Managerial economics and organizational architecture 5e ch005

Managerial Economics and Organizational Architecture, 5e Managerial Economics and Organizational Architecture, 5e Chapter 5: Production and Cost McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc All Rights Reserved Managerial Economics and Organizational Architecture, 5e Production Functions A production function specifies maximum output from given inputs: Q = f ( x1 , x2 , xn ) 5-2 Managerial Economics and Organizational Architecture, 5e Returns to Scale • The relation between output and a proportional variation of all inputs together • Increasing returns to scale - if inputs double, output more than doubles • Decreasing returns to scale - if inputs double, output less than doubles • Constant returns to scale- if inputs double, output doubles 5-3 Managerial Economics and Organizational Architecture, 5e Returns to a Factor • The relation between output and the variation in only one input, holding all other inputs constant • Total product - amount of output, Q, obtained when an input, L, increases • Average product Q/L • Marginal product ∆Q/∆L 5-4 Managerial Economics and Organizational Architecture, 5e Returns to a Factor Production function: Q=S1/2A1/2 S A Q MPS APS 9 9 3.00 4.24 5.20 6.00 6.70 3.00 1.24 0.96 0.80 0.70 3.00 2.12 1.73 1.50 1.34 5-5 Managerial Economics and Organizational Architecture, 5e Returns to a Factor: A Common Case Total product S Q/S Quantity of auto parts per unit of steel Law of diminishing returns – at some point, S1, the marginal product of a variable factor will decline as its use is increased Quantity of auto parts Q Average product Marginal product S1 Quantity of steel S2 S 5-6 Managerial Economics and Organizational Architecture, 5e Illustrating Production Choices with Isoquants • Isoquants show all combinations of two inputs that produce the same level of output, assuming efficient production • Shape of isoquants indicates substitutability between inputs 5-7 Managerial Economics and Organizational Architecture, 5e Isoquants Isoquants Quantity of Aluminum • show all combinations of two inputs that produce the same level of output • Moving to the northeast implies greater output A 300 200 100 S Quantity of Steel 5-8 Managerial Economics and Organizational Architecture, 5e Differing Input Substitutability Isoquants A A Quantity of Aluminum A S Quantity of Steel Fixed proportions S Quantity of Steel Normal case S Quantity of Steel Perfect substitutes 5-9 Managerial Economics and Organizational Architecture, 5e Isocost Lines • Isocosts show all combinations of two inputs that have the same cost • The slope of an isocost line changes as input prices change 5-10 Managerial Economics and Organizational Architecture, 5e Cost Concepts • Total cost – relation between total cost and output • Marginal cost – change in total cost when output rises one unit • Average cost – total cost divided by total output • Opportunity cost – value of a resource in it next best alternative 5-16 Managerial Economics and Organizational Architecture, 5e Cost Curves Total costs (in dollars) $ Total cost Q Marginal cost (in dollars) Cost per unit of output $ Average cost Q1 Q2 Quantity of output Q 5-17 Managerial Economics and Organizational Architecture, 5e Short Run versus Long Run • Short run – at least one input is fixed – cost curves are operating curves • Long run – all inputs are variable – cost curves are planning curves 5-18 Managerial Economics and Organizational Architecture, 5e Fixed versus Variable Costs • Fixed costs – incurred even if firm produces nothing • Variable costs – change with the level of output 5-19 Managerial Economics and Organizational Architecture, 5e Short-Run Cost Curves $ Total costs (in dollars) Total cost Total variable cost Average total cost Marginal cost Average variable cost (in dollars) Cost per unit of output $ Average fixed cost Q1 Q2 Q3 Quantity of output Q 5-20 Managerial Economics and Organizational Architecture, 5e Long-Run Average Cost envelope of short-run average cost curves $ SRAC1 SRAC5 SRAC5 SRAC2 SRAC3 SRAC4 Q 5-21 Managerial Economics and Organizational Architecture, 5e Cost Concepts • Economies of scale – Average costs fall as output expands • Economies of scope – cost of producing a joint set of products is less than cost of producing separately in separate firms 5-22 Managerial Economics and Organizational Architecture, 5e Additional Cost Concepts • Minimum efficient scale – plant size at which long-run average cost first reaches its minimum point (Q*) – Helps determine the number of firms in an industry and therefore the level of competition • Learning curves – costs decline with production experience 5-23 Managerial Economics and Organizational Architecture, 5e Learning Curve $ (in dollars) Cost per unit of output Average cost of producing Q* units Learning curve ΣQ Cumulative quantity of output produced 5-24 Managerial Economics and Organizational Architecture, 5e Economies of Scale versus Learning Effects (in dollars) Cost per unit of output $ Learning effect Average cost with low cumulative volume Average cost with high cumulative volume Q Quantity of output 5-25 Managerial Economics and Organizational Architecture, 5e Profit Maximization • A firm should increase output as long as marginal revenue exceeds marginal cost • A firm should not increase output if marginal cost exceeds marginal revenue • At the profit-maximizing level of output, MR=MC 5-26 Managerial Economics and Organizational Architecture, 5e Optimal Output and Changes in Marginal Cost $ MC0 Cost/revenue per unit (in dollars) MC1 MR Q0 Q1 Quantity of output Q 5-27 Managerial Economics and Organizational Architecture, 5e Factor Demand Efficient production requires that MPi/Pi= MPj/Pj From which we derive the demand curve (marginal revenue product) for input i Pi=MR× MPi Marginal revenue product, MRP, is the addition to revenue from using one more unit of an input 5-28 Managerial Economics and Organizational Architecture, 5e Factor Demand Curve (in dollars) Cost/revenue per unit of input $ P*i MRPi Q*i Quantity of input i Qi 5-29 Managerial Economics and Organizational Architecture, 5e Cost Estimation • Effective management decisions should incorporate estimates of short- and long-run costs • Use regression analysis • Short-run costs may be approximately linear VC = a + bQ 5-30 ... Managerial Economics and Organizational Architecture, 5e Cost Minimization Quantity of aluminum A’ A* Q* S S’ S* 5-14 Quantity of steel Managerial Economics and Organizational Architecture, 5e. .. 5-28 Managerial Economics and Organizational Architecture, 5e Factor Demand Curve (in dollars) Cost/revenue per unit of input $ P*i MRPi Q*i Quantity of input i Qi 5-29 Managerial Economics and Organizational. .. change 5-10 Managerial Economics and Organizational Architecture, 5e Isocost Lines Quantity of aluminum 200 100 $100 line 200 Quantity of steel $200 line 400 5-11 Managerial Economics and Organizational