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Ch08 the costs_of_production[1]

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  • 1. Chapter Objectives • • • • • Explicit and implicit costs Short-run production relationships Law of diminishing returns Short-run production costs Long-run production costs
  • 2. Introduction • Production The process by which inputs are combined, transformed, and turned into outputs. • According to the Law of Supply: – Firms are willing to produce and sell a greater quantity of a good when the price of the good is high. • The Firm’s Objective – The economic goal of the firm is to maximize profits.
  • 3. Introduction • Total Revenue – The amount a firm receives for the sale of its output (QxP). • Total Cost – The market value of the inputs a firm uses in production. • Profit is the firm’s total revenue minus its total cost.
  • 4. Economic Costs • Costs exist because resources are scarce, are productive, and have alternative uses. • A firm’s cost of production includes all the opportunity costs of making its output of goods and services.
  • 5. Economic Costs • Explicit and Implicit Costs: A firm’s total cost of production include: – Explicit costs are input costs that require a direct outlay of money by the firm: – Monetary payments made to factors of production – Implicit costs: All the opportunity costs of the resources supplied by the firm’s owners – Opportunity cost of owner-invested funds
  • 6. Economic Costs • Implicit costs: • The opportunity costs of using its self-owned resources, and self-employed resources. • Money payments that self-employed resources could have earned in their best alternative use.
  • 7. Economic Costs • Implicit costs: • For example, a firm's use of its own capital. This is considered an implicit cost because the capital could have been rented to another firm instead.
  • 8. Economic Profit versus Accounting Profit • Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs. • Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.
  • 9. Economic Profit versus Accounting Profit • When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. – Economic profit is smaller than accounting profit.
  • 10. Three Types of Profit • Accounting Profit – Total Revenue – Explicit Costs • Economic Profit – Total Revenue – Explicit Costs – Implicit Costs • Normal Profit – The difference between accounting profit and economic profit – Equal to implicit cost – A normal profit is a cost of doing business
  • 11. Example 1 Calculating Total Revenue, Total Cost, and Profit Initial Investment (Market Interest Rate Available) Total revenue $20,000 (10%) $30,000 Costs Belts from Supplier Labor cost Normal return/Opportunity Cost of Capital ($20,000 x 0.10) $15,000 14,000 2,000 Total Cost $31,000 Profit = total revenue - total cost -$1,000
  • 12. Example 2 • John sells corn – his revenues are $22,000/yr – he pays $10,000/yr in explicit costs – he could earn $11,000 at another job he likes equally well (implicit costs) • John’s economic profit is $22,000 - $10,000 - $11,000 = $1,000
  • 13. Example 3 • After graduation from University with a degree in economics, you face the following job choice: • Option 1: Job 1 Salary = $50,000/year • Option 2: Job 2: Start own business Salary = $50,000/year • If you choose option 2, you have to drain your $10,000 savings to start the business. Assume that you could have earned 10% on that money.
  • 14. Example 3 (continued) • Suppose you choose option 2… 1st year analysis: Revenue = $50,000 Costs of inventory = $8,000 Labor expenses = $15,000 Rent = $12,000 • acounting - inventory - rent - wages for worker economic - inventory - rent - wages for worker - opp cost of Labor ($50,000) - opp cost of funds = $1000  the normal rate of return on capital.
  • 15. Example 3 (continued) • Accounting profit = 50 – 8 – 15 – 12 = 15 • Economic profit = 50 – 8 – 15 – 12 – 50 – 1 = -36
  • 16. Market Forces and Economic Profit • Positive Economic Profit means the firm (owner) is more than covering opportunity costs • Doing better than the next best alternative • Firms enter this industry
  • 17. Market Forces and Economic Profit • Negative Economic Profit means the firm (owner) is not covering opportunity costs • Doing worst than the next best alternative • Firms exit this industry
  • 18. Short-Run Versus Long-Run Short run The period of time for which two conditions hold: • The firm is operating under a fixed factor of production, • Firms can neither enter nor exit an industry. Long run That period of time for which there are no fixed factors of production: • Firms can increase or decrease the scale of operation, • New firms can enter and existing firms can exit the industry.
  • 19. Production Relationships The Bases of Decisions: Market Price of Outputs, Available Technology, and Input Prices optimal method of production The production method that minimizes cost.
  • 20. Production Relationships Total product (TP): Total quantity, or total output of a particular good. Marginal product (MP): The additional output that can be produced by adding one more unit of a specific input. Marginal Product= Change in Total Product Change in Labor Input
  • 21. Production Relationships Average product (AP): also called labor productivity, is output per unit of labor input: Average Product = Total Product Units of Labor
  • 22. Law of Diminishing Returns • When additional units of a variable input (labor) are added to fixed inputs (capital or land) after a certain point, the marginal product of the variable input declines. • Example: • If additional workers are hired to work with a constant amount of capital equipment, output will eventually rise by smaller and smaller amounts as more workers are hired. • Diminishing returns always apply in the short run, and in the short run every firm will face diminishing returns.
