CHAPTER 9: Production Costs and Business Decisions

CHAPTER 9 Production Costs and Business Decisions The economist’s stock in trade—his tools—lies in his ability to and proclivity to think about all questions in terms of alternatives. The truth judgment of the moralist, which says that something is either wholly right or wholly wrong, is foreign to him. The win- list, yes-no discussion of politics is not within his purview. He does not recognize the either-or, the all-or-nothing situation as his own. His is not the world of the mutually exclusive. Instead, his is the world of adjustment, of coordinated conflict, of mutual gain. James M. Buchanan ost is pervasive in human action. Managers (as well as everyone else) are constantly forced to make choices, to do one thing and not another. Cost -- or more precisely, opportunity cost -- is the most highly valued opportunity not chosen. Although money is a frequently used measure of cost, it is not cost itself. Although we may not recognize it, cost also pervades our everyday thought and conversation. When we say “that course is difficult” or “the sermon seemed endless,” we are indicating the cost of activities. If the preacher’s extended commentary delayed the church picnic, the sermon was costly. Although complaints about excessive costs sometimes indicate an absolute limitation, more often they merely mean that the benefits of the activity are too small to justify the cost. Many people who “can’t afford” a vacation actually have the money but do not wish to spend it on travel, and most students who find writing research papers “impossible” are simply not willing to put forth the necessary effort. This chapter explores the meaning of cost in human behavior. We will begin by showing how seemingly irrational behavior can often be explained by the hidden costs of a choice. We will then develop the concept of marginal cost, which together with demand and the related concept of supply defines the limits of rational behavior, from personal activities like painting and fishing to business decisions like how much to produce. Inevitably, points made earlier will be reviewed and extended in this chapter. There is a cost in this repetition, but there is also some benefit in a few varied reiterations. We will use the cost analysis to make points that seem to defy common sense in business. For example, we will show that a firm should not necessarily seek to produce at the level at which the average cost of production is minimized. C Chapter 9 Production Costs and Business Decisions 2 Explicit and Implicit Costs Not all costs are obvious. It is not difficult to recognize an out-of-pocket expenditure— the monthly price you pay for a product or service. This is called an explicit cost. Explicit cost is the money expenditure required to obtain a resource, product, or service. For example, the price of your book is an explicit cost of taking a course in economics. Other costs are less immediately apparent. Hidden costs of the course might include the time spent going to class and studying, the risk of receiving a failing grade, and the discomfort of being confronted with material that may challenge some of your beliefs. These are implicit costs; together they add up to the value of what you could have done instead. Implicit cost is the forgone opportunity to do or squire something else or to put one’s resources to another use. Although implicit costs may not be recognized, they are often much larger than the more obvious explicit costs of an action. (Then, there are some “costs” that are recognized on accounting statements that should not be considered in making business decisions. These costs are called “sunk costs.” See the box on the next page.) The Cost of an Education A good illustration of the magnitude of implicit costs is the cost of an education. Suppose an MBA student—Eileen Payne—takes a course and pays $2,000 for tuition and $200 for books. The money cost of the course is $2,200, but that figure does not include the implicit costs to the student. To take a course, Eileen must attend class for about 45 hours and may have to spend twice that much time traveling to and from class, completing class assignments, and studying for examinations. The total number of hours spent on any one course, then, might be 135 (30 hours in class plus 105 hours of traveling, studying, and so forth). The student could have spent that time doing other things, including working for a money wage. If Eileen’s time is valued at $25 per hour (the wage she might have received if working), the time cost of the course is $3,375 (135 hours x $6). Moreover, if she experiences some anxiety because of taking the course, that psychic or risk cost must be added to the total as well. If Eileen would be willing to pay $500 to avoid the anxiety, the total implicit cost of taking the course climbs to $820. Explicit costs Tuition $2,000 Books 200 Total explicit cost $2,200 Implicit costs Time $3,375 Anxiety 500 Total implicit cost $3,875 Total costs of course $6,075 Chapter 9 Production Costs and Business Decisions 3 The opportunity cost of the student’s time represents the largest component of the total cost of the course. The value of one’s time varies from person to person. For students who are unable to find work, the time costs of taking a course may be quite small. That is why many young people go to