07 production costs

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07 production costs

  1. 1. Chapter 7Production Costs • Key Concepts • Summary • Practice Quiz • Internet Exercises ©2000 South-Western College Publishing 1
  2. 2. In this chapter, you will learn to solve these economic puzzles:Whyare is the differenceWhy would an accountant What multi-screen movie say a firm is makingand between the short-run a theatres replacing single- profitthe long-run? and an economist screen theaters? say it’s losing money? 2
  3. 3. What is a basicassumption in economics? The motivation for business decisions is profit maximization 3
  4. 4. To understand Profit, what is necessary?To distinguish between the way economists measure costs and the way accountants measure costs 4
  5. 5. What are Explicit Costs?Payments to nonowners of a firm for their resources 5
  6. 6. What are Implicit Costs? The opportunity costs of using resources owned by the firm 6
  7. 7. What is an example of Implicit Costs?When you invest your nest egg in your own enterprise, you give up earning interest on that money 7
  8. 8. How is Accounting Profit defined?Total revenue minus total explicit costs 8
  9. 9. What are Total Opportunity Costs?Explicit costs + Implicit costs 9
  10. 10. What is Economic Profit? Total revenue minus total opportunity costs 10
  11. 11. Computech’s Accounting Versus Economic Profit Item Accounting Profit Economic Profit Total Revenue $500,000 $500,000Less Explicit costs: Wages & salaries $400,000 $400,000 Materials $50,000 $50,000 Interest paid $10,000 $10,000 Other payments $10,000 $10,000Less implicit costs: Foregone salary 0 50,000 Foregone rent 0 10,000Foregone interest 0 5,000 Equals profit $30,000 -$30,000 11 Exhibit 1
  12. 12. What is Normal Profit? The minimum profit necessary to keep a firm in operation 12
  13. 13. When economists use the term “Profit”, which profit do they mean? Economic profit which, unlike accounting profit, includes implicit costs 13
  14. 14. What is a Fixed Input?Any resource for which the quantity cannot change during the period of time under consideration 14
  15. 15. What is the Short Run? A period of time so short that there is at least one fixed input 15
  16. 16. What is the Long Run?A period of time so long that all inputs are variable 16
  17. 17. What is a Variable Input? Any resource for which the quantity can change during the period of time under consideration 17
  18. 18. What is theProduction Function?The relationship between the maximum amounts of outputs a firm can produce and various quantities of inputs 18
  19. 19. What do TechnologicalAdvances make possible?More output is possible from a given quantity of inputs 19
  20. 20. What is Marginal Product?The change in total output produced by adding one unit of a variable input, with all other inputs used held constant 20
  21. 21. What is the Law ofDiminishing Returns?The principle that beyond some point the marginal product decreases as additional units of a variable resource are added to a fixed factor 21
  22. 22. What does the Law of Diminishing Returns assume?Fixed inputs; it is therefore a short-run concept 22
  23. 23. 60 Production Function50 Total Output4030 Total Output2010 Quantity of Labor 1 2 3 4 5 6 23
  24. 24. 12 Marginal Product Curve10 Marginal Output 8 6 Law of 4 Diminishing Returns 2 Quantity of Labor 1 2 3 4 5 6 24
  25. 25. What is Total Fixed Cost?Costs that do not vary as output varies and that must be paid even if output is zero 25
  26. 26. What isTotal Variable Cost?Costs that are zero when output is zero and vary as output varies 26
  27. 27. What is Total Cost?The sum of total fixed cost and total variable cost at each level of output 27
  28. 28. TC = TFC + TVC 28
  29. 29. What isAverage Fixed Cost?Total fixed cost divided by the quantity of output produced 29
  30. 30. AFC = TFC / Q 30
  31. 31. What is Average Variable Cost?Total variable cost divided by the quantity of output produced 31
  32. 32. AVC = TVC / Q 32
  33. 33. What is Average Total Cost?Total cost divided by the quantity of output produced 33
  34. 34. ATC = AFC + AVC = TC/Q 34
  35. 35. What is Marginal Cost? The change in total cost when one unit of output is produced 35
  36. 36. MC = ∆TC/∆ Q = ∆TVC/∆Q 36
  37. 37. Short-Run Cost Curves$800$700$600 Cost per unit TFC TC$500 TVC$400$300$200 TFC$100 1 2 3 4 5 6 7 8 9 Q 37
  38. 38. Short-Run Cost Curves$80$70 Cost per unit MC$60 ATC$50$40 AFC AVC$30$20$10 AFC 1 2 3 4 5 6 7 8 9 Q 38
  39. 39. What is the Marginal- Average Rule? When MC < AC, AC falls When MC > AC, AC risesIf MC = AC, AC at minimum 39
