Topic 8 Production, Cost and Factors of Production

Agenda
8.1 Efficient Production
8.2 Time Frame: The Short Run and the Long Run
8.3 Production in Short Run
8.4 Costs in the Short Run
8.5 Fixed Costs and Sunk Costs
8.6 Production in the Long Run
8.7 Technological change and globalization
8.8 Clusters, externalities, learning by doing, and
scope economies
 Efficient Production

• Inefficient firms often struggle to survive in a competitive market.

• Profitability is a key driver in the modern economy, and companies that promise
greater efficiency are more highly valued by investors.
• An example of this is Google's stock value increasing by 16% due to a cost
management policy.
• Managerial remuneration in most corporations is tied to profitability, which
makes efficient production essential.
• Efficient production and cost minimization are interconnected concepts.
• Efficiency is important not only in the private sector but also in public
institutions.
• Entrepreneurs use factors of production to transform inputs into goods or
services through production functions.
 Efficient Production

• Production function: a technological relationship that

specifies how much output can be produced with specific
amounts of inputs.
• Technological efficiency means that the maximum output
is produced with the given set of inputs.
• Economic efficiency defines a production structure that
produces output at least cost.
 The Time Frame

• Short run: a period during which at least one factor of

production is fixed. If capital is fixed, then more output is
produced by using additional labour.
• Long run: a period of time that is sufficient to enable all
factors of production to be adjusted.
• Very long run: a period sufficiently long for new technology
to develop.
 Production in Short Run

• In the short run, at least one factor of production remains fixed, limiting a producer's ability to make
significant changes. Here's an example:

• Bakery Production in the Short Run: Imagine a small bakery with a fixed amount of space and a
limited number of ovens, which is the capital (machinery) in this case. The number of bakers, who
represent labor, can be adjusted relatively quickly.
• Short Run Scenario: The bakery has a fixed number of ovens and limited space in its current location.
• Fixed Factor: Capital (Ovens and Space)
• Variable Factor: Labor (Bakers)
• In this short-run scenario:
• The bakery can hire or reduce the number of bakers relatively quickly as needed. If demand for their
products suddenly increases, they can schedule bakers to work longer hours or hire additional
bakers.
• However, they cannot expand their production capacity by adding more ovens or expanding the
baking area immediately. These changes would require significant time and resources, making them
long-run adjustments.
• So, in the short run, the bakery's production is constrained by the fixed capital (ovens and space),
and they must primarily rely on adjusting the variable factor (labor) to meet changing demand.
 Production in Short Run

• In the short run, at least one factor of production remains fixed, limiting a producer's ability to make
significant changes. Here's an example:

• Bakery Production in the Short Run: Imagine a small bakery with a fixed amount of space and a
limited number of ovens, which is the capital (machinery) in this case. The number of bakers, who
represent labor, can be adjusted relatively quickly.
• Short Run Scenario: The bakery has a fixed number of ovens and limited space in its current location.
• Fixed Factor: Capital (Ovens and Space)
• Variable Factor: Labor (Bakers)
• In this short-run scenario:
• The bakery can hire or reduce the number of bakers relatively quickly as needed. If demand for their
products suddenly increases, they can schedule bakers to work longer hours or hire additional
bakers.
• However, they cannot expand their production capacity by adding more ovens or expanding the
baking area immediately. These changes would require significant time and resources, making them
long-run adjustments.
• So, in the short run, the bakery's production is constrained by the fixed capital (ovens and space),
and they must primarily rely on adjusting the variable factor (labor) to meet changing demand.
 Production in Short Run

• Total product is the relationship between total output

produced and the number of workers employed, for a given
amount of capital.

• Marginal product of labour is the addition to output

produced by each additional worker. It is also the slope of
the total product curve.
 Production in Short Run

• Law of diminishing returns: when increments of a

variable factor (labour) are added to a fixed amount of
another factor (capital), the marginal product of the variable
factor must eventually decline.

