Production
1
Theory of the firm
Explanation of how a firm makes cost-minimizing production decisions
and how its cost varies with its output.
The Production Decisions of a Firm
The production decisions of firms are analogous to the purchasing decisions of
consumers, and can likewise be understood in three steps:
1. Production Technology
2. Cost Constraints
3. Input Choices
2
6.1 Firms and Their Production Decisions
Why Do Firms Exist?
Firms offer a means of coordination, missing if workers operated
independently.
Firms eliminate the need for every worker to negotiate every task they
will perform, and bargain over the fees for those tasks.
Firms can avoid this kind of bargaining by having managers that direct
the production of salaried workers— and the workers (as well as the
managers themselves) are simply paid a weekly or monthly salary.
3
The Technology of Production
Factors of production
Inputs into the production process (e.g., labor, capital, and materials).
Broad categories of labor, materials and capital, with more narrow subdivisions.
Labor inputs include skilled workers (carpenters, engineers) and unskilled
workers (agricultural workers), as well as the entrepreneurial efforts of the firm’s
managers.
Materials include steel, plastics, electricity, water, goods that the firm buys and
transforms into final products.
Capital includes land, buildings, machinery and other equipment, as well as
inventories.
4
The Production Function
Production function
Function showing the highest output that a firm can produce for every specified
combination of inputs. (6.1)
Production functions describe what is technically feasible when the firm
operates efficiently—that is, when the firm uses each combination of inputs as
effectively as possible.
The Short Run versus the Long Run
Short run Period of time in which quantities of one or more production
factors cannot be changed.
Fixed input Production factor that cannot be varied.
Long run Amount of time needed to make all production inputs
variable.
5
6.2 Production with One
Variable Input (Labor)
TABLE 6.1 PRODUCTION WITH ONE VARIABLE INPUT
AMOUNT OF AMOUNT OF TOTAL OUTPUT AVERAGE PRODUCT
MARGINAL PRODUCT (𝚫q/𝚫L)
LABOR (L) CAPITAL (K) (q) (q/L)
0 10 0 — —
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 −4
10 10 100 10 −8
6
Average and Marginal Products
Average product Output per unit of a particular input.
Marginal product Additional output produced as an input is increased by one
unit.
Marginal product of labor depends on the amount of capital used. If the capital
input increased from 10 to 20, the marginal product of labor most likely would
increase.
Average product of labor = Output/labor input = q/L
Marginal product of labor = Change in output/change in labor input = 𝚫q/𝚫L
7
The Slopes of the Product Curve
Figure 6.1 (1 of 2)
PRODUCTION WITH ONE VARIABLE
INPUT
Total product curve in (a) shows the output
produced for different amounts of labor input.
Average and marginal products in (b) can be
obtained (Table 6.1) from the total product
curve.
At point A in (a), the marginal product is 20
because the tangent to the total product
curve has a slope of 20.
At point B in (a) the average product of labor 2
0
is 20, which is the slope of the line from the
origin to B.
The average product of labor at point C in (a)
is given by the slope of the line 0C.
8
The Slopes of the Product Curve
Figure 6.1 (2 of 2)
PRODUCTION WITH ONE VARIABLE
INPUT
To the left of point E in (b), the marginal
product is above the average product and
the average is increasing; to the right of E,
the marginal product is below the average
product and the average is decreasing.
As a result, E represents the point at
which the average and marginal products
are equal, when the average product
reaches its maximum.
2
At D, when total output is maximized, the 0
slope of the tangent to the total product
curve is 0, as is the marginal product.
9
The Average Product of Labor Curve
In general, the average product of labor is given by the slope of the line drawn
from the origin to the corresponding point on the total product curve.
The Marginal Product of Labor Curve
In general, the marginal product of labor at a point is given by the slope of the
total product at that point.
THE RELATIONSHIP BETWEEN THE AVERAGE AND MARGINAL
PRODUCTS
When the marginal product of labor is greater than the average product, the
average product of labor increases.
At C in Fig 6.1, the average and marginal products of labor are equal.
Moving beyond C toward D, the marginal product falls below the average
product. Slope of the tangent to the total product curve at any point between C
and D is lower than the slope of the line from the origin. 10
The Law of Diminishing Marginal Returns
Law of diminishing marginal returns Principle that as the use of
an input increases with other inputs fixed, the resulting additions to output will
eventually decrease.
