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# Lecture 9 costs

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• What can you say about average cost?
• ### Lecture 9 costs

1. 1. Chapter 7The Cost of Production
2. 2. Expansion Path Capital per The expansion path illustrates year the least-cost combinations of labor and capital that can be 150 \$3000 used to produce each level of output in the long-run. Expansion Path \$2000 100 C 75 B 50 300 Units A 25 200 Units Labor per year 50 100 150 200 300©2005 Pearson Education, Inc. Chapter 7 2
3. 3. Optimal Inputs  The minimum cost combination can then be written as: MPL MPK w r  Increase in output for every dollar spent on an input is same for all inputs.©2005 Pearson Education, Inc. Chapter 7 3
4. 4. Expansion Path  It shows optimal input combinations to minimize cost to produce different levels of output  It shows the minimum cost to produce different levels of output  It shows the maximum amount of output that can be produced for different levels of expenditure.©2005 Pearson Education, Inc.
5. 5. A Firm’s Long Run Total Cost Curve Cost/ Year Long Run Total Cost F 3000 E 2000 D 1000 Output, Units/yr 100 200 300©2005 Pearson Education, Inc. Chapter 7 5
6. 6. ©2005 Pearson Education, Inc.
7. 7. LONG RUN AND SHORT RUN COSTS©2005 Pearson Education, Inc. Chapter 7 7
8. 8. Long Run Versus Short Run Cost Curves  In the short run, some costs are fixed  In the long run, firm can change anything including plant size Can produce at a lower average cost in long run than in short run Capital and labor are both flexible  We can show this by holding capital fixed in the short run and flexible in long run©2005 Pearson Education, Inc. Chapter 7 8
9. 9. The Inflexibility of Short Run Production Capital E Capital is fixed at K1. per To produce q1, min cost at K1,L1. year If increase output to Q2, min cost C is K1 and L3 in short run. In LR, can Long-Run change Expansion Path A capital and min costs falls to K2 K2 and L2. Short-Run P Expansion Path K1 Q2 Q1 Labor per year L1 L2 B L3 D F©2005 Pearson Education, Inc. Chapter 7 9
10. 10.  Production technology measures the relationship between input and output  Production technology, together with prices of factor inputs, determine the firm’s cost of production©2005 Pearson Education, Inc. Chapter 7 10
11. 11. Introduction  The optimal, cost minimizing, level of inputs can be determined  A firm’s costs depend on the rate of output  The characteristics of the firm’s production technology affect costs in the long run and short run©2005 Pearson Education, Inc. Chapter 7 11
12. 12. Measuring Cost: Which Costs Matter?  For a firm to minimize costs, we must clarify what is meant by costs and how to measure them It is clear that if a firm has to rent equipment or buildings, the rent they pay is a cost What if a firm owns its own equipment or building?  How are costs calculated here?©2005 Pearson Education, Inc. Chapter 7 12
13. 13. Measuring Cost: Which Costs Matter?  Accounting Cost Actual expenses plus depreciation charges for capital equipment  Economic Cost Cost to a firm of utilizing economic resources in production, including opportunity cost©2005 Pearson Education, Inc. Chapter 7 13
14. 14. Opportunity Cost  An Example A firm owns its own building and pays no rent for office space Does this mean the cost of office space is zero? The building could have been rented instead Foregone rent is the opportunity cost of using the building for production and should be included in the economic costs of doing business©2005 Pearson Education, Inc. Chapter 7 14
15. 15. Opportunity Cost  A person starting their own business must take into account the opportunity cost of their time Could have worked elsewhere making a competitive salary©2005 Pearson Education, Inc. Chapter 7 15
16. 16. Measuring Cost: Which Costs Matter?  Some costs vary with output, while some remain the same no matter the amount of output  Total cost can be divided into: 1. Fixed Cost  Does not vary with the level of output 2. Variable Cost  Cost that varies as output varies©2005 Pearson Education, Inc. Chapter 7 16
17. 17. Fixed and Variable Costs  Total output is a function of variable inputs and fixed inputs  Therefore, the total cost of production equals the fixed cost (the cost of the fixed inputs) plus the variable cost (the cost of the variable inputs), or… TC FC VC©2005 Pearson Education, Inc. Chapter 7 17
