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- 1. Cost of Production Mankiw 13
- 2. Firm’s Goal <ul><li>Profit maximization </li></ul><ul><li>Profits are Revenue( P*q)-Costs </li></ul><ul><li>What are firm’s costs ? </li></ul>
- 3. Costs <ul><li>Economic costs are the full costs of production including a normal rate of return on investment and the opportunity costs of each factor of production. </li></ul><ul><li>A normal rate of return is what you could have earned on your next best investment </li></ul>
- 4. Accounting Costs vs. Economic Costs <ul><li>Accounting costs are explicit costs </li></ul><ul><ul><li>Costs the firm gets a bill for like wages, interests on loans, rent </li></ul></ul><ul><li>Economic costs include opportunity cost </li></ul><ul><li>Consider identical firms, one managed by owner and one with a hired manager. </li></ul><ul><ul><li>Accounting costs will be higher for one with hired manager, but economic costs will not be </li></ul></ul>
- 5. Use the correct costs <ul><li>Accounting costs must be easily measured to reduce the ability to cheat for tax and other purposes. </li></ul><ul><li>Firms must take into account implicit costs as well as explicit costs to make correct decisions. </li></ul><ul><ul><li>Say you inherit a sum of money, should you think of it as free money and use it to start a business? </li></ul></ul>
- 6. Alexander owns a small factory that makes fishing lures. He can make 1,000 lures per year and sell them for $100 each. Alexander pays $25,000 for raw materials to produce the 1,000 lures. He invested a total of $100,000 in the building and equipment: $50,000 of his own savings and $50,000 borrowed at 10 percent; his own money was earning 10 percent interest too. Alexander could work at a competing factory for $40,000. According to this information, Alexander's accounting profit is <ul><li>$30,000. </li></ul><ul><li>$35,000. </li></ul><ul><li>$70,000. </li></ul><ul><li>$75,000. </li></ul><ul><li>$80,000. </li></ul>
- 7. Alexander owns a small factory that makes fishing lures. He can make 1000 lures per year and sell them for $100 each. Alexander pays $25,000 for raw materials to produce the 1000 lures. He invested a total of $100,000 in the building and equipment: $50,000 of his own savings and $50,000 borrowed at 10 percent; his own money was earning 10 percent interest too. Alexander could work at a competing factory for $40,000. According to this information, Alexander's economic profit is <ul><li>$25,000. </li></ul><ul><li>$30,000. </li></ul><ul><li>$35,000. </li></ul><ul><li>$70,000 </li></ul><ul><li>$75,000. </li></ul>
- 8. What makes up costs? <ul><li>Price of inputs </li></ul><ul><ul><li>An input is anything the firm buys to produce its product, like labor, raw materials, machines etc </li></ul></ul><ul><li>Production technology </li></ul><ul><ul><li>determines how many inputs are necessary to produce given amount of output </li></ul></ul>
- 9. Production <ul><li>Remember that we need to know about production to find the firms costs </li></ul><ul><li>We assume there are just two inputs, capital and labor, but that the can be used in various combinations to produce output. </li></ul><ul><ul><li>Can dig a ditch in an hour with 5 men and shovel or one man and ditch digging machine. </li></ul></ul>
- 10. Production Function <ul><li>A production function expresses the relationship between inputs and outputs. </li></ul><ul><li>Q=F(L,K) </li></ul><ul><li>Q=output </li></ul><ul><li>L=labor </li></ul><ul><li>K=capital </li></ul>
- 11. Short Run <ul><li>The short run is a period of time that is short enough so that at least one input is fixed </li></ul><ul><ul><li>The capital input is usually assumed fixed </li></ul></ul><ul><ul><li>Actual time period is different for different industries. </li></ul></ul><ul><li>Like assuming plant size is fixed. </li></ul><ul><li>Production function is simpler. </li></ul><ul><ul><li>Say capital is fixed at 10 units, Q=F(L,10) </li></ul></ul><ul><li>As L increases what will happen to Q? </li></ul>
- 12. Ice Cream Store <ul><li>.What does production function of an ice cream shop look like in the short run? </li></ul><ul><li>We assume the size of the shop is fixed </li></ul><ul><li>We need workers to sell ice cream, we add the first one or two and we sell a lot more ice cream. </li></ul>
- 13. Diminishing Returns <ul><li>At some point we add another worker, sales go up but not by as much. </li></ul><ul><li>Why? </li></ul><ul><ul><li>We have a fixed size of shop </li></ul></ul><ul><ul><li>We have a fixed number of cash registers </li></ul></ul><ul><li>This is what we call the principle of diminishing returns </li></ul>
- 14. Diminishing Returns <ul><li>Diminishing Returns must happen in short run because capital is fixed </li></ul><ul><li>Does not matter what the industry is </li></ul><ul><li>Important to remember that additional workers add less to output because they have less capital per worker </li></ul><ul><ul><li>Quality is the same. </li></ul></ul>