Figure 6.2
THE EFFECT OF TECHNOLOGICAL
IMPROVEMENT
Labor productivity (output per unit of
labor) can increase if there are
improvements in technology, even
though any given production process
exhibits diminishing returns to labor.
As we move from point A on curve O1
to B on curve O2 to C on curve O3 over
time, labor productivity increases.
11
Labor Productivity
Labor productivity Average product of labor for an entire
industry or for the economy as a whole.
PRODUCTIVITY AND THE STANDARD OF LIVING
Consumers in the aggregate can increase their rate of consumption in the long
run only by increasing the total amount they produce.
One of the most important sources of growth in labor productivity is growth in
the stock of capital.
Stock of capital Total amount of capital available for use in production.
Technological change Development of new technologies allowing factors of
production to be used more effectively.
12
6.3 Production with Two Variable Inputs
Isoquants
Curve showing all possible combinations of inputs that yield the same output.
TABLE 6.4 PRODUCTION WITH TWO VARIABLE INPUTS
LABOR INPUT
CAPITAL INPUT 1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120
ISOQUANT MAPS
Graph combining a number of isoquants, used to describe a production
function.
13
Figure 6.5
PRODUCTION WITH TWO
VARIABLE INPUTS
A set of isoquants, or isoquant
map, describes the firm’s
production function.
Output increases as we move
from isoquant q1 (at which 55
units per year are produced at
points such as A and D), to
isoquant q2 (75 units per year at
points such as B), and to
isoquant q3 (90 units per year at
points such as C and E).
By drawing a horizontal line at a particular level of capital—say 3, we can observe
diminishing marginal returns. Reading the levels of output from each isoquant as
labor is increased, we note that each additional unit of labor generates less and
less additional output. 14
Input Flexibility
Isoquants show the flexibility that firms have when making production
decisions: They can usually obtain a particular output by substituting one input
for another. It is important for managers to understand the nature of this
flexibility.
Diminishing Marginal Returns
Even though both labor and capital are variable in the long run, it is useful for a
firm that is choosing the optimal mix of inputs to ask what happens to output as
each input is increased, with the other input held fixed.
Because adding one factor while holding the other factor constant eventually
leads to lower and lower incremental output, the isoquant must become steeper
as more capital is added in place of labor and flatter when labor is added in
place of capital.
There are also diminishing marginal returns to capital. With labor fixed, the
marginal product of capital decreases as capital is increased. 15
Substitution Among Inputs
Marginal rate of technical substitution (MRTS) Amount by
which the quantity of one input can be reduced when one extra unit of another
input is used, so that output remains constant.
DIMINISHING MRTS
Because we are keeping output constant by moving along an isoquant, the total
change in output must be zero. Thus,
Now, by rearranging terms we see that
(6.2)
16
Figure 6.6
MARGINAL RATE OF
TECHNICAL SUBSTITUTION
Like indifference curves,
isoquants are downward
sloping and convex. The
slope of the isoquant at any
point measures the marginal
rate of technical substitution
—the ability of the firm to
replace capital with labor
while maintaining the same
level of output.
On isoquant q2, the MRTS
falls from 2 to 1 to 2/3 to 1/3.
17
Production Functions—Two Special Cases
Two extreme cases of production functions show the possible range of
input substitution in the production process: the case of perfect substitutes and
the fixed proportions production function, sometimes called a Leonitief
production function.
Fixed-proportions production function Production function with L-shaped
isoquants, so that only one combination of labor and capital can be used to
produce each level of output.
The fixed-proportions production function describes situations in which
methods of production are limited.
18
Figure 6.7
ISOQUANTS WHEN INPUTS
ARE PERFECT SUBSTITUTES
When the isoquants are
straight lines, the MRTS is
constant. Thus the rate at
which capital and labor can be
substituted for each other is the
same no matter what level of
inputs is being used.
Points A, B, and C represent
three different capital-labor
combinations that generate the
same output q3.
19
Figure 6.8
FIXED-PROPORTIONS
PRODUCTION FUNCTION
When the isoquants are L-
shaped, only one combination
of labor and capital can be
used to produce a given output
(as at point A on isoquant q1,
point B on isoquant q2, and
point C on isoquant q3). Adding
more labor alone does not
increase output, nor does
adding more capital alone.