18. 18. Fixed and Variable Costs  Which costs are variable and which are fixed depends on the time horizon  Short time horizon – most costs are fixed  Long time horizon – many costs become variable©2005 Pearson Education, Inc. Chapter 7 18
19. 19. Measuring Cost: Which Costs Matter?  Personal Computers Most costs are variable Largest component: labor  Software Most costs are sunk Initial cost of developing the software©2005 Pearson Education, Inc. Chapter 7 19
20. 20. Narayan Hridalaya  Providing health care involves high costs and low accessibility  What does a hospital produce?  What does a hospital use to produce this?  Narayan Hridalaya founded on the principle of providing low cost and accessible health care to all©2005 Pearson Education, Inc. 20
21. 21. Daily Bread  Multiple outlets in and around Bangalore  What are the outputs they produce?  What are the inputs?©2005 Pearson Education, Inc. 21
22. 22. AVERAGE AND MARGINAL COST©2005 Pearson Education, Inc. Chapter 7 22
23. 23. Marginal and Average Cost  In completing a discussion of costs, must also distinguish between Average Cost Marginal Cost©2005 Pearson Education, Inc. Chapter 7 23
24. 24. Measuring Costs  Marginal Cost (MC): The cost of expanding output by one unit Fixed costs have no impact on marginal cost, so it can be written as: ΔVC ΔTC MC Δq Δq©2005 Pearson Education, Inc. Chapter 7 24
25. 25. Measuring Costs  Average Total Cost (ATC) Cost per unit of output Also equals average fixed cost (AFC) plus average variable cost (AVC) TC ATC AFC AVC q TC TFC TVC ATC q q q©2005 Pearson Education, Inc. Chapter 7 25
26. 26. A Firm’s Short Run Costs©2005 Pearson Education, Inc. Chapter 7 26
27. 27. MC AND AC CURVES©2005 Pearson Education, Inc. Chapter 7 27
28. 28. Determinants of Short Run Costs – An Example  Assume the wage rate (w) is fixed relative to the number of workers hired  Variable costs is the per unit cost of extra labor times the amount of extra labor: wL VC w L MC q q©2005 Pearson Education, Inc. Chapter 7 28
29. 29. Determinants of Short Run Costs – An Example  Remembering that Q MPL L  And rearranging L 1 L for a 1 unit Q Q MPL©2005 Pearson Education, Inc. Chapter 7 29
30. 30. Determinants of Short Run Costs – An Example  We can conclude: w MC MPL  …and a low marginal product (MPL) leads to a high marginal cost (MC) and vice versa©2005 Pearson Education, Inc. Chapter 7 30
31. 31. Determinants of Short Run Costs  The rate at which these costs increase depends on the amount of input changes with change in output  i.e. Costs depend upon the nature of production process..©2005 Pearson Education, Inc. Chapter 7 31
32. 32. Determinants of Short Run Costs  If marginal product of labor decreases significantly as more labor is hired Costs of production increase rapidly Greater and greater expenditures must be made to produce more output©2005 Pearson Education, Inc. Chapter 7 32
33. 33. Determinants of Short Run Costs  Consequently (from the table): MC decreases initially with increasing returns 0 through 4 units of output MC increases with decreasing returns 5 through 11 units of output©2005 Pearson Education, Inc. Chapter 7 33
34. 34. Cost Curves for a Firm TC Cost 400 (\$ per Total cost year) VC is the vertical sum of FC and VC. 300 Variable cost increases with production and the rate varies with 200 increasing and decreasing returns. Fixed cost does not 100 vary with output 50 FC 0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output©2005 Pearson Education, Inc. Chapter 7 34
35. 35. Cost Curves 120 100 MCCost (\$/unit) 80 60 ATC 40 AVC 20 AFC 0 0 2 4 6 8 10 12 Output (units/yr)©2005 Pearson Education, Inc. Chapter 7 35
36. 36. ©2005 Pearson Education, Inc.
37. 37. Cost Curves  When MC is below AVC, AVC is falling  When MC is above AVC, AVC is rising  When MC is below ATC, ATC is falling  When MC is above ATC, ATC is rising  Therefore, MC crosses AVC and ATC at the minimums The Average – Marginal relationship©2005 Pearson Education, Inc. Chapter 7 37
38. 38. Cost Curves for a Firm  The line drawn from the origin to the P TC variable cost curve: 400 VC  Its slope equals AVC  The slope of a point 300 on VC or TC equals MC 200  Therefore, MC = AVC A at 7 units of output 100 (point A) FC 1 2 3 4 5 6 7 8 9 10 11 12 13 Output©2005 Pearson Education, Inc. Chapter 7 38
39. 39. LONG RUN COSTS©2005 Pearson Education, Inc. Chapter 7 39
40. 40. ©2005 Pearson Education, Inc.