  40. 40. What is the relationship between slopes of the MC and MP curves?The rising portion of the MP curve corresponds to the declining portion of the MC curve, and vice versa 40
  41. 41. What is the relationship between the minimumand maximum points ofthe MR and MP curves?The maximum point of the MP curve corresponds to the minimum point of the MC curve 41
  42. 42. 12 Marginal Product Curve10 8 Total Output 6 Maximum 42 Quantity of Labor 1 2 3 4 5 6 42
  43. 43. Short-Run Cost Curves$80$70 Minimum MC$60 Cost per unit$50 ATC$40 AVC$30$20$10 1 2 3 4 5 6 7 8 9 Q 43
  44. 44. What is the Long-runAverage Cost Curve?The curve that traces the lowest cost per unit at which a firm can produce any level of output when the firm can build any desired plant size 44
  45. 45. Short and Long-run Average Cost Curves$80$70 Short-run average$60 total cost curves$50$40$30$20$10 Long-run average cost curve 2 4 6 8 10 12 14 16 18 Q 45
  46. 46. What areEconomies of Scale?A situation in which the long-run average cost curve declines as the firm increases output 46
  47. 47. What are Constant Returns to Scale?A situation in which the long-run average cost curve does not change as the firm increases output 47
  48. 48. What areDiseconomies of Scale?A situation in which the long-run average cost curve rises as the firm increases output 48
  49. 49. Long-run Average Cost Curve$80$70 Constant returns to scale$60 Economies of scale$50$40 Diseconomies of scale$30$20$10 2 4 6 8 10 12 14 16 18 Q 49
  50. 50. Key Concepts 50
  51. 51. Key Concepts• What is a basic assumption in economics?• What are Explicit Costs?• What are Implicit Costs?• How is Accounting Profit defined?• What are Total Opportunity Costs?• What is Economic Profit?• What is Normal Profit? 51
  52. 52. Key Concepts cont.• When economists use the term “Profit”, which• When economists study the economy, what tim• What is a Fixed Input?• What is the Short Run?• What is the Long Run?• What is a Variable Input?• What is Marginal Product? 52
  53. 53. Key Concepts cont.• What is the Law of Diminishing Returns?• What is Total Fixed Cost?• What is Total Variable Cost?• What is Total Cost?• What is Average Fixed Cost?• What is Average Variable Cost?• What is Average Total Cost?• What is Marginal Cost?• What are Economies of Scale?• What are Diseconomies of Scale? 53
  54. 54. Summary 54
  55. 55. Economic profit is equal totalrevenue minus both explicit andimplicit costs. Implicit costs are theopportunity costs of foregonereturns to resources owned by thefirm. Economic profit is importantfor decision-making purposesbecause it includes implicit costsand accounting profit does not.Accounting profit equals totalrevenue minus explicit costs. 55
  56. 56. The short run is a time periodduring which a firm has at least onefixed input, such as its factory size.The long run for a firm is defined asas a period during which all inputsare variable. 56
  57. 57. A production function is therelationship between output andinputs. Holding all other factorsof production constant, theproduction function shows thetotal output as the amount of oneinput, such as labor, varies. 57
  58. 58. Marginal product is the changein total output caused by a one-unitchange in a variable input, such asthe number of workers hired, the lawof diminishing returns states thatafter some level of output in theshort run, each unit of the variableinput yields smaller and smallermarginal product. This range ofdeclining marginal product is theregion of diminishing returns. 58
  59. 59. Total fixed costs consists of coststhat cannot vary with the level ofoutput, such as rent for office space.Total fixed costs is the cost of inputsthat do not change as the firm changesoutput in the short run. Total variablecost consists of costs that vary with thelevel of output, such as wages. Totalvariable cost is the cost of variableinputs used in production. Total cost isthe sum of total fixed cost and totalvariable cost. 59
  60. 60. Short-Run Cost Curves$800$700$600 Cost per unit TFC TC$500 TVC$400$300$200 TFC$100 1 2 3 4 5 6 7 8 9 Q 60
  61. 61. Marginal cost is the change istotal cost associated with oneadditional unit of output. Averagefixed cost is the total fixed costdivided by total output. Averagevariable cost is the total variable costdivided by total output. Average totalcost is the total cost, or the sum ofaverage fixed cost and averagevariable cost, divided by output. 61
  62. 62. Short-Run Cost Curves$80$70 Cost per unit MC$60 ATC$50$40 AFC AVC$30$20$10 AFC 1 2 3 4 5 6 7 8 9 Q 62
