9795 Words May 29th, 2008 40 Pages
CHAPTER 5: COST THEORY

Huxley Manufacturing Company, a large firm in the defense industry, is considering a strategic move to shift production from its California plant to Mexico. Tariff reductions made possible by the North American Free Trade Agreement (NAFTA) opened up the potential to enjoy significant cost savings by shifting production south of the Mexican border. Huxley is considering three options. The simplest option is to negotiate a subcontracting arrangement in which a Mexican firm manufactures steering column components (SCCs) according to the specifications of Huxley. The subcontracting firm would then be paid by Huxley on a per-piece arrangement. A subcontracting arrangement would
In other words, when the number of inputs doubled, output quadrupled. Let’s convert this information into production costs. For simplicity’s sake, we will assume that labor constitutes the only variable input. Fixed costs are \$10/hour. If a worker was paid a wage of \$10/hour, the total cost of producing one unit of output would be \$20. If the firm hires two workers, four units could be produced at a total cost of \$30. Increasing production from one unit to four did not affect the firm’s fixed costs, but it caused total variable costs to rise from \$10 to \$20. Take special note of the proportionate changes in production and costs. Total variable costs increased as production increased, but when output quadrupled, variable costs doubled. The increase in variable costs was proportionately less than the change in production. Table 1 shows the correlation between production theory and cost theory during these stages of production.

Table 1
Labor Total Marginal Total Fixed Total Variable Total Output Product Costs Costs Costs

0 0 \$10 \$0 \$10
1 1 1 \$10 \$10 \$20
2 4 3 \$10 \$20 \$30

As production increases, eventually, the firm comes upon the law of diminishing returns. Because the marginal product of each additional input diminishes, progressively more inputs are needed to produce the same quantity of output. Put differently, increases in production are proportionately smaller than increases in