- 15. Example Are these numbers for output consistent with diminishing returns? Yes output increases at decreasing rate Would the firm ever hire 8 workers? No output decreases 128 8 5 147 7 5 144 6 5 125 5 5 96 4 5 63 3 5 32 2 5 9 1 5 0 0 5 Q L K
- 16. Graph
- 17. Marginal and Average Product Average Product=Q/L If L=1, AP=9/1=9 If L=2, AP=32/2=16 Marginal Product= ∆Q/∆L If L=1,MP=9-0/1-0=9 If L=2, MP=32-9/2-1=23 Where is diminishing returns? With 5 th worker, when MP falls 9 9 9 1 -19 16 128 8 3 21 147 7 19 24 144 6 29 25 125 5 33 24 96 4 31 21 63 3 23 16 32 2 - - 0 0 MP AP Q L
- 18. Graph of Marginal and Average Product Diminishing returns
- 19. Diminishing returns <ul><li>Begins when marginal product falls </li></ul><ul><li>Is equal to the slope of the total product curve </li></ul><ul><li>MP= ∆q/∆L </li></ul>
- 20. Marginal Product is slope of Total Product Curve 9 23
- 21. Labor Output 0 0 1 22 2 38 3 50 According to the table above, the marginal product of hiring the third worker is <ul><li>50. </li></ul><ul><li>38. </li></ul><ul><li>16.7. </li></ul><ul><li>12. </li></ul><ul><li>4. </li></ul>According to the table below, the marginal product of hiring the third worker is
- 22. Short Run <ul><li>Capital is fixed </li></ul><ul><li>Diminishing Returns is inevitable </li></ul><ul><li>In short run, TP and MP will always have the shapes of the curves in the previous slides </li></ul>
- 23. Total Product and Costs <ul><li>How do we go from the information about production to the cost curves? </li></ul><ul><li>Two types of inputs in the short run lead to two types of costs, fixed and variable </li></ul>
- 24. Fixed Costs <ul><li>Since firm always has the same amount of capital, even if it produces nothing, it will always have to pay the costs of that capital </li></ul><ul><li>In the example, firm has 5 units of capital if the cost of capital is $50 per unit, its fixed cost will always be $250 </li></ul>
- 25. Fixed Costs <ul><li>Fixed Costs are costs that do not change when output changes </li></ul><ul><li>Sunk costs are a special kind of fixed costs. </li></ul><ul><ul><li>Costs that cannot be recovered </li></ul></ul><ul><ul><li>Example would be a subway tunnel. Once it is built it has not other uses. </li></ul></ul><ul><ul><li>Sunk costs are not relevant to decisions </li></ul></ul>
- 26. Variable Costs <ul><li>Variable costs are costs that vary with output </li></ul><ul><li>Variable costs come from labor </li></ul><ul><li>Amount of labor needed to produce a given output multiplied by the price of labor </li></ul><ul><li>What if Pl=$100? </li></ul>
- 27. Which of the following is most likely a fixed cost in the short run? <ul><li>Wages paid to workers who assemble computers </li></ul><ul><li>Performance bonuses for sales staff of a pharmaceutical company </li></ul><ul><li>Payments for gasoline for company cars driven by the sales staff </li></ul><ul><li>Interest payments on funds borrowed by a farmer to finance farm machinery </li></ul><ul><li>Payments for chemicals in the production of drugs at a pharmaceutical company </li></ul>
- 28. Total Product 147 7 5 144 6 5 125 5 5 96 4 5 63 3 5 32 2 5 9 1 5 0 0 5 Q L K
- 29. Costs FC=Pk*K FC=50*5 VC=Pl*L VC=100*l 147 700 250 144 600 250 125 500 250 96 400 250 63 300 250 32 200 250 9 100 250 0 0 250 Q VC FC
- 31. VC=L*100 00 00 00 00 00 00 00 00 00
- 32. TP to VC <ul><li>Graph has not really changed shape when L is multiplied by 100 (Pl) </li></ul><ul><li>Shape of VC is determined by principle of diminishing returns </li></ul><ul><li>Convention is axis are reversed </li></ul>
- 33. Short Run Costs FC VC Q $ 250
- 34. Short Run Costs FC VC Q $ 250 TC TC=FC=VC
- 35. Costs 33.33 6.46 4.76 1.70 950 700 250 147 5.26 5.90 4.17 1.74 850 600 250 144 3.45 6.00 4.00 2.00 750 500 250 125 3.03 6.77 4.17 2.60 650 400 250 96 3.23 8.73 4.76 3.97 550 300 250 63 4.35 14.06 6.25 7.81 450 200 250 32 11.11 38.89 11.11 27.78 350 100 250 9 250 0 250 0 MC ATC AVC AFC TC V C F C Q MC= ∆TC/∆Q AFC=FC/Q AVC=VC/Q ATC=TC/Q TC=FC+VC VC=PL*L FC=Pk*K
- 36. Quantity of Output Fixed Costs Variable Costs 0 $10 $0 1 10 4 2 10 9 3 10 15 4 10 22 5 10 40 According to the table above, the marginal cost of producing the fifth unit is <ul><li>$3.60. </li></ul><ul><li>$8.00. </li></ul><ul><li>$10.00. </li></ul><ul><li>$40.00. </li></ul><ul><li>$18.00. </li></ul>According to the table below, the marginal cost of producing the fifth unit is
- 37. What will graph of Average Cost Curves look like? <ul><li>AFC=FC/Q, FC is constant as Q ↑, so AFC↓ </li></ul><ul><li>AVC =VC/Q is more difficult, both VC and Q are ↑ </li></ul><ul><li>AVC could ↑ or ↓or stay the same depending on which increases faster </li></ul><ul><li>Must look at shape of VC </li></ul>
- 38. Short Run Costs VC Q $ 50 VC increases slowly at first. Since VC is ↑ more slowly than q, AVC ↓. LaterVC increases faster than q and AVC ↑ .