41. 41. ©2005 Pearson Education, Inc.
42. 42. Long Run Cost with Economies and Diseconomies of Scale©2005 Pearson Education, Inc. Chapter 7 42
43. 43. Long Run Cost with Constant Returns to Scale  The optimal plant size will depend on the anticipated output If expect to produce q0, then should build smallest plant: AC = \$8 If produce more, like q1, AC rises If expect to produce q2, middle plant is least cost If expect to produce q3, largest plant is best©2005 Pearson Education, Inc. Chapter 7 43
44. 44. Long Run Cost with Economies and Diseconomies of Scale©2005 Pearson Education, Inc. Chapter 7 44
45. 45. Long Run Cost with Constant Returns to Scale  What is the firm’s long run cost curve? Firms can change scale to change output in the long run The long run cost curve is the dark blue portion of the SAC curve which represents the minimum cost for any level of output Firm will always choose plant that minimizes the average cost of production©2005 Pearson Education, Inc. Chapter 7 45
46. 46. Long Run Cost with Constant Returns to Scale  The long-run average cost curve envelops the short-run average cost curves  The LAC curve exhibits economies of scale initially but exhibits diseconomies at higher output levels©2005 Pearson Education, Inc. Chapter 7 46
47. 47. RETURNS TO SCALE©2005 Pearson Education, Inc. Chapter 7 47
48. 48. BIG CITIES  Metropolis twice the size of one, number of gas stations, length of pipelines, infrastructure decreases by 15%  Why?©2005 Pearson Education, Inc. 48
49. 49. Narayan Hridalaya  Provide health care at full price To patients from well to do background  These patients subsidize `poor’ patients  Run at a profit of 7.7%  Why is Narayan Hridalaya able to do this?©2005 Pearson Education, Inc. 49
50. 50. Narayan Hridalaya  Number of Beds, 2001: 225  Current No. of Beds across India: 30,000  How does number of beds play a role in profits?©2005 Pearson Education, Inc. 50
51. 51. Returns to Scale  Rate at which output increases as inputs are increased proportionately Increasing returns to scale Constant returns to scale Decreasing returns to scale©2005 Pearson Education, Inc. 51
52. 52. Returns to Scale  Increasing returns to scale: output more than doubles when all inputs are doubled What happens to the isoquants?©2005 Pearson Education, Inc. 52
53. 53. Increasing Returns to Scale Capital A The isoquants(machine move closer hours) together 4 30 2 20 10 5 10 Labor (hours)©2005 Pearson Education, Inc. 53
54. 54. Long Run Versus Short Run Cost Curves Increasing Returns to Scale  If input is doubled, output will more than double  To double output input is less than doubled  AC decreases at all levels of output©2005 Pearson Education, Inc. Chapter 7 54
55. 55. Long Run Costs  As output increases, firm’s AC of producing is likely to decline to a point 1. On a larger scale, workers can better specialize 2. Scale can provide flexibility – managers can organize production more effectively 3. Firm may be able to get inputs at lower cost if can get quantity discounts. Lower prices might lead to different input mix.©2005 Pearson Education, Inc. Chapter 7 55
56. 56. Returns to Scale  Constant returns to scale: output doubles when all inputs are doubled  Isoquants are equidistant apart©2005 Pearson Education, Inc. 56
57. 57. Returns to Scale Capital A(machine 6 hours) 30 4 Constant Returns: 2 Isoquants are 0 equally spaced 2 10 5 10 15 Labor (hours) ©2005 Pearson Education, Inc. 57
58. 58. Long Run Versus Short Run Cost Curves Constant Returns to Scale  If input is doubled, output will double  To double output, input has to less than double  AC cost is constant at all levels of output©2005 Pearson Education, Inc. Chapter 7 58
59. 59. Returns to Scale  Decreasing returns to scale: output less than doubles when all inputs are doubled  Isoquants become farther apart©2005 Pearson Education, Inc. 59
60. 60. Long Run Versus Short Run Cost Curves Decreasing Returns to Scale  If input is doubled, output will less than double  To double output has to more than double  AC increases at all levels of output©2005 Pearson Education, Inc. Chapter 7 60
61. 61. Long Run Costs  At some point, AC will begin to increase 1. Factory space and machinery may make it more difficult for workers to do their jobs efficiently 2. Managing a larger firm may become more complex and inefficient as the number of tasks increase 3. Bulk discounts can no longer be utilized. Limited availability of inputs may cause price to rise.©2005 Pearson Education, Inc. Chapter 7 61
62. 62. ©2005 Pearson Education, Inc.
