Download Production Costs - Helena Glebocki Keefe

Principles of Microeconomics
Chapter 13
Understanding Production Costs
Production Choices of Firms
• All firms have one goal in mind: MAX PROFITS
PROFITS = TOTAL REVENUE – TOTAL COST
• Two ways to reach this goal:
– Maximize total revenue
Total Revenue = Price X Quantity
– Minimize total costs
Total Costs = Fixed Costs + Variable Costs
Production Costs
Economic Costs for producers include explicit and implicit
costs
- Explicit Costs: Financial costs
- Implicit Costs: Opportunity costs
Example: Caroline can use $300,000 of her savings to start her
firm which is in a savings account paying 5% interest. OR Caroline
borrow $200,000 from a bank at the same interest rate and used
$100,000 from her savings. Which should she do?
Example of Economic Costs
Choice A:
Caroline’s cost to start her business:
–
–
–
–
Explicit Cost = $300,000
Implicit Cost = ($300,000 X 5%) = $15,000
Total Economic Cost = $315,000
Total Accounting Cost = $300,000
Choice B:
Caroline’s cost to start her business:
– Explicit Cost = $200,000 + $100,000 + ($200,000 X 5%) =
$310,000
– Implicit Cost = ($100,000 X 5%) = $5,000
– Total Economic Cost = $315,000
– Total Accounting Cost = $310,000
Application Reflection
Why does this matter?
•
•
•
This example illustrates the difference between economic costs and accounting costs
Economists always factor in opportunity costs into the decisions people and firms make
This will be important when we talk about economic profits – zero economic profits reflect
revenue minus economic costs which include the implicit opportunity costs of a decision.
They are not zero profits in the economic sense – the business can still be making an
accounting profit but break even with their economic profit!
What’s the most important takeaway?
•
•
•
Economists always factor in opportunity costs
Economic Costs will therefore be higher than accounting costs
Economic Profits reflect total revenue and total economic costs
MUDDIEST POINT?
Determining Production via Production
Function
Production Function: Relationship between quantity of
inputs and total output
Q = f(Land, Labor, Capital)
Example: Determine the production of good A if its
production function is:
Q = 100 K1/2 + 25 L1/2
Assume the firm uses one machine and increases its
workers by 10.
6
Determining Production via Production
Function
Production Function: Relationship between quantity of
inputs and total output
Q = f(Land, Labor, Capital)
Example: Determine the production of good A if its
production function is:
Q = 100 K1/2 + 25 L1/2
7
Production Function Example
Q = 100 K1/2 + 25 L1/2
CAPITAL
LABOR
Prod. Function
1
5
100*1
1
6
100*1
1
7
100*1
1
8
100*1
1
9
100*1
1
10
100*1
1/2
1/2
1/2
1/2
1/2
1/2
OUTPUT
1/2
+ 25*5
1/2
+ 25*6
1/2
+ 25*7
1/2
+ 25*8
1/2
+ 25*9
1/2
+ 25*10
155.9
161.2
166.1
170.7
175.0
179.1
No. of Machines
Constant
8
Production Function Example
Q = 100 K1/2 + 25 L1/2
CAPITAL
LABOR
1
5
100*1
1
6
100*1
1
7
100*1
1
8
100*1
1
9
100*1
1
10
100*1
No. of Workers
Increasing by 1
Prod. Function
1/2
1/2
1/2
1/2
1/2
1/2
OUTPUT
1/2
+ 25*5
1/2
+ 25*6
1/2
+ 25*7
1/2
+ 25*8
1/2
+ 25*9
1/2
+ 25*10
155.9
161.2
166.1
170.7
175.0
179.1
9
Production Function Example
Q = 100 K1/2 + 25 L1/2
CAPITAL
LABOR
Prod. Function
1
5
100*1
1
6
100*1
1
7
100*1
1
8
100*1
1
9
100*1
1
10
100*1
1/2
1/2
1/2
1/2
1/2
1/2
OUTPUT
1/2
+ 25*5
1/2
+ 25*6
1/2
+ 25*7
1/2
+ 25*8
1/2
+ 25*9
1/2
+ 25*10
Use Production Function
To calculate how much we produce
155.9
161.2
166.1
170.7
175.0
179.1
10
Production Costs
Rent Price of Capital = $800  FIXED COST
Wages of workers = $25  VARIABLE COST
CAPITAL
LABOR
1
5
1
6
1
7
1
8
1
9
1
10
Cost of CAPITAL Cost of LABOR
TOTAL COST
11
Production Costs
Rent Price of Capital = $800  FIXED COST
Wages of workers = $25  VARIABLE COST
CAPITAL
LABOR
Cost of CAPITAL Cost of LABOR
