cost effective model in manufacturing sector

automation

1. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Production and Production and
Cost Analysis ICost Analysis I

2. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Laugher CurveLaugher Curve
A woman hears from her doctor that she
has only half a year to live.
The doctor advises her to marry an
economist and to move to South Dakota.

3. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Laugher CurveLaugher Curve
“Will this cure my illness?” she asked.
No, but the half year will seem pretty long.”

4. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
IntroductionIntroduction
In the supply process, people first offer
their factors of production to the market.
Then the factors are transformed by firms
into goods that consumers want.
Production is the name given to that
transformation of factors into goods.

5. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Role of the FirmThe Role of the Firm
The firm is an economic institution that
transforms factors of production into
consumer goods – it:
Organizes factors of production.
Produces goods and services.
Sells produced goods and services.

6. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Virtual firms subcontract out all work.
More and more of the organizational structure
of business is being separated from the
business.
The Role of the FirmThe Role of the Firm
A virtual firm only organizes production.

7. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Firm and the MarketThe Firm and the Market
Firms operate within the market, while at
the same time —
Firms replace the market with command
and control.

8. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Firm and the MarketThe Firm and the Market
How an economy operates depends on:
Transaction costs – costs of undertaking
trades through the market, and
The rent or command over resources that
organizers can appropriate to themselves by
organizing the market in a certain way.

9. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Firm and the Market The Firm and the Market
Firms are the production organizations that
translate factors of production into
consumer goods.

10. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Firms Maximize ProfitFirms Maximize Profit
Profit is the difference between total
revenue and total cost.
Profit = total revenue – total cost

11. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Firms Maximize ProfitFirms Maximize Profit
Economists and accountants measure
profit differently.
Accountants focus on explicit costs and
revenue.
Economist focus on both explicit and implicit
costs and revenue.

12. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Firms Maximize ProfitFirms Maximize Profit
For an economist, total cost is explicit
payments to factors of production plus the
opportunity cost of the factors provided by
the owners of the firm.

13. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Firms Maximize ProfitFirms Maximize Profit
Economists define total revenue as the
amount a firm receives for selling its good
or service plus any increase in the value of
the assets owned by firms.

14. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Firms Maximize ProfitFirms Maximize Profit
For economists:
Economic profit =
(explicit and implicit revenue)
– (explicit and implicit cost)

15. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Production Process The Production Process
The production process can be divided into
the long run and the short run.

16. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Long Run and the Short The Long Run and the Short
RunRun
A long-run decision is a decision in which
the firm can choose among all possible
production techniques.

17. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Long Run and the Short The Long Run and the Short
RunRun
A short-run decision is one in which the
firm is constrained in regard to what
production decision it can make.

18. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Long Run and the Short The Long Run and the Short
RunRun
The terms long run and short run do not
necessarily refer to specific periods of
time.They refer to the degree of flexibility the
firm has in changing the level of output.

19. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Long Run and the Short The Long Run and the Short
Run Run
In the long run, all inputs are variable.
In the short run, some inputs are fixed.

20. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Production Tables and Production Tables and
Production FunctionsProduction Functions
A production table shows the output
resulting from various combinations of
factors of production or inputs.

21. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Production Tables and Production Tables and
Production FunctionsProduction Functions
Marginal product is the additional output
that will be forthcoming from an additional
worker, other inputs remaining constant.

22. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Production Tables and Production Tables and
Production FunctionsProduction Functions
Average product is calculated by dividing
total output by the quantity of the output.

23. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Production Tables and Production Tables and
Production FunctionsProduction Functions
Production function – a curve that
describes the relationship between the
inputs (factors of production) and outputs.

24. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Production Tables and Production Tables and
Production FunctionsProduction Functions
The production function tells the maximum
amount of output that can be derived from
a given number of inputs.

25. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
A Production TableA Production Table
Number of
workers
Total output
Marginal
product
Average
product
4
6
7
6
5
3
1
0
2
5
1
2
3
4
5
6
7
8
9
10
0
4
5
5.7
5.8
5.6
5.2
4.6
4.0
3.3
2.5
—
4
10
17
23
28
31
32
32
30
25
0

26. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
O
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30
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Number of workers
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Number of workers
7
6
5
4
3
2
1
0
MP
(a) Total product (b) Marginal and average product
AP
A Production FunctionA Production Function

27. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Law of Diminishing The Law of Diminishing
Marginal ProductivityMarginal Productivity
Both marginal and average productivities
initially increase, but eventually they both
decrease.

28. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Law of Diminishing The Law of Diminishing
Marginal ProductivityMarginal Productivity
This means that initially the production
function exhibits increasing marginal
productivity.
Then it exhibits diminishing marginal
productivity.
Finally, it exhibits negative marginal
productivity.

29. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Law of Diminishing The Law of Diminishing
Marginal ProductivityMarginal Productivity
The most relevant part of the production
function is that part exhibiting diminishing
marginal productivity.

30. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Law of Diminishing The Law of Diminishing
Marginal ProductivityMarginal Productivity
Law of diminishing marginal
productivity – as more and more of a
variable input is added to an existing fixed
input, after some point the additional output
one gets from the additional input will fall.

31. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Law of Diminishing The Law of Diminishing
Marginal ProductivityMarginal Productivity
Number of
workers
Total
output
Marginal
product
Average
product
Increasing
marginal returns
Diminishing
marginal returns

Diminishing
absolute returns

4
6
7
6
5
3
1
0
2
5
1
2
3
4
5
6
7
8
9
10
0
4
5
5.7
5.8
5.6
5.2
4.6
4.0
3.3
2.5
—
4
10
17
23
28
31
32
32
30
25
0

32. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
O
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Diminishing
marginal
returns
Diminishing
absolute
returns
32
30
28
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24
22
20
18
16
14
12
10
8
6
4
2
0
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Increasing
marginal
returns
Number of workers
TP
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Number of workers
7
6
5
4
3
2
1
0
MP
Diminishing
marginal
returns
Diminishing
absolute
returns
(a) Total product (b) Marginal and average product
AP
The Law of Diminishing The Law of Diminishing
Marginal ProductivityMarginal Productivity

33. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Law of Diminishing The Law of Diminishing
Marginal ProductivityMarginal Productivity
This law is also called the flower pot law.
If it did not hold true, the world’s entire food
supply could be grown in a single flower
pot.

34. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Costs of ProductionThe Costs of Production
There are many different types of costs.
Invariably, firms believe costs are too high
and try to lower them.

35. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Fixed Costs, Variable Costs, Fixed Costs, Variable Costs,
and Total Costsand Total Costs
Fixed costs are those that are spent and
cannot be changed in the period of time
under consideration.
In the long run there are no fixed costs since
all costs are variable.
In the short run, a number of costs will be
fixed.

36. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Fixed Costs, Variable Costs, Fixed Costs, Variable Costs,
and Total Costsand Total Costs
Workers represent variable costs – those
that change as output changes.

37. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Fixed Costs, Variable Costs, Fixed Costs, Variable Costs,
and Total Costsand Total Costs
The sum of the variable and fixed costs are
total costs.
TC = FC + VC

38. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Average CostsAverage Costs
Much of the firm’s discussion is of average
cost.

39. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Average CostsAverage Costs
Average total cost (often called average
cost) equals total cost divided by the
quantity produced.
ATC = TC/Q

40. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Average CostsAverage Costs
Average fixed cost equals fixed cost
divided by quantity produced.
AFC = FC/Q

41. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Average CostsAverage Costs
Average variable cost equals variable
cost divided by quantity produced.
AVC = VC/Q

42. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Average CostsAverage Costs
Average total cost can also be thought of
as the sum of average fixed cost and
average variable cost.
ATC = AFC + AVC

43. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Marginal CostMarginal Cost
Marginal cost is the increase (decrease)
in total cost of increasing (or decreasing)
the level of output by one unit.
In deciding how many units to produce, the
most important variable is marginal cost.

44. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

45. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Graphing Cost CurvesGraphing Cost Curves
To gain a greater understanding of these
concepts, it is a good idea to draw a graph.
Quantity is put on the horizontal axis and a
dollar measure of various costs on the
vertical axis.

46. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Total Cost CurvesTotal Cost Curves
The total variable cost curve has the same
shape as the total cost curve—increasing
output increases variable cost.

47. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
T
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$400
350
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150
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50
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FC
24
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Quantity of earrings
VC
TC
L
Total Cost CurvesTotal Cost Curves
O
TC = (VC + FC)

48. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Average and Marginal Cost Average and Marginal Cost
CurvesCurves
The marginal cost curve goes through the
minimum point of the average total cost
curve and average variable cost curve.
Each of these curves is U-shaped.

49. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Average and Marginal Cost Average and Marginal Cost
CurvesCurves
The average fixed cost curve slopes down
continuously.

50. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Downward-Sloping Shape of Downward-Sloping Shape of
the Average Fixed Cost Curvethe Average Fixed Cost Curve
The average fixed cost curve looks like a
child’s slide – it starts out with a steep
decline, then it becomes flatter and flatter.
It tells us that as output increases, the
same fixed cost can be spread out over a
wider range of output.

51. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The U Shape of the Average The U Shape of the Average
and Marginal Cost Curvesand Marginal Cost Curves
When output is increased in the short-run,
it can only be done by increasing the
variable input.

52. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The U Shape of the Average The U Shape of the Average
and Marginal Cost Curvesand Marginal Cost Curves
The law of diminishing marginal
productivity sets in as more and more of a
variable input is added to a fixed input.
Marginal and average productivities fall
and marginal costs rise.

53. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The U Shape of the Average The U Shape of the Average
and Marginal Cost Curvesand Marginal Cost Curves
And when average productivity of the
variable input falls, average variable cost
rise.

54. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The U Shape of the Average The U Shape of the Average
and Marginal Cost Curvesand Marginal Cost Curves
The average total cost curve is the vertical
summation of the average fixed cost curve
and the average variable cost curve.

55. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The U Shape of the Average The U Shape of the Average
and Marginal Cost Curvesand Marginal Cost Curves
If the firm increased output enormously,
the average variable cost curve and the
average total cost curve would almost
meet.
The firm’s eye is focused on average total
cost—it wants to keep it low.

56. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
C
o
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t
$30
28
26
24
22
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18
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10
8
6
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Quantity of earrings
246810121416182022 2426283032
Per Unit Output Cost Curves Per Unit Output Cost Curves
AFC
AVC
ATC
MC

57. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Relationship Between The Relationship Between
Productivity and CostsProductivity and Costs
The shapes of the cost curves are mirror-
image reflections of the shapes of the
corresponding productivity curves.

58. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Relationship Between The Relationship Between
Productivity and CostsProductivity and Costs
When one is increasing, the other is
decreasing.
When one is at a maximum, the other is at
a minimum.

59. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
C
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MC
Output Output
A
AP of
workers
MP of workers
The Relationship Between The Relationship Between
Productivity and CostsProductivity and Costs

60. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Relationship Between Relationship Between
Marginal and Average CostsMarginal and Average Costs
The marginal cost and average cost curves
are related.
When marginal cost exceeds average cost,
average cost must be rising.
When marginal cost is less than average cost,
average cost must be falling.

61. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Relationship Between Relationship Between
Marginal and Average CostsMarginal and Average Costs
Marginal cost curves always intersect
average cost curves at the minimum of the
average cost curve.

62. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Relationship Between Relationship Between
Marginal and Average CostsMarginal and Average Costs
The position of the marginal cost relative to
average total cost tells us whether average
total cost is rising or falling.

63. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Relationship Between Relationship Between
Marginal and Average CostsMarginal and Average Costs
To summarize:
If MC > ATC, then ATC is rising.
If MC = ATC, then ATC is at its low point.
If MC < ATC, then ATC is falling.

64. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Relationship Between Relationship Between
Marginal and Average CostsMarginal and Average Costs
Marginal and average total cost reflect a
general relationship that also holds for
marginal cost and average variable cost.
If MC > AVC, then AVC is rising.
If MC = AVC, then AVC is at its low point.
If MC < AVC, then AVC is falling.

65. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Relationship Between Relationship Between
Marginal and Average CostsMarginal and Average Costs
As long as average variable cost does not
rise by more than average fixed cost falls,
average total cost will fall when marginal
cost is above average variable cost,

66. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Relationship Between Relationship Between
Marginal and Average CostsMarginal and Average Costs
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MC
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AVC
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67. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Production and Production and
Cost Analysis ICost Analysis I
End of Chapter 9