college. Their time cost is generally lower than that of experienced workers who must give up the opportunity to earn a good wage in order to attend classes full time. The Cost of Bargains Every Wednesday, supermarkets run large newspaper ads listing their weekly specials. Generally only a few items are offered at especially low prices, for store managers know that most bargain seekers can be attracted to the store with just a few carefully selected specials. Once the customer has gone to the store offering a special on steak, he would have to incur a travel cost in order to buy other items in a different store. Even though peanut butter may be on sale elsewhere, the sum of the sale price and the travel cost exceed the regular price in the first store. Through attractive displays and packaging, customers can be persuaded to buy many other goods not on sale, particularly toiletries, which tend to bear high markups. Supermarket chains do not necessarily make huge profits. The grocery industry is reasonably competitive, and supermarket chains as a group are not highly profitable compared to other corporations. The stores manage to recoup some of the revenues lost on sale items by charging higher prices on other goods. In other words, the cost of a bargain on sirloin steak may be a high price for toothpaste. PERSPECTIVE: Why “Sunk Costs” Don’t Matter A sunk cost is a past cost. Economists define past costs as historical costs that cannot be altered by current decisions. Such costs are beyond the realm of choice. Will a rational, profit-maximizing business firm base its current decisions on its historical costs? An example can help to answer this question. Suppose an oil exploration firm purchases the mineral rights to a particular piece of property for $1 million. After several month of drilling, the firm concludes that the land contains no oil (or other valuable mineral resources). Will the firm reason that, having spent $1 million for the mineral rights, it should continue to look for oil on the land? If the chances of finding oil are nonexistent, the rational firm will cease drilling on the land and try somewhere else. The $1 million is a sunk cost that will not influence the decision to continue or cease exploration. Indeed, the firm may begin drilling on land for which it paid far less for mineral rights, if management believes that the chances of finding oil are higher there than on the $1 million property. The underlying reason that sunk costs do not matter to current production decisions is that in the economist’s use of the term, sunk costs are not really costs. The opportunity cost of an activity is the value of the best alternative not chosen. In the case of an historical cost, however, there are no longer any alternatives. Although the oil exploration firm at one time could have chosen an alternative way to spend the $1 million, once the choice was made the alternative ceased to be available. Nor can the firm resell the mineral rights for $1 million; those rights are now worth far less because of accumulated evidence that the land contains little or no valuable minerals. Sunk costs, however painful the memory of them might be, are gone and best forgotten by the firm. Profits are made by looking forward, not backward. Chapter 9 Production Costs and Business Decisions 4 Some shoppers make the rounds of the grocery stores when sales are announced. For such people, time and transportation are cheap. A person who values his or her time at $10 an hour is not going to spend an hour trying to save a dollar or two. The cost of gas alone can make it prohibitively expensive to visit several stores. Because of the costs of acquiring information, many shoppers do not even bother to look for sales. The expected benefits are simply not great enough to justify the information cost. These shoppers enter the market “rationally ignorant.” Marginal Cost So far we have been considering cost as the determining factor in the decision to undertake a particular course of action. The rational person weight the cost of an action against it benefits and comes to a decision: whether to invest in an education, to shop around for a bargain, or to operate an airplane. The question is, how much of a given good or service will an individual choose to produce or consume? How does cost limit a behavior once a person has decided to engage in it? The answer lies in the concept of marginal cost. Rational Behavior and Marginal Cost Marginal cost is the additional cost incurred by producing one additional unit of a good, activity, or service. Marginal cost is the cost incurred by reading one additional page, making one additional friend, giving one additional gift, or going one additional mile. Depending on the good, activity, or service in question, marginal cost may stay the same or vary as additional units are produced. For example, imagine that Jan smith wants to give Halloween candy to ten of her friends. In a sense, Jan is producing gifts by procuring bags of candy. If she can buy as many bags as she wants at a unit price of fifty cents, the marginal cost of each additional unit she buys is the same, fifty cents. The marginal cost is constant over the range of production. Marginal cost can vary with the level of output, however, for two reasons. The first has to do with the opportunity cost of time. Suppose Jan wants to give each friend a