  • 23. Law of Diminishing Returns (1) Units of the Variable Resource (Labor) 0 1 2 3 4 5 6 7 8 (3) (4) Marginal Product Average (MP), Product (2) (AP), Total Product Change in (2)/ Change in (1) (2)/(1) (TP) 0 10 Increasing ] 10 10 Marginal 15 ] 12.50 25 Returns 20 ] 15 45 15 ] Diminishing 15 60 10 ] Marginal 14 70 Returns 5 ] 12.50 75 0 ] Negative 10.71 75 Marginal ] -5 Returns 8.75 70
  • 24. Law of Diminishing Returns • With no labor input, total product is zero, a plant with no workers will produce no output. • Column 2: resulting from combining each level of a variable input (labor) in column 1 with a fixed amount of capital. • Column 3: the change in total product associated with each unit of labor.
  • 25. • MP is negative if TP declines when labor use rises 30 TP 20 10 0 Marginal Product, MP • MP rises when TP increases at an increasing rate, and declines when TP increases at a decreasing rate. Total Product, TP Law of Diminishing Returns 1 2 Increasing Marginal 20 Returns 3 4 5 6 7 8 9 Negative Marginal Returns Diminishing Marginal Returns 10 AP 1 2 3 4 5 6 7 8 9 MP
  • 26. Relationship of AP and MP • AP rises when MP > AP • AP falls when MP < AP • AP is maximized when MP = AP
  • 27. Stages of Production In stage I: • TP is increasing • AP is increasing • MP increases, reaches a maximum & decreases to AP • Is it rational to produce here? - No, because MP > AP
  • 28. Stages of Production In stage II: • • • • TP is increasing AP is decreasing MP is decreasing and less than AP, but still positive Is it rational to produce here? - Yes, because TP is still increasing
  • 29. Stages of Production In stage III: • • • • TP is decreasing AP is decreasing MP decreasing and negative Is it rational to produce here? - No, because TP is decreasing/MP is negative
  • 30. Short-Run Production Costs • Short run costs • Fixed Costs – Are those costs that do not vary with the quantity of output produced – There are no fixed costs in the long run. • Variable Costs – Are those costs that do vary with the quantity of output produced – Materials, most labor
  • 31. Short-Run Production Costs • Total Costs – Total Fixed Costs (TFC) – Total Variable Costs (TVC) – Total Costs (TC) – TC = TFC + TVC
  • 32. Example
  • 33. Fixed costs
  • 34. Variable costs
  • 35. TC, TVC, and TFC $1100 TC 1000 900 TVC 800 Costs 700 600 Fixed Cost 500 400 Total Cost 300 200 Variable Cost 100 0 TFC 1 2 3 4 5 6 7 8 9 10 Q
  • 36. Per-Unit (average) Production Costs • Average Costs – Average costs can be determined by dividing the firm’s costs by the quantity of output it produces. – The average cost is the cost of each typical unit of product.
  • 37. Per-Unit Production Costs • Average Fixed Cost (AFC) AFC = TFC/Q • Average Variable Cost (AVC) AVC = TVC/Q • Average Total Cost (ATC) ATC = TC/Q = TFC/Q + TVC/Q ATC = AFC+AVC
  • 38. Example
  • 39. Marginal cost • Marginal cost (MC) = cost of an additional unit of output • Marginal cost (MC) The increase in total cost that results from producing 1 more unit of output.
  • 40. Marginal cost • MC are costs the firm can control directly and immediately. • A firm’s decisions as to what output level to reproduce are typically marginal decisions: – Decisions to produce a few more or a few less units. • Marginal cost helps answer the following question: – How much does it cost to produce an additional unit of output?
  • 41. Marginal cost
  • 42. Graphical AFC • AFC declines as quantity rises.
  • 43. Graphical AVC $200 150 Costs • AVC falls because of increasing marginal returns, then rises because of diminishing marginal returns 100 AVC 50 0 1 2 3 4 5 6 7 8 9 10 Q
  • 44. Graphical ATC Costs $3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 1.50 ATC 1.25 1.00 0.75 0.50 0.25 0 1 2 3 4 5 6 7 8 9 10 Quantity of Output Copyright © 2004 South-Western
  • 45. Graphical ATC • The ATC curve is U-shaped. • At very low levels of output ATC is high because fixed cost is spread over only a few units. • ATC declines as output increases. • ATC starts rising because AVC rises substantially.
  • 46. Graphical Relationships $200 • ATC is the vertical sum of AVC and AFC. Costs 150 ATC AVC 100 AFC 50 AVC AFC 0 1 2 3 4 5 6 7 8 9 10 Q
  • 47. Graphical Relationships $200 • AVC declines, reaches a minimum, and then increases again. 150 Costs • MC curve intersects the AVC and ATC at their respective minimum MC ATC AVC 100 50 AFC 0 1 2 3 4 5 6 7 8 9 10 Q
  • 48. Graphical Relationships • AVC and ATC get closer together as output increases, but the two lines never meet.