63. 63. Long Run Versus Short Run Cost Curves  In the long run: Firms experience increasing and decreasing returns to scale and therefore long-run average cost is “U” shaped. Long-run marginal cost curve measures the change in long-run total costs as output is increased by 1 unit©2005 Pearson Education, Inc. Chapter 7 63
64. 64. Long Run Versus Short Run Cost Curves  Long-run marginal cost leads long-run average cost: If LMC < LAC, LAC will fall If LMC > LAC, LAC will rise Therefore, LMC = LAC at the minimum of LAC  In special case where LAC is constant, LAC and LMC are equal©2005 Pearson Education, Inc. Chapter 7 64
65. 65. Long Run Average and Marginal Cost Cost (\$ per unit of output LMC LAC A Output©2005 Pearson Education, Inc. Chapter 7 65
66. 66. Economies and Diseconomies of Scale  Economies of Scale Increase in output is greater than the increase in inputs  Diseconomies of Scale Increase in output is less than the increase in inputs  U-shaped LAC shows economies of scale for relatively low output levels and diseconomies of scale for higher levels©2005 Pearson Education, Inc. Chapter 7 66
67. 67. Long Run Costs  Increasing Returns to Scale Output more than doubles when the quantities of all inputs are doubled  Economies of Scale Doubling of output requires less than a doubling of cost©2005 Pearson Education, Inc. Chapter 7 67
68. 68. COST OUTPUT ELASTICITY©2005 Pearson Education, Inc. Chapter 7 68
69. 69. Long Run Costs  Economies of scale are measured in terms of cost-output elasticity, EC  EC is the percentage change in the cost of production resulting from a 1-percent increase in output EC CC MC QQ AC©2005 Pearson Education, Inc. Chapter 7 69
70. 70. Long Run Costs  EC is equal to 1, MC = AC  Costs increase proportionately with output  Neither economies nor diseconomies of scale  EC < 1 when MC < AC  Economies of scale  Both MC and AC are declining  EC > 1 when MC > AC  Diseconomies of scale  Both MC and AC are rising©2005 Pearson Education, Inc. Chapter 7 70
71. 71. ECONOMIES OF SCOPE©2005 Pearson Education, Inc. Chapter 7 71
72. 72. Economies of Scope  P&G produces different types of anti aging creams  Would it benefit P&G to Produce them separately?©2005 Pearson Education, Inc. Chapter 7 72
73. 73. Production with Two Outputs – Economies of Scope  Many firms produce more than one product and those products are closely linked  Examples: Chicken farm--poultry and eggs Automobile company--cars and trucks University--teaching and research©2005 Pearson Education, Inc. Chapter 7 73
74. 74. Production with Two Outputs – Economies of Scope  Advantages 1. Both use capital and labor 2. The firms share management resources 3. Both use the same labor skills and types of machinery©2005 Pearson Education, Inc. Chapter 7 74
75. 75. Production with Two Outputs – Economies of Scope  The degree of economies of scope (SC) can be measured by percentage of cost saved producing two or more products jointly: C(q1 ) C(q 2 ) C(q1 ,q2 ) SC C(q1 ,q2 )  C(q1) is the cost of producing q1  C(q2) is the cost of producing q2  C(q1,q2) is the joint cost of producing both products©2005 Pearson Education, Inc. Chapter 7 75
76. 76. Production with Two Outputs – Economies of Scope  With economies of scope, the joint cost is less than the sum of the individual costs  Interpretation: If SC > 0  Economies of scope If SC < 0  Diseconomies of scope The greater the value of SC, the greater the economies of scope©2005 Pearson Education, Inc. Chapter 7 76
77. 77. Production with Two Outputs – Economies of Scope  There is no direct relationship between economies of scope and economies of scale May experience economies of scope and diseconomies of scale May have economies of scale and not have economies of scope©2005 Pearson Education, Inc. Chapter 7 77