miniature watercolor, which she will paint herself over the course of the day. To make time for painting, Jan can forgo any of the various activities that usually make up her day. She may choose to give up recreational activities, housekeeping chores, or time spent on work or study. If she behaves rationally, she will give up the activities she values least. To do the first painting, she may forgo straightening up her room—an activity that is low on most people’s lists of preferences. The marginal cost of her first watercolor is therefore a messy room. To paint the second watercolor, Jan will give up the more next-to-last item on her list of favorite activities. As she produces more and more paintings, Jan will forgo more and more valuable alternatives. In other words, the marginal cost of her paintings will rise with her output. If the marginal cost of each new painting is plotted against the quantity of paintings produced, a curve like the one in Figure 9.1 will result. Because the marginal Chapter 9 Production Costs and Business Decisions 5 cost of each additional painting is higher than the marginal cost of the last one, the curve slopes upward to the right. Although the marginal cost curve is generally assumed to slope upward, as the one in Figure 9.1 does, that need not be the case. If Jan placed equal value on all the forgone activities, her marginal cost would be constant and the marginal cost curve would be horizontal. FIGURE 9.1 Rising Marginal Cost To produce each new watercolor, Jan must give up an opportunity more valuable than the last. Thus the marginal cost of her paintings rises with each new work. __________________________________ The Law of Diminishing Returns The second reason marginal cost may vary with output involves a technological relationship known as the law of diminishing marginal returns. According to the law of diminishing marginal returns, as more and more units of one resource -- labor, fertilizer, or any other resource -- are applied to a fixed quantity of another resource -- land, for instance -- the increase in total added output gained from each additional unit of the variable resource will eventually begin to diminish. In other words, beyond some point less output is received for each added unit of a resource. That is, more of the resource will be required to produce the same amount of output as before. Beyond some point, the marginal cost of additional units of output rises. Although the law of diminishing returns applies to any production process, its meaning is most easily grasped in the context of agricultural production. Assume you are producing tomatoes. You have a fixed amount of land (an acre) but can vary the quantity of labor you apply to it. If you try to do planting all by yourself -- dig the holes, pour the water, insert the plants, and core them up -- you will waste time changing tools. If a friend helps you, you can divide the tasks and specialize. Less time will be wasted in changing tools. Chapter 9 Production Costs and Business Decisions 6 The time you would have spent changing tools can be spent planting more tomatoes, thus increasing the harvest. At first, output may expand faster than the labor force. That is, one laborer may be able to plant 100 tomatoes an hour; two working together may be able to plant 250 an hour. Thus the marginal cost of planting the additional 150 plants is lower than the cost of the first 100. Up to a point, the more workers, the greater their efficiency, and the lower the marginal cost—all because of the economies of specialization. At some point, however, the addition of still more laborers will not contribute as much to production as in the past, if only because a large number of workers on a single acre of ground will start bumping into one another. Then the marginal cost of putting plants into the ground will begin to rise. Diminishing returns are an inescapable fact of life. If returns did not diminish at some point, output would expand indefinitely and the world’s food supply could be grown on just one acre of land (For that matter, it could be grown in a flower box.) The point at which output begins to diminish varies from one production process to the next, but eventually all marginal cost curves will slope upward to the right, as in Figure 9.1. Table 9.1 shows the marginal cost of producing tomatoes with various numbers of workers, assuming that each worker is paid $5 and that production is limited to one acre. Working alone, one worker can produce a quarter of a bushel; two can produce a full bushel (columns 1 and 2). The third column shows the amount each additional worker adds to total production, called the marginal product. Marginal product is the increase in total output that results when one additional unit of a resource—for example, labor, fertilizer, and land -- is added to the production process, everything else held constant. The first worker contributed 0.25 (one quarter) of a bushel; the second worker, an additional 0.75 of a bushel, and so on. These are the marginal products of successive units of labor. The important information is shown in the last two columns of the table. Although two workers are needed to produce the first bushel (column 4), because of the efficiencies of specialization, only one additional worker is needed to produce the second. Beyond that point, however, returns diminish. Each