20
EXAMPLE 6.4 A PRODUCTION FUNCTION FOR WHEAT
Food grown on large farms in the United States is usually produced with a capital-
intensive technology. However, food can also be produced using very little capital
(a hoe) and a lot of labor (several people with the patience and stamina to
work the soil).
Most farms in the United States and Canada, where labor is relatively expensive,
operate in the range of production in which the MRTS is relatively high (with a high
capital-to-labor ratio), whereas farms in developing countries, in which labor is
cheap, operate with a lower MRTS (and a lower capital-to-labor ratio).
The exact labor/capital combination to use depends on input prices.
21
EXAMPLE 6.4 A PRODUCTION FUNCTION FOR WHEAT
Figure 6.9
ISOQUANT DESCRIBING THE
PRODUCTION OF WHEAT
A wheat output of 13,800
bushels per year can be
produced with different
combinations of labor and
capital.
The more capital-intensive
production process is shown
as point A, the more labor-
intensive process as point B.
The marginal rate of technical
substitution between A and B
is 10/260 = 0.04.
22
6.4 Returns to Scale
Returns to scale Rate at which output increases as inputs are
increased proportionately.
INCREASING RETURNS TO SCALE
Situation in which output more than doubles when all inputs are doubled.
CONSTANT RETURNS TO SCALE
Situation in which output doubles when all inputs are doubled.
DECREASING RETURNS TO SCALE
Situation in which output less than doubles when all inputs are doubled.
23
Figure 6.10
RETURNS TO SCALE
When a firm’s production process exhibits However, when there are increasing
constant returns to scale as shown by a returns to scale as shown in (b), the
movement along line 0A in part (a), the isoquants move closer together as
isoquants are equally spaced as output inputs are increased along the line.
increases proportionally.
24
Describing Returns to Scale
Returns to scale need not be uniform across all possible levels of
output. For example, at lower levels of output, the firm could have increasing returns
to scale, but constant and eventually decreasing returns at higher levels of output.
In Figure 6.10 (a), the firm’s production function exhibits constant returns. Twice as
much of both inputs is needed to produce 20 units, and three times as much is
needed to produce 30 units.
In Figure 6.10 (b), the firm’s production function exhibits increasing returns to scale.
Less than twice the amount of both inputs is needed to increase production from 10
units to 20; substantially less than three times the inputs are needed to produce 30
units.
Returns to scale vary considerably across firms and industries. Other things being
equal, the greater the returns to scale, the larger the firms in an industry are likely to
be.
25
Cost of production
26
7.1 Measuring Cost: Which Costs Matter?
Economic Cost versus Accounting Cost
Accounting cost Actual expenses plus depreciation charges for capital
equipment.
Economic cost Cost to a firm of utilizing economic resources in production.
Opportunity Cost Cost associated with opportunities forgone when a firm’s
resources are not put to their best alternative use.
The concept of opportunity cost is particularly useful in situations where
alternatives that are forgone do not reflect monetary outlays.
Economic cost = Opportunity cost
Sunk Costs Expenditure that has been made and cannot be recovered.
Because a sunk cost cannot be recovered, it should not influence the firm’s
decisions. A prospective sunk cost is an investment. Here the firm must decide
whether that investment in specialized equipment is economical. 27
Fixed Costs and Variable Costs
Total cost (TC or C) Total economic cost of production, consisting
of fixed and variable costs.
Fixed cost (FC) Cost that does not vary with the level of output and that can
be eliminated only by shutting down.
Variable cost (VC) Cost that varies as output varies.
Fixed cost does not vary with the level of output—it must be paid even if
there is no output. The only way that a firm can eliminate its fixed costs is by
shutting down.
28
SHUTTING DOWN
Shutting down doesn’t necessarily mean going out of business.
By reducing the output of that factory to zero, the company could eliminate the
costs of raw materials and much of the labor, but it would still incur the fixed
costs of paying the factory’s managers, security guards, and ongoing
maintenance. The only way to eliminate those fixed costs would be to close the
doors, turn off the electricity, and perhaps even sell off or scrap the machinery.
FIXED OR VARIABLE?
How do we know which costs are fixed and which are variable?
Over a very short time horizon—say, a few months—most costs are fixed.