• Average product of labour is the number of units of output

produced per unit of labour at different levels of
employment.
 Costs in the Short Run

• Fixed costs are costs that are independent of the level of

output.
• Variable costs are related to the output produced.
• Total cost is the sum of fixed cost and variable cost.
 Costs in the Short Run

• Average fixed cost is the total fixed cost per unit of output.
• Average variable cost is the total variable cost per unit of output.
• Average total cost is the sum of all costs per unit of output.
• Marginal cost of production is the cost of producing each
additional unit of output.
 Terms in Services

• Teamwork and Interdependence: Many employees work in teams

within organizations. For instance, various departments, like
accounting, marketing, sales, or production units, operate as teams.
The impact of adding or removing one person from a specific team may
not be easily measurable in terms of individual output. Instead, it can
affect team dynamics, morale, and the team's overall productivity.

• Long-Term Productivity: Hiring or firing decisions can have

implications for long-term productivity and company culture. For
instance, adding a person to the human resources department may not
have an immediate impact on measurable output, but it might influence
morale and, in turn, long-term productivity and retention of employees.
 Fixed Costs And Sunk Costs

• Sunk cost is a fixed cost that has already been incurred and cannot be recovered,
even by producing a zero output.
• Irrelevance for Decision-Making: Sunk costs should not factor into future
decisions because they are past expenses that cannot be changed. Making
decisions based on sunk costs is often referred to as "throwing good money after
bad." It can lead to poor decision-making and financial losses.
• Examples of Sunk Costs: Common examples of sunk costs include money spent
on equipment, software, or machinery that has become obsolete, as well as tuition
fees for an education program that a person has already abandoned. These costs
are no longer recoverable.
• Opportunity Cost: Focusing on sunk costs can lead to the neglect of opportunity
costs, which are the potential benefits that could be gained from alternative
choices. For example, if you've spent a significant amount on a failing business
venture, continuing to invest in it because of those sunk costs might prevent you
from pursuing more profitable opportunities.
 Fixed Costs And Sunk Costs

• Behavioral Economics: Behavioral economics recognizes that individuals may have

an emotional attachment to sunk costs. This can lead to a phenomenon known as the
"sunk cost fallacy," where people continue investing in something simply because they
have already spent money on it, even when it's not economically rational.
• Business Decisions: In the business world, recognizing and disregarding sunk costs is
crucial. Companies should evaluate future investments based on their expected returns
and costs, not on what has been spent in the past. If a project is no longer economically
viable, it should be discontinued, regardless of the resources already invested.
• Legal and Regulatory Considerations: In some cases, legal and regulatory
requirements may affect how sunk costs are treated. For example, in accounting, there
are rules about when and how certain costs can be written off as expenses.
• Learning from Mistakes: While sunk costs should not dictate decisions, they can still
provide valuable learning experiences. Examining why investments failed and what can
be done differently in the future is important. It's about applying lessons learned rather
than continuing to invest simply to recoup sunk costs.
 Long-run Production And Costs

• Production costs almost always decline when the scale of the

operation initially increases. We refer to this phenomenon simply
as economies of scale.
• Increasing returns to scale implies that, when all inputs are
increased by a given proportion, output increases more than
proportionately.
• Constant returns to scale implies that output increases in direct
proportion to an equal proportionate increase in all inputs.
• Decreasing returns to scale implies that an equal proportionate
increase in all inputs leads to a less than proportionate increase in
output.
 Long-run Production And Costs

• Long-run average total cost is the lower envelope of all the short-
run ATC curves.

• Minimum efficient scale defines a threshold size of operation

such that scale economies are almost exhausted.
 Technological Change: Globalization And
Localization
• Technological change represents innovation that can reduce the
cost of production or bring new products on line.
• Globalization is the tendency for international markets to be ever
more integrated.
 Clusters, Learning By Doing, Scope Economies

• Cluster: a group of firms producing similar products, or engaged in

similar research.
• Learning by doing can reduce costs. A longer history of
production enables firms to accumulate knowledge and thereby
implement more efficient production processes.
• Economies of scope occur if the unit cost of producing particular
products is less when combined with the production of other
products than when produced alone.
• A platform is a hardware-cum-software capital installation that has
multiple production capabilities.
• Source:Curtis, D. (2017). Principles of Microeconomics.