Production and Cost Analysis in the Short-Run

[Audio] This chapter looks at short-run production and cost. In the short-run, all production functions incur diminishing returns when variable inputs are used relative to at least one fixed input, reducing the additional amounts of the output being produced. Diminishing returns in production causes a short-run increase in the marginal cost, as production of more output becomes increasingly costly. The Wall Street Journal article on page 113 illustrates the relationship between efficiency and costs in the fast-food industry, where speed of service at drive-through windows determines the competition for market share. In addition, the discussion of the empirical evidence demonstrates that the theoretical U-shaped cost curves may not always be appropriate in real-world firms and industries. Case for Analysis: The Long-Distance Journey of a Fast-Food Order (p. 113) -Fast-food restaurants use drive-through windows to increase profitability. Sixty-five percent of revenues come from drive-through windows for fast-food outlets such as Wendy's, McDonald's, Burger King, Arby's and Taco Bell. -Production technology changes include the following. The use of separate kitchens for drive-through windows. Timers to monitor the time it takes the customers to drive from the menu board to the cash/ pickup window. Redesigning kitchens to minimize unnecessary movement by the workers. Use of remote order-taking to cut costs. -Remote order-taking from a call center is a new development that is being tested by 50 McDonald franchises. The trade-offs with increased speed at the drive-through windows are employee dissatisfaction and stress with constant monitoring, and decreased accuracy in filling orders. There have also been break-downs in communication over long distances. -Fast-food restaurants try to gain an advantage over their competitors by: Increasing the number of customers. Decreasing the costs of production through changing the production technology, lowering input prices, and changing the scale of operation..

[Audio] Defining the Production Function Production Function: The relationship between a flow of inputs and the resulting flow of outputs in a production process during a given period of time. The production function shows the maximum amount of output that can be produced with a given combination of inputs. Equation 5.1 (p. 115): Q=f(L, K, M,…) where: Q= quantity of output L=quantity of labor input K=quantity of capital input M=quantity of materials input The production function is a general function and can be applied to large-scale production processes as well as production in small firms..

[Audio] Fixed Inputs Versus Variable Inputs Managers use both fixed and variable inputs in a production function. -Fixed Input: An input whose quantity a manager cannot change during a given period of time. Examples are acreage of land and farm equipment for crop production. -Variable Input: An input whose quantity a manger can change during a given period of time. Examples are farm workers, fertilizers, and seeds in crop production..

[Audio] Short-Run Versus Long-Run Production Functions The Wall Street Journal article illustrates the difference between the short-run and long-run production. -Short-Run Production Function: A production process that uses at least one fixed input. -Long-Run Production Function: A production process in which all inputs are variable. Productivity and the Fast-Food Industry The Wall Street Journal article illustrates the difference between short-run and long-run production. With fixed inputs and a given technology, employees worked faster to achieve the goal of a 90-second turnaround for each drive-through customer. In the long-run, as quality decreased and employees became dissatisfied, management responded by placing an intercom at the end of the drive-through line to correct mistakes in orders and rearranged the kitchens..

[Audio] Model of a Short-Run Production Function Three measures of productivity, or the relationship between inputs and the output, are total product, average product and marginal product. Total Product: The total quantity of output produced with a given quantity of fixed and variable inputs. Equation 5.2 (p. 117): TP or Q=f(L, ).

[Audio] Average Product and Marginal Product Average Product: The amount of output per unit of variable input. Equation 5.3 (p. 117): AP=TP/L or AP=Q/L where: AP= average product of labor.

[Audio] Marginal Product: The additional output produced with an additional unit of variable input. Equation 5.4 (p. 117): MP=∆TP/∆L or MP= ∆Q/∆L where: MP= marginal product of labor.

[Audio] Relationships Among Total, Average and Marginal Product -When the numbers in the total product column increase at in increasing (decreasing) rate, the numbers in the marginal product column increase (decrease). -When the marginal product is greater (smaller) than the average product, the average product numbers increase (decrease). -Figures 5.1a and 5.1b (p. 119) illustrate the graphs of these curves and their relationships..

[Audio] Relationships Among Total, Average and Marginal Product -When the numbers in the total product column increase at in increasing (decreasing) rate, the numbers in the marginal product column increase (decrease). -When the marginal product is greater (smaller) than the average product, the average product numbers increase (decrease). -Figures 5.1a and 5.1b (p. 119) illustrate the graphs of these curves and their relationships..