Over such a short period, a firm is usually obligated to pay for contracted
shipments of materials.
Over a very long time horizon—say, ten years—nearly all costs are variable.
Workers and managers can be laid off (or employment can be reduced by
attrition), and much of the machinery can be sold off or not replaced as it
becomes obsolete and is scrapped. 29
Fixed versus Sunk Costs
Shutting down doesn’t necessarily mean going out of business. Fixed costs can
be avoided if the firm shuts down a plant or goes out of [Link] costs,
on the other hand, are costs that have been incurred and cannot be recovered.
When a firm’s equipment is too specialized to be of use in any other industry,
most if not all of this expenditure is sunk, i.e., cannot be recovered.
Why distinguish between fixed and sunk costs?
Fixed costs affect the firm’s decisions looking forward, sunk costs do not.
Fixed costs that are high relative to revenue and cannot be reduced might lead
a firm to shut down—eliminating those fixed costs and earning zero profit might
be better than incurring ongoing losses.
Incurring a high sunk cost might later turn out to be a bad decision, but the
expenditure is gone and cannot be recovered by shutting down.
30
AMORTIZING SUNK COSTS
Amortization Policy of treating a one-time expenditure as an annual cost
spread out over some number of years.
Amortizing large capital expenditures and treating them as ongoing fixed costs
can simplify the economic analysis of a firm’s operation.
For simplicity, we will usually treat sunk costs in this way as we examine the
firm’s production decisions.
31
EXAMPLE 7.2 SUNK, FIXED, AND VARIABL E COSTS:
COMPUTERS, SOFTWARE, AND PIZZAS
It is important to understand the characteristics of production costs and to be able to
identify which costs are fixed, which are variable, and which are sunk.
Good examples include the personal computer industry (where most costs are variable),
the computer software industry (where most costs are sunk), and the pizzeria business
(where most costs are fixed).
Because computers are very similar, competition is intense, and profitability depends on
the ability to keep costs down. Most important are the cost of components and labor.
A software firm will spend a large amount of money to develop a new application. The
company can recoup its investment by selling as many copies of the program as
possible.
For the pizzeria, sunk costs are fairly low because equipment can be resold if the pizzeria
goes out of business. Variable costs are low—mainly the ingredients for pizza and
perhaps wages for a workers to produce and deliver pizzas.
32
Marginal and Average Cost
TABLE 7.1 A FIRM’S COSTS
RATE OF FIXED COST VARIABLE COST TOTAL COST MARGINAL AVERAGE FIXED AVERAGE AVERAGE
OUTPUT (DOLLARS PER (DOLLARS PER (DOLLARS PER COST (DOLLARS COST (DOLLARS VARIABLE COST TOTAL COST
(UNITS PER YEAR) YEAR) YEAR) PER UNIT) PER UNIT) (DOLLARS PER (DOLLARS PER
YEAR) UNIT) UNIT)
(FC) (1) (VC) (2) (TC) (3) (MC) (4) (AFC) (5) (AVC) (6) (ATC) (7)
0 50 0 50 — — — —
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
33
MARGINAL COST (MC)
Marginal cost (MC) Increase in cost resulting from the production of one
extra unit of output.
Because fixed cost does not change as the firm’s level of output changes,
marginal cost is equal to the increase in variable cost or the increase in total
cost that results from an extra unit of output.
AVERAGE TOTAL COST (ATC)
Average total cost (ATC) Firm’s total cost divided by its level of output.
Average fixed cost (AFC) Fixed cost divided by the level of output.
Average variable cost (AVC) Variable cost divided by the level of output.
34
7.2 Costs in the Short Run
The Determinants of Short-Run Cost
The change in variable cost is the per-unit cost of the extra labor w times
the amount of extra labor needed to produce the extra output ΔL. Because
ΔVC = wΔL, it follows that
The extra labor needed to obtain an extra unit of output is ΔL/Δq = 1/MPL. As
a result,
• (7.1)
DIMINISHING MARGINAL RETURNS AND MARGINAL COST
Diminishing marginal returns means that the marginal product of labor
declines as the quantity of labor employed increases.
As a result, when there are diminishing marginal returns, marginal cost
will increase as output increases.