TOTAL COST
1
5
800
125
925
1
6
800
150
950
1
7
800
175
975
1
8
800
200
1000
1
9
800
225
1025
1
10
800
250
1050
12
Marginal Product of Labor
Marginal Product – Increase in output resulting from
an increase in one of the inputs
MPL = Change in Output/ Change in Labor
LABOR
OUTPUT
5
155.9
6
161.2
7
166.1
8
170.7
9
175.0
10
179.1
MPL
13
Marginal Product of Labor
Marginal Product – Increase in output resulting from
an increase in one of the inputs
MPL = Change in Output per Worker
LABOR
OUTPUT
MPL
5
155.9
6
161.2
5.30
7
166.1
4.90
8
170.7
4.60
9
175.0
4.30
10
179.1
4.10
14
Increasing Labor Only
Diminishing Marginal Returns: Output is
increasing at a decreasing rate
15
Marginal Analysis
• Marginal analysis: examination of the associated costs and potential
benefits of specific business activities or financial decisions.
• Goal: to determine if the costs associated with the change in activity
will result in a benefit that is sufficient enough to offset them.
• Instead of focusing on business output as a whole, the impact on the
cost of producing an individual unit is most often observed as a point
of comparison.
Marginal Analysis
• Marginal analysis: examination of the associated costs and potential
benefits of specific business activities or financial decisions.
• Goal: to determine if the costs associated with the change in activity
will result in a benefit that is sufficient enough to offset them.
• Instead of focusing on business output as a whole, the impact on the
cost of producing an individual unit is most often observed as a point of
comparison.
Marginal Analysis
• Marginal analysis: examination of the associated costs and potential
benefits of specific business activities or financial decisions.
• Goal: to determine if the costs associated with the change in activity
will result in a benefit that is sufficient enough to offset them.
• Instead of focusing on business output as a whole, the impact on the
cost of producing an individual unit is most often observed as the
best point of comparison.
Example of Marginal Analysis
•
•
A manufacturer wishes to expand its production
A marginal analysis of the costs and benefits is necessary
COSTS
BENEFITS
Additional manufacturing equipment
Estimated increase in sales attributed to the
additional production
Additional employees for increased output
Larger or New Facilities
Additional materials for production
•
If the increase in income > the increase in cost, the expansion may be a wise
investment
Production Costs
K * $100
L * $25
Fixed + Variable
LABOR
OUTPUT
FIXED COST
VARIABLE COST TOTAL COST
5
156
800
125
925
6
161
800
150
950
7
166
800
175
975
8
171
800
200
1000
9
175
800
225
1025
10
179
800
250
1050
AFC
AVC
ATC
MC
To analyze the production decisions of a
firm, a firm conducts “marginal analysis”
Decisions are based on per-unit calculations
Therefore, need to calculate costs/unit
20
Production Costs
FIXED COST VARIABLE COST TOTAL COST
FC/Q
VC/Q
TC/Q
AFC
AVC
ATC
LABOR
OUTPUT
MC
5
156
800
125
925
5.13
0.80
5.93
6
161
800
150
950
4.96
0.93
5.89
4.69
7
166
800
175
975
4.82
1.05
5.87
5.10
8
171
800
200
1000
4.69
1.17
5.86
5.47
9
175
800
225
1025
4.57
1.29
5.86
5.83
10
179
800
250
1050
4.47
1.40
5.86
6.16
Costs per unit of output
produced
21
Average Fixed Cost Curve
Cost
AFC
Q
22
Average Variable Cost Curve
Cost
AVC
Q
23
Average Total Cost Curve
Cost
ATC
Q
24
Marginal Cost Curve
Cost
MC
ATC
Q
• When MC < ATC  ATC is falling
• When MC > ATC  ATC is rising
• MC crosses ATC at minimum – EFFICIENT SCALE
25
Application
Mila’s Coffee Shop currently has only 2 locations. However if it expands in the
future, it is facing the following SRATC:
Average Total Cost
Number of
Locations
Q = 100
Q = 200
Q = 300
Q = 400
1
30
20
25
30
2
40
25
15
25
3
50
35
25
20
• If Mila’s Coffee Shop is currently serving 200 customers, what is its SRATC?