  63. 63. The marginal-average ruleexplains the relationship betweenmarginal cost and average cost.When the marginal cost is less thanthe average cost, the average costfalls. When the marginal cost isgreater than the average cost, theaverage cost rises. Following thisrule, the marginal cost curveintersects the average total costcurve at their minimum points. 63
  64. 64. Marginal cost and marginalproduct are mirror images of eachother. Assuming a constant wage rate,marginal cost equals the wage ratedivided by the marginal product.Increasing returns cause marginal costto fall, and diminishing returns causemarginal cost to rise. This explains theU-shaped marginal cost curve. 64
  65. 65. 12 Marginal Product Curve10 8 Total Output 6 Maximum 42 Quantity of Labor 1 2 3 4 5 6 65
  66. 66. $80$70 Minimum MC$60 Marginal cost$50$40$30$20$10 1 2 3 4 5 6 7 8 9 Q 66
  67. 67. The long-run average cost curve is acurve drawn tangent to all possibleshort-run average total curves. When thelong-run average cost curve decreases asoutput increases, the firm experienceseconomies of scale. If the long-runaverage cost curve remains unchangedas output increases, the firm experiencesconstant returns to scale. If the long-runaverage cost curve increases, the firmexperiences diseconomies of scale. 67
  68. 68. Long-run Average Cost Curve$80$70 Constant returns to scale$60 Economies of scale$50$40 Diseconomies of scale$30$20$10 2 4 6 8 10 12 14 16 18 Q 68
  69. 69. Chapter 7 Quiz ©2000 South-Western College Publishing 69
  70. 70. 1. Explicit costs are payments to a. hourly employees. b. insurance companies. c. utility companies. d. all of the above.D. Explicit costs are payments to non owners of a firm. 70
  71. 71. 2. Implicit costs are the opportunity costs of using the resources of a. outsiders. b. owners. c. banks. d. retained earnings.B. Implicit costs are opportunity costs that a business owner incurs when using resources owned by the firm. 71
  72. 72. 3. Which of the following equalities is true? a. Economic profit = total revenue - accounting profit. b. Economic profit = total revenue - explicit costs - accounting profit. c. Economic profit = total revenue - implicit costs - explicit costs. d. Economic profit = opportunity costs + accounting costs.C. The difference between accounting profit and economic profit is that economic profit is total revenue minus both explicit and implicit costs. Accounting profit is total revenue minus explicit costs only. 72
  73. 73. 4. Fixed inputs are factors of production that a. are determined by a firm’s size. b. can be increased or decreased quickly as output changes. c. cannot be increased or decreased quickly as output changes. d. none of the above.C. In the short run, there are two types of inputs, fixed and variable. Because a firm cannot change its plant capacity, some of its inputs are fixed. In the long run, all costs are variable. 73
  74. 74. 5. An example of a variable input is a. raw materials. b. energy. c. hourly labor. d. all of the aboveD. As a firm produces more, it will use more raw materials, energy, and labor. Therefore, all are variable costs. 74
  75. 75. 6. Suppose a car wash has 2 washing stations and 5 workers and is able to wash 100 cars per day. When it adds a third station, but no more workers, it is able to wash 150 cars per day. The marginal product of the third washing station is a. 100 cars per day. b. 150 cars per day. c. 5 cars per day. d. 50 cars per day.D. 50 cars is how many extra cars can be washed by adding a new machine, ceteris paribus. 75
  76. 76. 7. If the units of variable input in a production process are 1, 2, 3, 4, and 5 and the corresponding total outputs are 10, 22, 33, 42, and 48, respectively, the marginal product of the fourth unit is a. 2. b. 6. c. 9. d. 42.C. The difference between 42 and 33 is 9, the extra output when producing 4 units instead of 3. 76
  77. 77. 8. The total fixed cost curve is a. upward sloping. b. downward sloping. c. upward, and then downward sloping. d. unchanged with the level of output.D. Fixed costs never change regardless of the units of output; therefore its curve has to be horizontal at a fixed cost dollar value. 77
  78. 78. 9. Assuming that the marginal cost curve is a smooth U-shaped curve, the corresponding total cost curve has a (an) a. linear shape. b. S-shape. c. U-shape. d. reverse S-shape.D. Marginal cost decreases as output increases from zero, and then increases beyond a certain output level. A reverse-S-Shape total cost curve corresponds to the changes in its slope (MC) as output expands. 78