[Audio] Economic Explanation of the Short-Run Production Function Increasing Marginal Returns: The region where the marginal product is positive and increasing so that total product increase at an increasing rate. Law of Diminishing Returns or Law of the Diminishing Marginal Product: The region where the marginal product is positive but decreasing so that the total product is increasing at a decreasing rate. This occurs because capital input and state of technology are held constant in the short-run. As more labor is added to the fixed capital input, the marginal product eventually starts decreasing. Examples are too many automobile workers in a factory, too many accountants in an office space, and too many farmers on a plot of land. Decreasing Marginal Returns: The region where the marginal product curve is negative so that the total product is decreasing. Real-World Firm and Industry Productivity Issues Examples of Diminishing Return and Productivity Changes Poultry farms have traditionally had problems catching chickens inside chicken houses with human catchers. Machines capable of catching and caging 150 chickens per minute were produced and replaced some of the human catchers. Broaches, surgical instruments used for hip replacement surgery, have traditionally been made by hand. New computer controls and new materials now allow a broach to be made in less than 5 percent of the time it took in 1994. Hospitals are increasingly treating larger numbers of patients with fixed numbers of hospital beds and buildings. Identical rooms are designed so that doctors and nurses can find equipment easily. Nurse stations are placed so that all patients are visible. Filers and ultraviolet devices kill germs and reduce infections. Productivity Across Industries New productivity methods for crops have led large increases in productivity in agriculture. New types of seeds are developed that can withstand droughts or floods. The introduction of Henry Ford's assembly line production and the restructuring of management procedures have resulted in an increase in productivity in the automobile industry. Other new developments include the use of the Internet to link companies with auto parts suppliers. Computer-aided design tools and engineering tools are used to reduce quality problems. Productivity differs across industries. In recent years, productivity has increased in the service sector and durable goods manufacturing. Information technology (IT) accounted for 80% of increases in productivity growth in the late 1990s..

[Audio] Economists define costs as opportunity costs. Opportunity Cost: The economic measure of cost that reflects the use of resources in one activity, such as a production process by one firm, in terms of the opportunities foregone or activities not undertaken..

Opportunity Cost. The economic measure of cost that reflects the use of resources in one activity, such as a production process by one firm, in terms of the opportunities forgone in undertaking the next best alternative activity..

[Audio] Opportunity costs include implicit as well as explicit costs: Explicit Costs: A cost that is reflected in a payment to another individual, such as a wage paid to a worker, that is recorded as a payment (think of whatever you write a check for in business). Implicit Costs: A cost that represents the value of using a resource that is not explicitly paid out and is often difficult to measure, because it is typically not recorded in a firm's accounting system. Historic costs are not included in calculation of the opportunity cost. Historic Cost: The amount of money a firm paid for an input when it was purchased, which for machines and capital equipment could have occurred many years in the past..

[Audio] Accounting Profit Versus Economic Profit Measures Profits differ in accounting and economics as costs are defined differently. Profit: The difference between the total revenue a firm receives from the sale of its output and the total cost of producing that output..

[Audio] Accounting Profit: The difference between total revenue and total cost where cost includes only the explicit costs of production. Economic Profit: The difference between total revenue and total cost where cost includes both the explicit and any implicit costs of production. The difference between accounting economic profits can be substantial for a firm. The text illustrates the importance of the distinction for the Coca Cola Company..

[Audio] Definition of Short-Run Cost Functions Short-Run Cost Function: A cost function for a short-run production process in which there is at least one fixed input of production..

[Audio] Remember: Fixed costs per unit decrease with every additional unit produced..

[Audio] Total Fixed Cost (TFC): The cost of using the fixed input, which remains constant regardless of the amount of output produced. TFC= (PK)( ) where: PK= price per unit of capital (fixed input) Total Variable Cost (TVC): The total cost of using the variable input, which increases as more output is produced. TVC= (PL)(L) where: PL= price per unit of labor (variable input) Total Cost (TC): The sum of the total fixed cost plus the total variable cost. TC= TFC+TVC Average Fixed Cost (AFC): The total fixed cost per unit of output. AFC= AFC/Q Average Variable Cost (AVC): The total variable cost per unit of output. AVC= AVC/Q Average Total Cost (ATC): The total cost per unit of output, which also equals average fixed cost plus average variable cost. ATC= TC/Q ATC= AFC+AVC Marginal Cost (MC): The additional cost of producing an additional unit of output, which equals the change in total cost or the change in total variable cost as output changes. MC= ∆TC/ ∆Q MC= ∆TVC/ ∆Q.

[Audio] Total Fixed Cost (TFC): The cost of using the fixed input, which remains constant regardless of the amount of output produced. TFC= (PK)( ) where: PK= price per unit of capital (fixed input) Total Variable Cost (TVC): The total cost of using the variable input, which increases as more output is produced. TVC= (PL)(L) where: PL= price per unit of labor (variable input) Total Cost (TC): The sum of the total fixed cost plus the total variable cost. TC= TFC+TVC.

[Audio] Average Fixed Cost (AFC): The total fixed cost per unit of output. AFC= AFC/Q Average Variable Cost (AVC): The total variable cost per unit of output. AVC= AVC/Q Average Total Cost (ATC): The total cost per unit of output, which also equals average fixed cost plus average variable cost. ATC= TC/Q ATC= AFC+AVC Marginal Cost (MC): The additional cost of producing an additional unit of output, which equals the change in total cost or the change in total variable cost as output changes. MC= ∆TC/ ∆Q MC= ∆TVC/ ∆Q.

Relationships Among Total, Average and Marginal Cost.

[Audio] Relationship Between Short-Run Production and Cost Marginal cost and marginal product are inversely related to each other. Average variable cost and average product are inversely related to each other. This is illustrated in Figures 5.3a and 5.3b (p. 130)..

Implications for Managers. Costs play an important role in determining an effective competitive strategy, especially for firms that have no control over the price of their products. The distinction between fixed and variable costs is important for managers..