additional worker contributes less, so that two more workers are needed to produce the third bushel and give more to produce the fourth. If the table were extended, each bushel beyond the fourth would require a progressively larger number of workers. Column 5 shows that if all workers are paid the same wage, $5, the marginal cost of a bushel of tomatoes will decline from $10 for the first bushel to $5 for the second before rising to $10 again for the third bushel. That is, increasing marginal costs (or diminishing returns) emerge after the addition of the third worker. If the marginal cost of each bushel (column 5) is plotted against the number of bushels harvested, a curve like the one in Figure 9.2 will result. Although the curve slopes downward at first, for most purposes the relevant segment of the curve is the upward-sloping portion above point a, will be explained in detail later). Chapter 9 Production Costs and Business Decisions 7 TABLE 9.1 Marginal Costs of Producing Tomatoes Contribution Number of of Each Workers Marginal Number Worker to Required to Cost of of Total Production Produce Each Each Bushel, Workers Number of (Marginal Additional Figured at Employed Bushels Product) Bushel $5 per Worker (1) (2) (3) (4) (5) 1 0.25 0.25 2 1.00 0.75 (1st bushel) 2 $10 3 2.00 1.00 (2 nd bushel) 1 $ 5 Point at Which Diminishing Maginal Returns Emerge 4 2.60 0.60 5 3.00 0.40 (3rd bushel) 2 $10 6 3.30 0.30 7 3.55 0.25 8 3.75 0.20 (4th bushel) 5 $25 9 3.90 0.15 10 4.00 0.10 _______________________________________ FIGURE 9.2 The Law of Diminishing Marginal Returns As production expands with the addition of new workers, efficiencies of specialization initially cause marginal cost to fall. At some point, however—here, just beyond two bushels—marginal cost will begin to rise again. At that point, marginal returns will begin to diminish and marginal costs will begin to rise. _______________________________________ The Cost-Benefit Tradeoff Just as a producer’s marginal cost schedule shows the increasing cost of supplying more goods, the demand curve, as explained earlier, shows the decreasing value or marginal benefit of those goods to the people consuming them. Together, marginal costs and benefits determine how many units will be produced and consumed up to the intersection of the marginal cost and demand (marginal benefit) curves, the marginal benefit of each Chapter 9 Production Costs and Business Decisions 8 additional unit exceeds it marginal cost. In other words, people can gain through production and consumption of those units. The intersection of the two curves represents the limit of production, or the point at which welfare is maximized. To see this point, consider the costs and benefits of an activity like fishing. The Costs and Benefits of Fishing Gary Schmidt likes to fish. What he does with the fish he catches is of no consequence to us; he can make them into trophies, give them away, or store them in the freezer. Even if Gary places no money value on the fish, we can use dollars to illustrate the marginal costs and benefits of fishing to Gary. (Money figures are not values, but a means of indicating relative value.) What is important is that Gary wants to fish. How many fish will he catch? From our earlier analysis of Jan’s desire to paint (page 181), we know that the cost of catching each additional fish will be higher than the cost of the one before. Gary will confront an upward-sloping marginal cost curve like the one in Figure 9.3. Gary’s demand curve for fishing will slope downward, for as the cost of catching each additional fish rises, Gary will be less and less inclined to spend more time on the activity (see Figure 9.3). _______________________________________ FIGURE 9.3 Costs and Benefits of Fishing For each fish up to the fifth, Gary receives more in benefits than he pays in costs. The first fish gives him $4.67 in benefits (point a) and costs him only $1 (point b). The fifth yields equal costs and benefits (point c), but the sixth costs more than it is worth. Therefore Gary will catch no more than five fish. From the positions of the two curves, we can see that Gary will catch up to five fish before he packs up his rod and heads for home. He places a relatively high value of $4.67 on the first fish (point a in the figure) and places the relatively low marginal cost of $1 on forgone opportunities for it (point b). In other words, he gets $3.67 more value from using his time, energy, and other resources to fish than he wold receive from his nexr best alternative. The marginal benefit of the second fish also exceeds its marginal cost, although by a small amount ($2.75-$4.25 -- $1.50). Gary continues to gain with the third and fourth fishes, but the fifth fish is a matter of indifference to him. Its marginal value equals its marginal cost (point c). Although we cannot say that Gary will actually bother to catch a fifth fish, we do know that five is the limit toward which he will aim. Chapter 9 Production Costs and Business Decisions 9 He will not catch a sixth—at least during the period of time offered by the graph— because it would cost him more than he would receive in benefits. The Costs and Benefits of Preventing Accidents All of us would prefer to avoid accidents. In that sense we have a demand for accident prevention, whose curve should slope downward like all other demand curves. Preventing