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Industrial Organization Part 1: Costs of Production MicroMod5 Objectives • By the end of this module, SWBAT – Explain the difference between accounting and economic profits and explicit vs. implicit costs – Describe the relationship between the production function and total cost curve – Draw and describe the “big three” average cost curves and then show how marginal cost fits in – Explain the benefits of economies of scale in the long run applications of costs of production SLOs • Corporations routinely focus on decreasing the costs of production for goods and services in order to maximize profit • Understanding costs is a lifelong learning skill in the field of economics that explains much firm behavior • Also, important to understand the externalities of minimizing costs – Layoffs – Tax shelters – Undocumented laborers, migrant laborers, etc. Recap on Profit • Profit = Total Revenue - Total Cost • Costs come in two flavors – Explicit - costs that require expenditures by business (accountant’s cost) – Implicit - costs that do not require expenditures by businesses (i.e. time, energy, other opportunity costs) – Explicit + implicit costs = total costs Recap on Profit • in similar fashion, accounting profit = TR - total explicit costs • economic profit = TR - total cost • total cost figure forms the basis for a whole series of curves that provides a detailed picture of supplier behavior Production Function • relationship between quantity of inputs used to produce and quantity of output • looks like left half of Laffer Curve • diminishing marginal product - as amount of inputs increases, becomes less productive • common sense tells you this is true - “too many cooks in the kitchen” adage Total Cost Curve • other way to express the same notion as production function • diminishing marginal product due to rising marginal cost Total Cost Curve Production Function Total Cost Curve The Big Three • Fixed costs - costs that don’t vary with quantity of goods, services produced • Variable costs - costs that DO vary with quantity of goods, services produced • Marginal cost - increase in total cost that arises from the next unit of good, service The Big Three - Salon Example • Fixed costs - rent for hair salon • Variable costs - hair product in terms of gel, relaxer, mousse, etc. • Marginal cost - how much the next dye job you do will cost you in terms of materials Average Total Cost • U-shaped graph • mathematically, it is average fixed cost plus average variable cost • AFC graph shaped like an L, AVC graph shaped like very elastic supply curve • resulting sum in ATC graph becomes a flattened U Average Total Cost Marginal Cost • • • • • steepest rise of all cost curves initially falls with ATC but then quickly rises whenever MC < ATC, ATC is decreasing whenever MC > ATC, ATC is increasing MC always, always, always intersects ATC at ATC’s lowest point • this region called “efficient scale” - place where business operates at lowest cost margin Marginal Cost Long Run vs. Short Run • Long run curves differ from short run curves • recall that even though demander usually more flexible in economic decisions than supplier, fixed short run costs can become variable • (i.e. new production facility, invention of new production techniques) Long Run vs. Short Run • As a result, long run curves much flatter than short run cost curves in the same way supply and demand curves are more elastic in the long run • three distinct phases – economies of scale (production up, costs down) – constant returns to scale (production up, costs level) – diseconomies of scale (production up, costs up) Long Run vs. Short Run