• If it was expecting to serve 200 customers over the next several years, how
many locations should it have?
• If instead it was expecting to increase its customer base to 400 in the long
run, how many locations should it have?
• Graph the SRATC and LRATC.
Application
Mila’s Coffee Shop currently has only 2 locations. However if it expands in the
future, it is facing the following SRATC:
Average Total Cost
•
•
•
•
Number of
Locations
Q = 100
Q = 200
Q = 300
Q = 400
1
30
20
25
30
2
40
25
15
25
3
50
35
25
20
If Mila’s Coffee Shop is currently serving 200 customers, what is it’s SRATC?
If it was expecting to serve 200 customers over the next several years, how
many locations should it have?
If instead it was expecting to increase its customer base to 400 in the long run,
how many locations should it have?
Graph the SRATC and LRATC.
Application
Mila’s Coffee Shop currently has only 2 locations. However if it expands in the
future, it is facing the following SRATC:
Average Total Cost
•
•
•
•
Number of
Locations
Q = 100
Q = 200
Q = 300
Q = 400
1
30
20
25
30
2
40
25
15
25
3
50
35
25
20
If Mila’s Coffee Shop is currently serving 200 customers, what is it’s SRATC?
If it was expecting to serve 200 customers over the next several years, how
many locations should it have?
If instead it was expecting to increase its customer base to 400 in the long run,
how many locations should it have?
Graph the SRATC and LRATC.
Application
Mila’s Coffee Shop currently has only 2 locations. However if it expands in the
future, it is facing the following SRATC:
Average Total Cost
•
•
•
•
Number of
Locations
Q = 100
Q = 200
Q = 300
Q = 400
1
30
20
25
30
2
40
25
15
25
3
50
35
25
20
If Mila’s Coffee Shop is currently serving 200 customers, what is it’s SRATC?
If it was expecting to serve 200 customers over the next several years, how
many locations should it have?
If instead it was expecting to increase its customer base to 400 in the long run,
how many locations should it have?
Graph the SRATC and LRATC.
Application
Mila’s Coffee Shop currently has only 2 locations. However if it expands in the
future, it is facing the following SRATC:
Average Total Cost
•
•
•
•
Number of
Locations
Q = 100
Q = 200
Q = 300
Q = 400
1
30
20
25
30
2
40
25
15
25
3
50
35
25
20
If Mila’s Coffee Shop is currently serving 200 customers, what is it’s SRATC?
If it was expecting to serve 200 customers over the next several years, how
many locations should it have?
If instead it was expecting to increase its customer base to 400 in the long run,
how many locations should it have?
Graph the SRATC and LRATC.
Long Run vs. Short Run Total Cost
ATC
SRATC 1
One Cafe
SRATC 2
Two Cafes
SRATC 3
Three Cafes
LRATC 1
Output
Economies of Scale
Diseconomies of Scale
ATC is falling with
increase in output
ATC is rising with
increase in output
31
Application Reflection
Why does this matter?
•
•
•
Costs differ in the short run and long run, because in the short run some costs are fixed, in
the long run all costs are variable.
A firm can adjust its size to match the lowest ATC over time
It is limited in how much it can change in the short run - it is difficult to just build a new
location in one month or one week, but over the course of several months or years, any firm
can adjust its size
What’s the most important takeaway?
•
•
Costs differ in short run and long run
In the long run, firms will adjust production to try to reach lowest possible ATC and
therefore the LRATC touches the lowest points on the SRATC
MUDDIEST POINT?
Key Takeaways
• All firms are profit maximizing and therefore
want to minimize their costs
• To make their production decisions – need to
consider ATC, AVC, AFC and MC
• NEXT: Merge cost curves with revenue to
understand how different types of firms make
production decisions