35
The Shapes of the Cost Curves
FIGURE 7.1
COST CURVES FOR A FIRM
In (a) total cost TC is the
vertical sum of fixed cost FC
and variable cost VC.
In (b) average total cost ATC
is the sum of average variable
cost AVC and average fixed
cost AFC.
Marginal cost MC crosses the
average variable cost and
average total cost curves at
their minimum points.
36
THE AVERAGE-MARGINAL RELATIONSHIP
Marginal and average costs are another example of the average-marginal relationship
described in Chapter 6 (with respect to marginal and average product).
Because average total cost is the sum of average variable cost and average fixed cost
and the AFC curve declines everywhere, the vertical distance between the ATC and
AVC curves decreases as output increases.
TOTAL COST AS A FLOW
Total cost is a flow: the firm produces a certain number of units per year. Thus its total
cost is a flow—for example, some number of dollars per year. For simplicity, we will often
drop the time reference, and refer to total cost in dollars and output in units.
Knowledge of short-run costs is particularly important for firms that operate in an
environment in which demand conditions fluctuate considerably. If the firm is currently
producing at a level of output at which marginal cost is sharply increasing, and if demand
may increase in the future, management might want to expand production capacity to
avoid higher costs. 37
7.3 Cost in the Long Run
The User Cost of Capital
User cost of capital Annual cost of owning and using a capital asset, equal
to economic depreciation plus forgone interest.
The user cost of capital is given by the sum of the economic depreciation and
the interest (i.e., the financial return) that could have been earned had the
money been invested elsewhere. Formally,
•
We can also express the user cost of capital as a rate per dollar of
capital:
•
38
The Cost-Minimizing Input Choice
We now turn to a fundamental problem that all firms face: how to
select inputs to produce a given output at minimum cost.
For simplicity, we will work with two variable inputs: labor (measured in hours of
work per year) and capital (measured in hours of use of machinery per year).
THE PRICE OF CAPITAL
The price of capital is its user cost, given by r = Depreciation rate + Interest rate.
THE RENTAL RATE OF CAPITAL
Cost per year of renting one unit of capital.
If the capital market is competitive, the rental rate should be equal to the
user cost, r. Why? Firms that own capital expect to earn a competitive
return when they rent it. This competitive return is the user cost of capital.
Capital that is purchased can be treated as though it were rented at a rental
rate equal to the user cost of capital. 39
The Isocost Line
● isocost line Graph showing all possible combinations of labor and
capital that can be purchased for a given total cost.
To see what an isocost line looks like, recall that the total cost C of producing
any particular output is given by the sum of the firm’s labor cost wL and its
capital cost rK:
• (7.2)
If we rewrite the total cost equation as an equation for a straight line,
we get
•
It follows that the isocost line has a slope of ΔK/ΔL = −(w/r), which is
the ratio of the wage rate to the rental cost of capital.
40
Choosing Inputs
FIGURE 7.3
PRODUCING A GIVEN
OUTPUT AT MINIMUM COST
Isocost curves describe the
combination of inputs to
production that cost the
same amount to the firm.
Isocost curve C1 is tangent to
isoquant q1 at A and shows
that output q1 can be
produced at minimum cost
with labor input L1 and
capital input K1.
Other input combinations—
L2, K2 and L3, K3-yield the
same output but at higher
41
cost.
FIGURE 7.4
INPUT SUBSTITUTION
WHEN AN INPUT PRICE
CHANGES
Facing an isocost curve C1,
the firm produces output q1
at point A using L1 units of
labor and K1 units of capital.
When the price of labor
increases, the isocost curves
become steeper.
Output q1 is now produced at
point B on isocost curve C2
by using L2 units of labor and
K2 units of capital.
42
Recall that in our analysis of production technology, we showed that the
marginal rate of technical substitution of labor for capital (MRTS) is the negative
of the slope of the isoquant and is equal to the ratio of the marginal products of
labor and capital:
• (7.3)
It follows that when a firm minimizes the cost of producing a particular
output, the following condition holds:
•
We can rewrite this condition slightly as follows:
• (7.4)
43
FIGURE 7.6
A FIRM’S EXPANSION PATH
AND LONG-RUN TOTAL
COST CURVE
In (a), the expansion path
(from the origin through points
A, B, and C) illustrates the
lowest-cost combinations of
labor and capital that can be
used to produce each level of
output in the long run— i.e.,
when both inputs to
production can be varied.
