Arnold - Econ13e - ch21 Production and Cost

CHAPTER
21
PRODUCTION
AND
COSTS
ECONOMICS
Roger A. Arnold • Thirteenth Edition
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
©Sashkin/Shutterstock
21-1 Why Firms Exist
21-2 Two Sides to Every Business Firm
21-3 Production
21-4 Costs of Production: Total, Average,

Marginal
21-5 Production and Costs in the Long Run
21-6 Shifts in Cost Curves
2
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. ©SashkinShutterstock
21-1 Why Firms Exist (1 of 3)
• Business Firm: An entity that employs factors of production

(resources) to produce goods and services to be sold to
consumers, other firms, or the government
• firms are formed when benefits can be obtained form
individuals working as a team
3
21-2 Two Sides to Every Business Firm (1 of 3)
• There are two sides to every market: buying and selling

• There are two sides to every business firm: revenue and cost
sides; we can see both of these sides by focusing on profit
• Total revenue is equal to the price of a good multiplied by the
quantity of the good sold : P x Q
• The total cost that a firm incurs is related to the production of
the firm; produce nothing, incur no costs; produce something,
incur costs
• Profit: The difference between total revenue and total cost
4
• 21-2a More on Total Cost

• Explicit Cost: A cost incurred when an actual (monetary)
payment is made
• Implicit Cost: A cost that represents the value of resources
used in production for which on actual (monetary) payment
is made
5
• 21-2b Accounting Profit vs. Economic Profit

• Accounting Profit: The difference between total revenue
and explicit costs
• Economic Profit: The difference between total revenue and
total cost, including both explicit and implicit costs
• 21-2c Zero Economic Profit is Not as Bad as it Sounds
• Normal Profit: Zero economic profit, the level of profit
necessary to keep resources employed in a firm. A firm that
earns normal profit is earning revenue equal to its total
costs (explicit plus implicit costs)
6
EXHIBIT 1
Accounting Profit and Economic Profit
7
21-3 Production (1 of 6)
• Production: transformation of resources or inputs into goods

and services
• Fixed Input: An input whose quantity cannot be changed as
output changes
• Variable Input: An input whose quantity can be changed as
output changes
• Short Run: A period during which some inputs in the
production process are fixed
• Long Run: A period during which all inputs in the production
process can be varied. (No inputs are fixed.)
8
• 21-3a Common Misconceptions About the Short Run and

Long Run
• Individuals naturally think that the long run is a longer
period than the short run, but this is not the right way to
differentiate between the two
• Instead, think of each as a period during which some
condition exists:
– The short run is the period during which at least one put is
fixed (it could be for 6 months, 2 years, etc.
– The long run is the period during which all inputs are variable
(i.e., no input is fixed; the short run could be a longer period
than the long run
9
21-3 Production in short run (3 of 6)
Marginal Physical Product Law of Diminishing Marginal

(MPP): Returns:
● The change in output that ● As ever larger amounts of a
results from changing the variable input are combined with
variable input by one unit, with fixed inputs, eventually the
all other inputs held fixed marginal physical product of the
variable input will decline
● Why hire a 4th worker? (Exhibit
∆𝑄 2) The firm must ask and answer
𝑀𝑃𝑃= these questions:
∆𝐿 – 1. What can the additional 19
units of output be sold for?
– 2. What does it cost to hire the
fourth worker?
10
EXHIBIT 2
Production in the Short Run and the Law of Diminishing Marginal
Returns
11
12
13
• 21-3c Whose Marginal Productivity Are We Talking About?

• Looking at Exhibit 2, it is easy to fall into the trap of
believing that 19 units is the marginal productivity of the 4th
worker, but its not
• Instead, an MPP of 19 can easily be attached to any of the
workers
• 21-3d Marginal Physical Product and Marginal Cost
• Fixed Costs: Costs that do not vary with output; the costs
associated with fixed inputs
• Variable Costs: Costs that vary with output; the costs
associated with variable inputs
14
● • 21-3d Marginal Physical Product and Marginal Cost (cont)

• Total Cost (TC): The sum of fixed costs and variable costs
(TC = TFC + TVC)
• Marginal Cost (MC): The change in total cost that results
from a change in output: MC = TC/Q
• In Exhibit 3, we establish the link between the MPP of a
variable input and MC
15
EXHIBIT 3
Marginal Physical Product and Marginal Cost (1 of 2)
16
EXHIBIT 3
Marginal Physical Product and Marginal Cost (2 of 2)
17
How MPP Affects MC
18
● • 21-3e Average Productivity

• When the press or laypersons use the word productivity,
they are usually referring to average physical product
instead of marginal physical product
• Usually, when the term labor productivity is used in the

newspaper and in government documents, it refers to the
average hourly (physical) productivity of labor
19
Marginal (1 of 3)
• Average Fixed Cost (AFC): Total fixed cost divided by

quantity of output: AVC = TVC/Q
• Average Variable Cost (AVC): Total variable cost divided by
quantity of output: AVC = TVC/Q
• Average Total Cost (ATC): Total cost divided by quantity of
output: ATC = TC/Q
• Alternatively, we can say that ATC equals the sum of AFC and
AVC:
• ATC = AFC + AVC
• Exhibit 5 brings together much of the material re short-run
production and costs
20
EXHIBIT 4
Total, Average, and Marginal Costs (1 of 2)
21
EXHIBIT 4
Total, Average, and Marginal Costs (2 of 2)
22
EXHIBIT 5
A Review of Production and Costs in the Short Run
23
CH 9 • 24
Marginal (2 of 3)
• 21-4a The AVC and ATC Curves in Relation to the MC Curve

