
average cost curve is flat
The average cost curve is always pierced at its minimum point by a

rising marginal cost curve

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Link between Production and Costs
Key determinants of cost curves:

Factor prices
Production function
Knowledge of both, factor prices and the production function

allows us to calculate the cost curve

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Short-run and Long-run
Time is a crucial requirement for the adjustment of production. We

distinguish between two different time periods:
Short-run; the time period in which all variable factors of
production such as the utilization of installed capital or the
employed labor force (e.g. by overtime) can be adjusted
Long-run; the time period in which any production factor can
be adjusted, including fixed factors such as the amount and
type of capital installed

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Law of diminishing returns
In the short-run, there are fixed and variable factors of

production
Typically, we observe diminishing returns to the variable
factors
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U-shaped Cost Curves
Marginal cost rise as the marginal product of inputs is going

down, e.g. decreasing marginal product of labor at constant
wage rates
Diminishing returns imply rising marginal costs
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Choice of inputs
Assumption: Firms minimize costs (in order to maximize profits)
Least-cost rule; in order to minimize costs, firms choose their

inputs according to the marginal product per Euro
marginal product of capital marginal product of labor
= (6)
price of capital wage rate
Substitution rule; If the price of one factor in production falls

while all other factor prices remain the same, firms will profit by
substituting the now-cheaper factor for other factors until the
marginal products per Euro are equal for all inputs

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Economic Costs vs. Business Accounting
Business accountig: The fundamental identity of the income

statement
Net income/net profit = total revenue − total expenses (7)
Business accounting only deals with transactions in which money

actually changes hands
Opportunity costs of production: Any resource devoted to the

production of one good implies that society gives up the
opportunity to produce something else

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Pierce the Veil of Money
Economists are interested in the true resource costs of business

activity, i.e. opportunity costs not included in the income
statements
Unpaid hours by the owners of small businesses
Negative environmental effects
In a well functioning competitive market

price = opportunity costs (8)

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Summary: Theory of Production
Production function; a mathematical concept which describes

the relation between the amount of output and a certain quantity
of productive inputs
The marginal product as well as the law of diminishing returns

refer to the c.p. effect of one additional unit of a particular
productive input on output. The latter states that the marginal
product declines with each additional unit added
Returns to scale reflect the effect of an equal increase in all

productive inputs on output. Important cases are economies of
scale, constant returns to scale and decreasing returns to scale

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Summary: Theory of Production
Time is a crucial requirement for the adjustment of production

capacities, we distinguish between the short-run in which all
variable factors in production can be adjusted and the long-run in
which any factor of production can be adjusted
The concept of technological change refers to changes in the

underlying techniques of production, we distinguish between
process and product innovations
Business firms are specialized organizations devoted to managing

the process of production

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Summary: Analysis of Costs
Total costs are the sum of fixed and variable costs
Marginal cost is the extra total cost of producing one additional

unit. Average total cost is the sum of (ever declining) average
fixed cost and average variable cost. In the short-run, average
costs are represented by a U-shaped cost curve
Firms minimize their costs, i.e. they follow the least-cost rule as
well as the substitution rule when choosing their inputs

Economics 1

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Dr. Christoph Bierbrauer

Cologne Business School

Summer Term 2016

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Review of Central Concepts: Consumer Behavior

Production and Business Organization

A discussion of the fundamentals of the Production Theory

Productive capacity determines the ability of an economy to

Production is executed by specialized organizations: Firms

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

The concept describes the productive capabilities of a firm

Any particular production function is subject to changes, it may

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Example: A Cobb-Douglas Production Function

where Y is the total production, L labor input, K capital input

If β = 0.55, a 1% increase in capital usage will lead to

Empirically, we observe capital-intensive as well as labor-intensive

Total and Marginal Product

Marginal product; is the extra output produced by one additional

The marginal product is crucial for understanding how wages and

Average product; total output divided by total units of input

Law of Diminishing Returns

The addition of one unit of a particular productive input yields

Law of Diminishing Returns, cont.

Diminishing returns are an empirical regularity, they prevail

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Returns to Scale - A concept for the long run

The concepts of diminishing returns and marginal product

In many cases we are interested in the effect of a proportional

Returns to scale describe the effect of a scale increase of inputs

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Returns to Scale, cont.

Increasing returns to scale or economies of scale; an increase

Constant returns to scale; an increase in all inputs leads to a

Decreasing returns to scale; a balanced increase of all inputs

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Short-run and Long-run

Time is a crucial requirement for the adjustment of production

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Technology determines the amount of output that can be

Technological Change: Innovation

We distinguish between two different types of technological

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Productivity measures the ratio of total output to a weighted

Total factor productivity; output divided by an index of all inputs

Labor productivity; output per unit of labor

Productivity growth; when output grows faster than the

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Sources of Productivity growth

Technological advances; the introduction of process

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Fixed and Variable Costs

We are interested in the analysis of costs as these form the

Two components of total cost (TC):

Variable costs (VC) depend on the amount of output produced,

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

fixed FC and variable costs VC represent the sunk costs, even

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Total Costs, cont.

Total costs TC increase as production is initiated

Marginal Cost Diagram