In (b), the corresponding
long-run total cost curve (from
the origin through points D, E,
and F) measures the least
cost of producing each level
of output. 44
EXAMPLE 7.5 REDUCING THE USE OF ENERGY
FIGURE 7.7a
ENERGY EFFICIENCY
THROUGH CAPITAL
SUBSTITUTION FOR LABOR
Greater energy efficiency can
be achieved if capital is
substituted for energy.
This is shown as a movement
along isoquant q1 from point A
to point B, with capital
increasing from K1 to K2 and
energy decreasing from E2 to
E1 in response to a shift in the
isocost curve from C0 to C1.
45
EXAMPLE 7.5 REDUCING THE USE OF ENERGY
FIGURE 7.7b
ENERGY EFFICIENCY
THROUGH
TECHNOLOGICAL CHANGE
Technological change implies that
the same output can be produced
with smaller amounts of inputs.
Here the isoquant labeled q1 shows
combinations of energy and capital
that will yield output q1; the
tangency with the isocost line at
point C occurs with energy and
capital combinations E2 and K2.
Because of technological change
the isoquant shifts inward, so the
same output q1 can now be
produced with less energy and
capital, in this case at point D, with
energy and capital combination E1
46
and K .
Long-Run Average Cost
In the long run, the ability to change the amount of capital allows the
firm to reduce costs.
The most important determinant of the shape of the long-run average and
marginal cost curves is the relationship between the scale of the firm’s
operation and the inputs that are required to minimize its costs.
Long-run average cost curve (LAC) Curve relating average cost of
production to output when all inputs, including capital, are variable.
Short-run average cost curve (SAC) Curve relating average cost of
production to output when level of capital is fixed.
Long-run marginal cost curve (LMC) Curve showing the change in
long-run total cost as output is increased incrementally by 1 unit.
47
FIGURE 7.9
LONG-RUN AVERAGE AND
MARGINAL COST
When a firm is producing at
an output at which the long-
run average cost LAC is
falling, the long-run
marginal cost LMC is less
than LAC.
Conversely, when LAC is
increasing, LMC is greater
than LAC.
The two curves intersect at
A, where the LAC curve
achieves its minimum.
48
Economies and Diseconomies of Scale
As output increases, the firm’s average cost of producing that output is
likely to decline, at least to a point.
This can happen for the following reasons:
1. If the firm operates on a larger scale, workers can specialize in the
activities at which they are most productive.
2. Scale can provide flexibility. By varying the combination of inputs utilized to
produce the firm’s output, managers can organize the production process
more effectively.
3. The firm may be able to acquire some production inputs at lower cost
because it is buying them in large quantities and can therefore negotiate
better prices. The mix of inputs might change with the scale of the firm’s
operation if managers take advantage of lower-cost inputs. 49
At some point, however, it is likely that the average cost of production
will begin to increase with output.
There are three reasons for this shift:
1. At least in the short run, factory space and machinery may make it more
difficult for workers to do their jobs effectively.
2. Managing a larger firm may become more complex and inefficient as the
number of tasks increases.
3. The advantages of buying in bulk may have disappeared once certain
quantities are reached. At some point, available supplies of key inputs may
be limited, pushing their costs up.
50
Economies of scale Situation in which output can be doubled for
less than a doubling of cost.
Diseconomies of scale Situation in which a doubling of output requires more
than a doubling of cost.
Increasing Returns to Scale: Output more than doubles when the quantities of all
inputs are doubled.
Economies of Scale: A doubling of output requires less than a doubling of cost.
Economies of scale are often measured in terms of a cost-output elasticity,
EC. EC is the percentage change in the cost of production resulting from a
1-percent increase in output:
• (7.5)
To see how EC relates to our traditional measures of cost, rewrite equation as
follows:
• (7.6)
51
The Relationship between Short-Run and Long-Run Cost
FIGURE 7.10
LONG-RUN COST WITH
ECONOMIES AND
DISECONOMIES OF SCALE
The long-run average cost
curve LAC is the envelope of
the short-run average cost
curves SAC1, SAC2, and
SAC3.
With economies and
diseconomies of scale, the
minimum points of the short-
run average cost curves do
not lie on the long-run
average cost curve.
