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Unit 3 Lesson 1 Introduction, costs, productivity (1) The Costs of Production ECONOMIC COSTS: costs in economics deal with forgoing The opportunity to produce alternative goods and services. This is the same thing as opportunity costs. EXPLICIT COSTS: payment to non-owners ex: If I invest money in my business that money could have been used elsewhere. If I work in that business, I could have worked (earned money) elsewhere. IMPLICIT COSTS: what the resources could have earned in their best alternative employment. Give example of programmer that starts own business that could have made 100,000 in another job as opposed to being in business for himself. NORMAL PROFIT: minimum amount of money needed to keep the business operating. The implicit costs are included here. Implicit costs are included here. (Also called zero economic profit) Total Revenue: Explicit Costs : Implicit Costs : Economic Profit 200,000 100,000 100,000 0 ECONOMIC PROFIT: TOTAL REVENUE (TR) - (All costs implicit and explicit) This is also called pure profit. Notice it includes normal profit. Total Revenue: 200,000 Explicit Costs : 90,000 Implicit Costs : 100,000 Economic Profit 10,000 (This means you are making $10,000 more than you would have made in your next best alternative. Economic profit is not the same thing as accounting profit. Accounting profit is TR - Explicit costs. It does not build in any profits. Short Run: A time period that is too short to vary the size of production. They can not expand their plant... Long Run period of time extensive enough for the firm to change quantities of all resources employed in production (Plant, Labor...) Law of Diminishing Marginal Returns: as successive units of a variable resource are added to a fixed resource, beyond some point the extra, or marginal, product attributable to each additional unit of variable resource will decline. If you are a factory owner and your factory has 4 machines those four machines (and the land and building) are your Fixed costs. With no workers you are producing nothing. If you add a worker the marginal return is increased. If you add a second and third and fourth your marginal return increases. It may even increase with the fifth. What happens if you add a seventh, or an eighth. Your marginal return starts to diminish. TOTAL PRODUCT: combined output from each level of labor and fixed capital goods. Q labor 0 1 2 3 4 5 6 TP 0 15 34 48 60 62 60 MP 15 19 14 12 2 -2 AP 0 15 17 16 15 12.4 10 Notice that graphically the total product 1) Rises at an increasing rate. (Additional workers help a lot.) 2) Increases at a decreasing rate. The slope has changed. (Additional workers help but not as much as they did.) 3) Reaches the maximum and then declines. (Additional workers actually hinder production.) MARGINAL PRODUCT: change in total output with each additional input of labor. Notice that graphically the Marginal Product curve is the slope of the Total product curve. It measures the degree of change associated with each additional worker. This means it will go through the same three stages. 1) It will rise when the Total Product is increasing at an increasing rate. 2) It will begin to decrease when the Total Product starts increasing at a decreasing rate. 3) It will be below zero when Total product starts declining. When Total product is at its maximum the Marginal Product is at zero. AVERAGE PRODUCT: OUTPUT PER WORKER. TP/# OF WORKERS When the marginal product is rising the average product must also be rising. The change in total product is positive therefore the average product must also be increasing. When marginal product is below average product the average product must be declining. Unit 3 Lesson 2 (2) Costs, revenue FIXED COSTS: Those costs which in total do not vary with changes in output. These costs are the same no matter how many of the products that are produced. This is because the firm has had to buy things for production. They are paying for them. (Ex. plant, equipment...) These can only be changed in the long run. VARIABLE COSTS: Those costs which change with the level of output. (Ex. Labor) Notice that the variable costs do not increase at a constant rate in relation to the increase in production. This also goes back to the Law of Diminishing Marginal Returns. The early units add more to Total product than the later units but still cost the same. Once total product starts to decrease it takes more and more variable resources (which cost more) to obtain the same increase in product. TOTAL COSTS: Sum of fixed and variable costs at each level of output. Make them graph it before showing this. AVERAGE FIXED COSTS: TFC/Q (NOTICE IT DECLINES AS Q INCREASES) Notice it declines as Q increases. AVERAGE VARIABLE COSTS: TVC/Q It declines, reaches a minimum and then increases. The average variable cost is at first high because the firm is understaffed and each worker is costly because the firm is understaffed (workers will work slower because they have to go from machine to machine, they may not be able to work the machines as well... As you add more workers they specialization kicks in and production gets more efficient. This leads to lower costs. Eventually the production gets so crowded that workers are waiting in line to produce. This means that each worker costs more per unit produced. AVERAGE TOTAL COSTS: TC/Q OR AFC + AVC OVERHEAD 22-4 MARGINAL COSTS: Additional cost (change in cost) of productin one more unit. MC = _ TC/ _ Q OR _ VC/ _ Q NOTICE that _VC/_Q works because fixed costs do not change in the short run! It is the Marginal Cost that determines if a firm wants to produce an additional unit. The total cost will increase. If the marginal cost is below the average cost what will happen to the average cost? It will fall. It is like a test score. If the change in your score is less than your average what happens. OVERHEAD 22-5 Average Fixed Cost Average Variable Cost 1 100 90.00 190 100 90 2 50 85.00 135 100 80 3 33.33 80.00 113.33 100 70 Total Product Variable Cost Average Total Cost Fixed Cost Marginal Cost 0 240 4 75.00 100 100 60 5 74.00 94 100 70 91.67 100 80 6 16.67 75.00 7 14.29 77.14 539 91.43 100 90 8 12.50 81.25 650 93.75 100 110 9 11.11 86.67 780 97.78 100 130 10 10.00 93.00 930 103 100 150 To calculate VC you take AVC and multiply it by Q. MC From this VC you can then get change in VC = To calculate FC you take AFC and multiply by Q. If labor is the only variable resource and each unit of labor was paid $10, what is the marginal cost at each level of production? Quantity of Labor 0 1 2 3 4 5 6 Total Product 0 15 34 48 60 62 60 Marginal Product 15 19 14 12 2 -2 Average Product 0 15 17 16 15 12.4 10 Marginal Cost Now lets look at MP and MC together. If each additional unit of labor added is done so at the same price the MC will fall as long as the MP is rising. This is because marginal cost is simply the (constant) price or cost of an extra worker divided by his or her marginal product. This means that as long as MP is rising the MC will be falling. However, we know that the Law of Diminishing Returns will eventually take over and the MP will begin to fall. When this happens the MC curve will rise. This means that MP and MC are mirror images of each other. See p. 427 and overhead 22-6. The MC curve will intersect the ATC and AVC at their minimum point. This is because when the change in cost is less than ATC the ATC will fall. If it is more than ATC than ATC will rise. AVERAGE REVENUE: TR / Q. If all units are sold at the same price it is equal to that price. AR = P*Q/Q = P Total Revenue: PRICE X Q. MARGINAL REVENUE: The extra revenue that results in selling one more unit. Marginal Revenue = _ TR/_Q = P*Q2 - P*Q1 = P(Q2 - Q1) = Price O2 - Q1 (Q2 - Q1)