- 39. Average Cost Curves AFC AVC Q $
- 40. Average Total Cost <ul><li>Total Cost has the same shape as Variable cost (TC=FC+VC) </li></ul><ul><li>ATC=AFC+AVC </li></ul><ul><li>ATC>AVC, ATC will be above AVC </li></ul><ul><li>ATC will have the same shape as AVC </li></ul><ul><li>ATC-AVC=AFC </li></ul>
- 41. Average Cost Curves AFC AVC Q $ ATC AFC
- 42. Marginal Cost <ul><li>Marginal Cost will ↑ </li></ul><ul><ul><li>MC is slope of TC curve, slope is increasing </li></ul></ul><ul><ul><li>MC increases because amount of labor to produce additional units of output is increasing due to diminishing returns </li></ul></ul>
- 43. Labor Output 0 0 1 22 2 38 3 50 Over the range indicated, the production process in the table above exhibits ________ marginal product of labor, and the marginal cost curve for this firm would be ________. <ul><li>increasing; downward sloping. </li></ul><ul><li>increasing; upward sloping. </li></ul><ul><li>decreasing; downward sloping. </li></ul><ul><li>decreasing; upward sloping. </li></ul><ul><li>constant; downward sloping then upward sloping. </li></ul>Over the range indicated, the production process in the table below exhibits _________ marginal product of labor, and the marginal cost curve for this firm would be _________.
- 44. Answer <ul><li>When labor increases from 0 to 1, output increases by 22. Each unit of output takes 1/22 unit of labor </li></ul><ul><li>When labor increases from 1 to 2, output increases by 18. Each unit of output takes 1/18 unit of labor </li></ul>
- 45. MC intersects AC at the minimum <ul><li>If MC<AC, AC falls </li></ul><ul><ul><li>If your semester grades are lower than your GPA, GPA falls </li></ul></ul><ul><li>If MC>AC, AC rises </li></ul><ul><ul><li>If your semester grades are higher than your GPA, GPA rises </li></ul></ul><ul><li>If MC=AC, AC stays the same </li></ul><ul><ul><li>If your semester grades are the same as your GPA, GPA stays the same </li></ul></ul>
- 46. Average Cost Curves AVC Q $ ATC MC
- 47. When marginal cost is above average total cost, <ul><li>average total cost is rising. </li></ul><ul><li>average total cost is falling. </li></ul><ul><li>average total cost is minimized. </li></ul><ul><li>average fixed cost is rising. </li></ul>
- 48. Long Run Cost Curves <ul><li>In Long Run all costs are variable because there are not fixed inputs </li></ul><ul><li>Usually Long Run Curves have the same shape as Short Run Curves </li></ul><ul><li>Diminishing returns is not the reason for the shape of long run curves </li></ul><ul><ul><li>No fixed inputs </li></ul></ul>
- 49. Returns to scale <ul><li>Economies of scale refer to the property where long-run average total cost falls as the quantity of output increases. </li></ul><ul><li>Diseconomies of scale refer to the property where long-run average total cost rises as the quantity of output increases. </li></ul><ul><li>Constant returns to scale refers to the property where long-run average total cost stays the same as the quantity of output increases </li></ul>
- 50. Average Total Cost in the Short and Long Runs
- 51. Long Run Costs <ul><li>We think most cost curves in long run are U shaped because in most industries we do not see many small firms or just one big firm. </li></ul>
- 52. The short run is a period of time less than three months long. <ul><li>True </li></ul><ul><li>False </li></ul>
- 53. The long run average cost curve is U-shaped because the principle of diminishing returns. <ul><li>True </li></ul><ul><li>False </li></ul>

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