• Average-marginal rule: When the marginal magnitude is
above the average magnitude, the average magnitude rises;
when the marginal magnitude is below the average
magnitude, the average magnitude falls
• We can apply the average-marginal rule to find out what the
ATC and AVC curves look like in relation to the MC curve
(Exhibit 6)
• The analysis holds for both the ATC curve and the AVC
curve
25
EXHIBIT 6
Average and Marginal Cost Curves
26
Marginal (3 of 3)
• 21-4b Tying Short-Run Production to Costs

• To summarize our earlier discussion, see Exhibit 7
• 21-4c One More Cost Concept: Sunk Cost
• Sunk cost: A cost incurred in the past that cannot be changed
by current decisions and therefore cannot be recovered
• Economists’ Advice: Ignore Sunk Costs; a present decision
can affect only the future, never the past
• Behavior Economics and Sunk Cost: In a study, researchers
found that people who paid more for their tickets to the
theater attended more often than those who paid less
– It seems likely that the greater the sunk cost, the more likely they
were to attend the performance
27
EXHIBIT 7
Tying Production to Costs
28
21-5 Production and Costs in the Long Run (1 of 5)
• 21-5a Long-Run Average Total Cost Curve

• Long-Run Average Total Cost (LRATC) Curve: A curve
that shows the lowest (unit) cost at which a firm can
produce any given level of output
• Given a decision between 3 different plant sizes, a manager
will choose the plant size represented by SRATC that
corresponds to the quantity he wants to produce, which
yields the lowest unit cost
• If we were to ask the same question for every possible
output level, we would derive the LRATC
• Exhibit 8 shows a host of SRATC curves and one LRATC
curve
29
EXHIBIT 8
Long-Run Average Total Cost Curve (LRATC)
30
• 21-5b Economies of Scale, Diseconomies of Scale, and

Constant Returns to Scale
• Economies of Scale: Economies that exist when inputs are
increased by some percentage and output increases by a
greater percentage, causing unit costs to call
• Constant Returns to Scale: The condition when inputs are
increased by some percentage and output increases by an
equal percentage, causing unit costs to remain constant
• Diseconomies of Scale: The condition when inputs are
increased by some percentage and output increases by a
smaller percentage, causing unit costs to rise
31
• 21-5b Economies of Scale, Diseconomies of Scale, and

Constant Returns to Scale (cont)
• Minimum Efficient Scale: The lowest output level at
which average total costs are minimized
32
EXHIBIT 9
A Review of Production and Costs in the Long Run
33
• 21-5c Why Economies of Scale?

• Up to a certain point, long-run unit costs of production fall
as a firm grows, for two main reasons:
– 1. Growing firms offer greater opportunities for employees to
specialize; workers can become highly proficient at narrowly
defined tasks, often producing more output at lower unit costs
– 2. Growing firms (especially large ones) can take advantage of
highly efficient mass production techniques and equipment
that ordinarily require large setup costs and are economical
only if they can be spread over large numbers of units
34
• 21-5d Why Diseconomies of Scale?

• These usually arise at the point where a firm’s size causes
coordination, communication, and monitoring problems
• There is also a monetary incentive not to pass the point of operation
at which diseconomies of scale exist, and firms usually find ways to
do so, including reorganizing, dividing operations, etc.
• 21-5d Minimum Efficient Scale and Number of Firms in an Industry
• Some industries have a smaller number of firms
• The MES as a percentage of US consumption or total sales is not
the same for all industries
• By dividing the MES as a percentage of total sales into 100, we can
estimate the number of efficient firms it takes to satisfy total
consumption for a product
35
21-6 Shifts in Cost Curves (1 of 1)
• 21-6a Taxes
• A tax won’t affect a firm’s fixed costs because the tax is paid only
when output is produced, and fixed cost is present even if output is
zero
• 21-6b Input Prices
• A rise or fall in variable input prices causes a corresponding change
in the firm’s average total, average variable, and marginal cost curves
• 21-c Technology
• Technology often brings (1)the capability of using fewer inputs to
produce a good, or (2) lower input prices
• In either case, technological changes lower variable costs and so
average variable cost, average total cost, and marginal costs; the cost
curves shift downward
36

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CHAPTER

21-2 Two Sides to Every Business Firm

21-4 Costs of Production: Total, Average,

21-5 Production and Costs in the Long Run

21-6 Shifts in Cost Curves

• Business Firm: An entity that employs factors of production

• There are two sides to every market: buying and selling

• 21-2a More on Total Cost

• 21-2b Accounting Profit vs. Economic Profit

Accounting Profit and Economic Profit

• Production: transformation of resources or inputs into goods

• 21-3a Common Misconceptions About the Short Run and

Marginal Physical Product Law of Diminishing Marginal

• 21-3c Whose Marginal Productivity Are We Talking About?

● • 21-3d Marginal Physical Product and Marginal Cost (cont)

Marginal Physical Product and Marginal Cost (1 of 2)

Marginal Physical Product and Marginal Cost (2 of 2)

● • 21-3e Average Productivity

• Usually, when the term labor productivity is used in the

• Average Fixed Cost (AFC): Total fixed cost divided by

Total, Average, and Marginal Costs (1 of 2)

Total, Average, and Marginal Costs (2 of 2)

A Review of Production and Costs in the Short Run

• 21-4a The AVC and ATC Curves in Relation to the MC Curve

Average and Marginal Cost Curves

• 21-4b Tying Short-Run Production to Costs

Tying Production to Costs

• 21-5a Long-Run Average Total Cost Curve

Long-Run Average Total Cost Curve (LRATC)

• 21-5b Economies of Scale, Diseconomies of Scale, and

• 21-5b Economies of Scale, Diseconomies of Scale, and

A Review of Production and Costs in the Long Run

• 21-5c Why Economies of Scale?

• 21-5d Why Diseconomies of Scale?

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