  • 49. Graphical Relationships • • • • • • Marginal cost and diminishing returns Marginal cost and marginal product Marginal cost and average variable cost Marginal cost and average total cost Production curves and cost curves Shifts in cost curves
  • 50. Graphical Relationships • Marginal cost rises with the amount of output produced. – This reflects the property of diminishing marginal product.
  • 51. Graphical Relationships • Marginal cost and marginal product Declining MP Implies That MC Will Eventually Rise with Output
  • 52. Graphical Relationships • Marginal cost and marginal product In the short run, every firm is constrained by some fixed input that: leads to diminishing returns to variable inputs As a firm approaches that capacity, it becomes increasingly costly to produce successively higher levels of output. Marginal costs ultimately increase with output in the short run.
  • 53. Graphical Relationships • Marginal cost and average variable cost - When MC is below average cost, average cost is declining. - When MC is above average cost, average cost is increasing. - Rising MC intersects AVC at the minimum point of AVC.
  • 54. Graphical Relationships • Relationship between Marginal Cost and Average Total Cost – The relationship between ATC and MC is exactly the same as the relationship between AVC and MC. – If MC is below ATC, ATC will decline toward MC. – If MC is above ATC, ATC will increase. – As a result, MC intersects ATC at ATC’s minimum point, for the same reason that it intersects the AVC curve at its minimum point.
  • 55. Graphical Relationships • Three Important Properties of Cost Curves – MC eventually rises with the quantity of output. – The ATC curve is U-shaped. – The MC curve crosses the ATC curve at the minimum of ATC.
  • 56. Relationship between Production curves and cost curves Average Product and Marginal Product Production Curves AP MP Quantity of Labor Cost (Dollars) MC AVC Cost Curves Quantity of Output
  • 57. Shifts in cost curves – Changes in resources prices or technology will cause costs curves to shift. – If fixed cost increases, the AFC curve would be shifted upward. The ATC curve would also move upward. – If the price (wage) of labor or some other variable input rose, AVC, ATC, and MC would rise and those cost curves would all shift upward.
  • 58. Short-Run Production Costs A Summary of Cost Concepts Term Definition Equation Accounting costs Out-of-pocket costs or costs as an accountant would define them. Sometimes referred to as explicit costs. - Economic costs Costs that include the full opportunity costs of all inputs. These include what are often called implicit costs. - Total fixed costs Costs that do not depend on the quantity of output produced. These must be paid even if output is zero. TFC Total variable costs Costs that vary with the level of output. TVC Total cost The total economic cost of all the inputs used by a firm in production. Average fixed costs Fixed costs per unit of output. Average variable costs Variable costs per unit of output. Average total costs Total costs per unit of output. Marginal costs The increase in total cost that results from producing 1 additional unit of output. TC = TFC + TVC AFC = TFC/q AVC = TVC/q ATC = TC/q ATC = AFC + AVC MC = DTC/Dq
  • 59. Long-run production costs • For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. – In the short run, some costs are fixed. – In the long run, fixed costs become variable costs.
  • 60. Long-run production costs • Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.
  • 61. Long-Run Production Costs • The firm can alter its plant capacity; it can build a larger plant. • The industry also can change its overall capacity. • The long run allows sufficient time for new firms to enter or for existing firms to leave and industry. • We are concerning only with changes in plant capacity.
  • 62. Long-Run Production Costs • Choose your plant size – In the long run, a firm may choose its level of capital, and will select a size of firm that provides the lowest level of ATC. • Minimize ATC – No distinction between Fixed and Variable Costs because all resources, and therefore all costs, are variable in the long run. • Different ATC curves: Short run • Long run ATC: Envelope of short run ATC
  • 63. Average Total Costs Long-Run ATC Curve ATC-1 ATC-5 ATC-2 ATC-3 ATC-4 Output • Any number of short-run optimum size cost curves can be constructed. • The long-run ATC curve shows the lowest ATC at which any output level can be produced.
  • 64. Average Total Costs Long-Run ATC Curve ATC-1 ATC-5 ATC-2 ATC-3 ATC-4 Output The long-run ATC curve just “envelopes” the short run ATCs Long-Run ATC
  • 65. Economies and diseconomies of scale • Economies of scale – factors that lower average cost as the size of the firm rises in the long run – Sources: Labor specialization, Managerial specialization, Efficient capital, etc. • Diseconomies of scale – factors that raise average cost as the size of the firm rises in the long run – Sources: increased cost of managing and coordination as firm size rises • Constant returns to scale – average costs do not change as firm size changes
  • 66. Average Total Costs Long-Run ATC Shapes Constant Returns To Scale Economies Of Scale Diseconomies Of Scale Long-Run ATC q1 q2 Output Long-run ATC curve where economies of scale exist
  • 67. Minimum efficient scale • Minimum efficient scale = lowest level of output at which Long-Run ATC is minimized