52
7.5 Production with Two Outputs—
Economies of Scope
Product Transformation Curves
Product transformation curve Curve showing the various combinations of two
different outputs (products) that can be produced with a given set of inputs.
FIGURE 7.11
PRODUCT
TRANSFORMATION CURVE
The product transformation curve
describes the different
combinations of two outputs that
can be produced with a fixed
amount of production inputs.
The product transformation
curves O1 and O2 are bowed out
(or concave) because there are
economies of scope in
production.
53
Economies and Diseconomies of Scope
Economies of scope Situation in which joint output of a single firm
is greater than output that could be achieved by two different firms when each
produces a single product.
Diseconomies of scope Situation in which joint output of a single firm is less
than could be achieved by separate firms when each produces a single
product.
The Degree of Economies of Scope
To measure the degree to which there are economies of scope, we should ask
what percentage of the cost of production is saved when two (or more)
products are produced jointly rather than individually.
•
(7.7)
Degree of economies of scope (SC) Percentage of cost savings resulting
when two or more products are produced jointly rather than Individually.
54
EXAMPLE 7.6 ECONOMIES OF SCOPE IN THE TRUCKING INDUSTRY
In the trucking business, several related products
can be offered, depending on the size of the load
and the length of the haul. This range of possibilities
raises questions about both economies of scale and
economies of scope.
The scale question asks whether large-scale, direct
hauls are more profitable than individual hauls by
small truckers. The scope question asks whether a
large trucking firm enjoys cost advantages in operating direct quick hauls and indirect,
slower hauls.
Because large firms carry sufficiently large truckloads, there is usually no advantage to
stopping at an intermediate terminal to fill a partial load.
Because other disadvantages are associated with the management of very large firms, the
economies of scope get smaller as the firm gets bigger.
The study suggests, therefore, that to compete in the trucking industry, a firm must be
large enough to be able to combine loads at intermediate stopping points.
55
7.6 Dynamic Changes in Costs—
The Learning Curve Graph relating amount of inputs needed by a firm to
produce each unit of output to its cumulative output.
As management and labor gain experience with production, the firm’s
marginal and average costs of producing a given level of output fall for four
reasons:
1. Workers often take longer to accomplish a given task the first few times
they do it. As they become more adept, their speed increases.
2. Managers learn to schedule the production process more effectively,
from the flow of materials to the organization of the manufacturing itself.
3. Engineers who are initially cautious in their product designs may gain
enough experience to be able to allow for tolerances in design that save
costs without increasing defects. Better and more specialized tools and
plant organization may also lower cost.
4. Suppliers may learn how to process required materials more effectively
and pass on some of this advantage in the form of lower costs. 56
Graphing the Learning Curve
FIGURE 7.12
THE LEARNING CURVE
A firm’s production cost may
fall over time as managers
and workers become more
experienced and more
effective at using the
available plant and
equipment.
The learning curve shows the
extent to which hours of labor
needed per unit of output fall
as the cumulative output The learning curve is based on the relationship
increases.
(7.8)
57
Learning versus Economies of Scale
FIGURE 7.13
ECONOMIES OF SCALE
VERSUS LEARNING
A firm’s average cost of
production can decline over
time because of growth of
sales when increasing returns
are present (a move from A to
B on curve AC1),
or it can decline because
there is a learning curve (a
move from A on curve AC1 to
C on curve AC2).
58
EXAMPLE 7.7 THE LEARNING CURVE IN PRACTICE
Learning-curve effects can be important in determining the
shape of long-run cost curves and can thus help guide
management decisions.
Managers can use learning-curve information to decide
whether a production operation is profitable and, if so, how
to plan how large the plant operation and the volume of
cumulative output need be to generate a positive cash flow.
FIGURE 7.14
LEARNING CURVE FOR
AIRBUS INDUSTRIE
The learning curve relates the labor
requirement per aircraft to the
cumulative number of aircraft
produced.
As the production process becomes
better organized and workers gain
familiarity with their jobs, labor
requirements fall dramatically.
59
Cost Functions and the Measurement of Scale Economies
The scale economies index (SCI) provides an index of whether or not
there are scale economies.
SCI is defined as follows: • (7.12)
FIGURE 7.16
CUBIC COST FUNCTION
A cubic cost function implies that the average and the marginal cost curves are
U-shaped. 60