accidents also entails costs, however, whether in time, forgone opportunities, or money. Should we attempt to prevent all accidents? Not if the cost of ensuring that you will never stumble down the stairs is $100 (again, we are using dollars to indicate relative value). If the only injury you expect to suffer were a bruised knee, would you spend $100 to prevent the accident? As with the question of how long to fish, marginal cost and benefit curves can help illustrate the point at which preventing accidents ceases to be cost effective. Suppose Al Rosa’s experience indicates that he can expect to have ten accidents over the course of the year. If he tries to prevent all of them, the value of preventing he last one, as indicated by the demand curve in Figure 9.4, will be only $1 (point a). The marginal cost of preventing it will be much greater: approximately $6 (point b). If Al is rational, he will not try to prevent the last accident. As a matter of fact, he will try to prevent only five accidents (point c). As with the tenth accident, it will cost more than it is worth to Al to prevent the sixth through ninth accidents. He would try to prevent all ten accidents only if his demand for accident prevention were so great that his demand curve intersected the marginal cost curve at point b. Some accidents may be unavoidable. In that case, the marginal cost curve will eventually become vertical. Other accidents may be avoidable in the sense that it is physically possible to take measures to prevent them—although the rational course may be to allow them to happen. _________________________________ FIGURE 9.4 Accident Prevention Given the increasing marginal cost of preventing accidents and the decreasing marginal value of preventing the accidents, c accidents will be prevented. _________________________________ The Production Function in Pictures Business firms combine various factors of production in order to produce various goods and services. Although there are thousands of different factors of production, or inputs, Chapter 9 Production Costs and Business Decisions 10 for simplicity we often use a model with only two factors, labor and capital. We can then study how the two inputs can be combined to produce an output. The relationship between inputs and output is called the production function. The general equation for the production function is: Q = f (L, K) where Q is output, L is labor, K is capital, and f is the functional relationship between inputs and output. In the short run, we assume that capital cannot be varied; labor is therefore, the only variable factor. To increase output, then, a firm must increase the amount of labor. The relationship between the amount of the variable input (labor) and output can be illustrated with a total product curve such as that in the upper half of Figure 9.5. Suppose that the curve is that of a commercial fishing firm. The firm’s capital—the boat and equipment—is fixed in the short run. Only the number of workers can vary. As the amount of labor increases from zero, the fish catch (output) increases. Between zero and 5 workers, output increases at an increasing rate. As more workers are hired total output continues to increase, although at a decreasing rate, until 15 workers are hired. Beyond that point, hiring more workers reduces output. The reason the total product curve has that particular shape can be seen more clearly in the lower half of Figure 9.5, which shows the average and marginal product curves. The average product of labor is total output divided by the amount of labor, or Q/L. The marginal product of labor is the change in total output brought about by changing the amount of labor by one unit. Because at least some workers are needed to operate the boat and the equipment, the first few workers hired greatly increase total output; marginal product is rising. Between 5 and 15 workers, the marginal product of labor falls, although the average product continues to rise (because it is less than marginal product). Total product continues to rise, but no longer at an increasing rate. The law of diminishing marginal returns has taken effect. At seven workers, marginal product equals average product and average product is maximized. As more workers are hired average product falls. Note that as long as marginal product is positive, more labor means more output and the total product curve will have a positive slope. Beyond 15 workers, marginal product becomes negative and total product falls. The boat may be so crowded that workers bump into each other and reduce the amount of work that each does. To catch more fish once this stage has been reached, the firm must buy a larger boat. Some economists divide the production function of Figure 9.5 into three stages. In stage one, from zero to seven workers, total product and average product of labor both rise. In stage two, between seven and 15 workers, total product rises while average product falls. In stage three, beyond 15 workers, total product and average product both fall (and marginal product is negative). . for most of the 198 0s and 199 0s. Chapter 9 Production Costs and Business Decisions 15 In order to understand the problem of insurance cost increases, we. product and average product both fall (and marginal product is negative). Chapter 9 Production Costs and Business Decisions 11 Price and Marginal Cost: