Topic 4- Part 1 : Cost Analaysis

Producer Theory and Company Operation Decisions:

Dr. Mina Sami Ayad

Outline

1. Types of Markets
2. Decision Times Frame.
3. Short-Run Technology Constraint.
4. Short-Run Cost
5. Short-Run Cost and Short-Run Technology
6. Long-Run Cost

2
Types of Markets
 Decision Times Frame
All decisions can be placed in two time frames:
▪ The short run
▪ The long run

The Short Run:

(1) The quantity of one or more resources used in
production is fixed.
• For Example, Firm Plant (Capital)
(2) Other resources can be changed.
• For Example, Labor and Raw Materials.
(3) Decisions are irreversible and can be changed.
Decision Times Frame

The Long Run

(1) It is a time frame in which the quantities of all
resources—including the plant size—can be varied.
(2) Decisions may incur Sunk Costs and cannot be
reversed.
 Decision Times Frame
Capital
0 1 2 3 4 5 6
0 0 0 0 0 0 0 0
1 0 1 3 7 10 12 13
Labor 2 0 3 10 18 24 29 33
3 0 7 18 30 40 46 50
4 0 10 24 40 50 56 57
5 0 12 29 46 56 58 59
6 0 13 33 50 57 59 60

Isoquant is important concept. An isoquant is the set of all

possible combinations of the two inputs that yield the
same maximum possible level of output.
Short-Run Technology Constraint

• To increase output in the short run, a firm must increase

the amount of labor employed.

• Three concepts describe the relationship between output

and the quantity of labor employed:
▪ Total product
▪ Marginal product
▪ Average product
Short-Run Technology Constraint
Labor Total Product Marginal Product Average Product MP-AP
0 0
1 10 10 10 0
2 24 14 12 2
3 40 16 13.33333333 2.666667
4 50 10 12.5 -2.5
5 56 6 11.2 -5.2
6 57 1 9.5 -8.5
(1) At Maximum Point OF Average Product ➔ MP is at the top.

(2) Before Maximum Point ➔ MP> AP and each extra labor adds value.

(3) After Maximum Point ➔ Added Value of extra labor is less then before. AP>MP.
 Short-Run Technology Constraint
1. Product Curves

• Total product is the total output produced in a given

period.

• The marginal product of labor is the change in total

product that results from a one-unit increase in the
quantity of labor employed, with all other inputs
remaining the same.

• The average product of labor is equal to total product

divided by the quantity of labor employed.
 Short-Run Technology Constraint
1. Product Curves

Total Product
 Short-Run Technology Constraint
1. Product Curves

Marginal Product
• Initially increasing
marginal returns
• When the marginal
product of a worker
exceeds the marginal
product of the previous
worker, the marginal
product of labor
increases and the firm
experiences increasing
marginal returns.
Short-Run Technology Constraint
1. Product Curves

• Eventually diminishing
marginal returns
• When the marginal
product of a worker is
less than the marginal
product of the previous
worker, the marginal
product of labor
decreases and the firm
experiences diminishing
marginal returns.
Short-Run Technology Constraint
1. Product Curves
Short-Run Technology Constraint
1. Product Curves
 Short-Run Technology Constraint
1. Product Curves

(1) We should not hire labor with negative Marginal

Productivity.

(2) Top MP is at three Labor.

(3) Without looking at the costs and the price that the
output sells for, we are unable to determine how many
workers to employ.

(4) When AP is rising is a good Sign for sure.

 Short-Run Technology Constraint
1. Product Curves

(5) As long as the MP>AP ➔ the average product will

rise.

(6) When AP=MP ➔ AP reaches its maximum.**

 Short-Run Costs

• We can see that 50 units of output can be produced by

three different input combinations on isoquant curve (L
= 6, K = 3), (L = 4, K = 4) and (L = 3, K = 6). The
question is which input combination will the firm
choose?

• So, for every level of output, the firm chooses the least
cost input combination. (minimizing Costs)
 Short-Run Costs

q TFC TVC TC AFC AVC AC MC

0 20 0 20
1 20 10 30 20 10 30 10
2 20 18 38 10 9 19 8
3 20 24 44 6.666667 8 14.66667 6
4 20 29 49 5 7.25 12.25 5
5 20 33 53 4 6.6 10.6 4
6 20 39 59 3.333333 6.5 9.833333 6
7 20 47 67 2.857143 6.714286 9.571429 8
8 20 50 70 2.5 6.25 8.75 3
9 20 75 95 2.222222 8.333333 10.55556 25
10 20 95 115 2 9.5 11.5 20
Short-Run Costs
Short-Run Costs

Producing at Minimum of
AVC is important.
Short-Run Costs
Short-Run Costs
 Short-Run Costs

(1) We never produce with negative Marginal Costs.

(2) Average fixed costs get smaller as more quantity is

produced.

(3) The vertical distance between ATC and AVC smaller

as output increases.

(4) MC intersects AVC and ATC at their minimums.

Short-Run Costs
Short-Run Costs and Short-Run
Technology
 Short-Run Costs and Short-Run
Technology
q TFC TVC TC AFC AVC AC MC TP MP AP
0 20 0 20 0
1 20 10 30 20 10 30 10 3 3 3
2 20 18 38 10 9 19 8 8 5 4
6.66666 14.6666 4.66666
3 20 24 44 7 8 7 6 14 6 7
4 20 29 49 5 7.25 12.25 5 19 5 4.75
5 20 33 53 4 6.6 10.6 4 23 4 4.6
3.33333 9.83333 4.33333
6 20 39 59 3 6.5 3 6 26 3 3
2.85714 6.71428 9.57142
7 20 47 67 3 6 9 8 28 2 4
8 20 50 70 2.5 6.25 8.75 3 29 1 3.625
2.22222 8.33333 10.5555 3.11111
9 20 75 95 2 3 6 25 28 -1 1
10 20 95 115 2 9.5 11.5 20 26 -2 2.6
 Short-Run Costs and Short-Run
Technology
• Shifts in Cost Curves
• The position of a firm’s cost curves depend on two
factors:
▪ Technology
▪ Prices of productive resources
 Long-Run Costs

• Typically, the plant size can only be changed in the long-

run, that is, it is often the last input to become variable.

• In the long-run, we want to select a plant size that gives

us the lowest costs for our level of output.
• If the desired output is only 25 units, then a small plant is
able to produce at a lower average cost ($40) than the
medium size plant ($50).
• However, if our desired output is 40 units, then the
medium size plant is able to produce at a lower average
cost than the small plant.
Long-Run Costs
 Long-Run Costs

• The long run average cost curve shows the minimum

average cost of producing any given level of output.

• The long-run average cost curve is obtained by

combining the possible short-run curves (i.e. it is
obtained by combining all possible plant sizes).

• If increasing output reduces the per unit cost, the firm is

experiencing economies of scale
 Long-Run Costs

• Larger Plant Size with highest product guarantees least

costs: Economies of Scale
 Long-Run Costs

• Diseconomies of scale occurs when average costs

increase as plant size increases.

• Economies of Scale is good for many reasons:

1. As plant capacity increases, firms are able to specialize
their labor and capital to a greater degree.
2. For many products, significant costs are in design and
development (Brands).
3. Spreading the cost of placing the order over more units,
reduces the per unit cost.