  79. 79. $1,500 Total Cost Curve Total Cost Exhibit 10$1,250$1,000 TC $750 $500 $250 Quantity of Output 50 100 150 200 250 300 79
  80. 80. 10. If both the marginal cost and the average variable cost curves are U-shaped, at the point of minimum average variable cost, the marginal cost must be a. greater than the average variable cost. b. less than the average variable cost. c. equal to the average variable cost. d. at its minimum.C. If the margin is above the average, the average will increase. If the margin is less than the average, the average will decrease. If the margin equals the average, average does not change, that is, it is a horizontal curve. 80
  81. 81. 11. Which of the following is true at the point where diminishing returns set in? a. Both marginal product and marginal cost are at a maximum. b. Both marginal product and marginal cost are at a minimum. c. Marginal product is at a maximum and marginal cost at a minimum. d. Marginal product is at a minimum and marginal cost at a maximum.C. The rising portion of the MP curve corresponds to the declining portion of the MC curve, and vice versa 81
  82. 82. 12. As shown in Exhibit 10, total fixed cost for the firm is a. Zero. b. $250 c. $500. d. $750 e. $1,000B. $250 is the answer because total cost is 0 when output is zero. These are costs that have to be paid even when output is zero. 82
  83. 83. 13. As shown in Exhibit 10, the total cost of producing 100 units of output per day is a. Zero. b. $250. c. $500. d. $750. e. $1,000. C. A vertical line drawn at 100 units crosses the total cost curve at $500. 83
  84. 84. 14. In Exhibit 10, if the total cost of producing 99 units of output per day is $475, the marginal cost of producing the 100th unit of output per day is approximately a. Zero. b. $25. c. $475. d. $500B. When total cost at 99 units is $475 and total cost at 100 units is $500, the cost of producing the 100th unit is $25. 84
  85. 85. 15. Each potential short-run average total cost curve is tangent to the long-run average cost curve at a. the level of output that minimizes short-run average total cost. b. the minimum point of the average total cost curve. c. the minimum point of the long-run average cost curve. d. a single point on the short-run average total cost curve.D. The long-run LRAC is derived from all possible SRAC. Geometrically, the only way to draw this is to connect all the curves by a smooth curve; thus, the LRAC curve touches each SRAC curve at only one place. 85
  86. 86. Short and Long-run Average Cost Curves$80$70 Short-run average$60 total cost curves$50$40$30$20$10 Long-run average cost curve 2 4 6 8 10 12 14 16 18 Q 86
  87. 87. 16. Suppose a typical firm is producing X units of output per day. Using any other plant size, the long-run average cost would increase. The firm is operating at a point which its a. long-run average cost curve is at a minimum. b. short-run average total cost curve is at a minimum. c. both (a) and (b) are true. d. neither (a) nor (b) is true. C. When a firm is producing at the minimum points of the long-run average cost curve, it is operating at the most efficient level possible. 87
  88. 88. 17. The downward-sloping segment of the long- run average cost curve corresponds to a. diseconomies of scale. b. both economies and diseconomies of scale. c. the decrease in average variable cost. d. economies of scale. D. Economies of scale takes place when a firm increases its efficiency by producing more units of output. 88
  89. 89. Long-run Average Cost Curve$80$70 Constant returns to scale$60 Economies of scale$50$40 Diseconomies of scale$30$20$10 2 4 6 8 10 12 14 16 18 Q 89
  90. 90. 18. Long-run diseconomies of scale exist when the a. short-run average total cost curve falls. b. long-run marginal cost curve rises. c. long-run average cost curve falls. d. short-run average cost curve rises. e. long-run average cost curve rises. E. Diseconomies of scale are evident when increasing output leads to inefficiencies. 90
  91. 91. 19. Long-run constant returns to scale exist when the a. short-run average total cost curve is constant. b. long-run average cost curve rises. c. long-run average cost curve is flat. d. long-run average cost curve falls.C. Constant returns to scale are evident when there is no change in costs as output increases. 91
  92. 92. Internet ExercisesClick on the picture of the book, choose updates by chapter for the latest internet exercises 92
  93. 93. END 93

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