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Production and Cost in the Firm • Session 6 : CHAPTER 7 • Tips for Navigation in the presentation: The link “ ” in the top left appears on every slide and operates as a hyper link to the slide “Lecture Outline” • Navigation Bar to main topics • Two thoughts to start with: • Corn & Beef • Formulas 1 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 1.1 Production and Cost in the Firm • Rising demand for Ethanol has increased the price of beef because both goods use corn as an input in their production 2 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 1.2 Summary of Formulas Label Variable Input (Labor) Total Production Average Product Marginal Product Labor Cost Fixed Cost Total Cost Marginal Cost Average Total Cost Average Variable Cost Average Fixed Cost Average Total Cost Abbreviation Formula L q AP q/L MP chg q / chg L VC FC TC VC + FC MC chg TC / chg q ATC TC / q AVC VC / q AFC FC / q ATC ATC = AFC + AVC 3 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End Session 6 Lecture Outline • • • • • • • 1. First Slide 2 Profit Measures 3 Short and Long Run 4 Short Run Costs 5 Long Run Costs 6 Surplus: Producer & Consumer 7. End of Presentation 4 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 2.0 Profit Measures • 2.0 Profit Measures: – – – – 2.1 Explicit & Implicit Cost (Dn) 2.2 Economic Profit (Table) 2.3 Accounting, Economic, Normal Profit (Dn) 2.4 Self-Evaluation Exercise 5 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 2.1 Explicit and Implicit Costs • Explicit costs – Refer to the firm’s actual cash payments for resources wages, rent, taxes, etc. • Implicit costs – The opportunity costs of using resources owned by the firm or provided by the firm’s owners – Require no cash payment and no entry in the firm’s accounting statement, which records its revenues, explicit costs, and accounting profits 6 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 2.2 a Economic Profit • Here is a stylized example that makes the distinction between explicit and implicit costs and the difference between “accounting profit” and the economists alternative measure “economic profit” . • Wanda Wheeler currently earns $50,000 in her current job – She decides to start her own business – She withdraws $20,000 from her savings account, hires an assistant (at $21,000), and uses a spare bay in her garage that had been renting for $1,200 a year – The next slide shows these numbers in a table 7 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 2.2b Economic Profit • • Accounting profit equals total revenue minus explicit costs used to determine a firm’s taxable income However, this ignores the opportunity cost of Wanda’s own resources – – – • Her forgone salary of $50,000 Annual interest of $1,000 from the savings used to start the business Rental income of $1,200 Economic profit equals total revenue minus all costs, both explicit and implicit – Accounting profit of $64,000 less implicit costs of $52,200 economic profit of $11,800 Total revenue Less explicit costs: Assistant's salary Material and equipment Equals accounting profit Less implicit costs: Wanda's forgone salary Forgone interest on savings Forgone garage rental Equals economic profit $105,000 41,000 -21,000 -20,000 $64,000 52,200 50,000 -1,000 -1,200 $11,800 8 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 2.3 Normal Profit • There is one other profit measure to consider: the accounting profit required to induce the firm’s owners to employ their resources in the firm • Alternatively, the accounting profit just sufficient to ensure that all resources used by the firm earn their opportunity cost normal profit occurs when economic profit = $0 – Accounting profit = $64,000 – Normal profits = $50,000 + $1,200 + $1,000 = $52,200 (aka implicit costs, aka opportunity costs) – Economic profit = $11,800 – When economic profits are greater than zero, an incentive for others to enter the market – When economic profits are $0, markets are in equilibrium • Then firms are earning normal profits 9 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 2.4 Self-Evaluation Exercise • Just do Question 1 10 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 3.0 Click to next slide for 3.0 Outline 11 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 3.0 Short&Long Run, Marginal Product • • • • • 1 Fixed and Variable Resources (Dn) 2 Law of Diminishing Marginal Returns (Dn) 3 Total & Marginal Product (Table,Graph) 4 Summary of Product Formulas (*) 5 Self-Evaluation Exercise (*) 12 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 3.1 Fixed and Variable Resources • Resources can be divided into two categories – Variable resources can change quickly to change the output rate – Fixed resources resources which cannot be easily changed • This provides us the distinction between the short run and the long run NY & NJ Hudson – Short run at least one resource is fixed – Long run all resources are variable Holland Tunnel 1927: 1 Tube (WPA Project) River Crossings Lincoln Tunnel 1934: 2 Tubes (WPA Project) 13 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 3.2 Law of Diminishing Marginal Returns • As more of a variable resource is combined with a given amount of a fixed resource, marginal product eventually declines • This is the most important feature of production in the short run dictates the shape of the production function and the cost curves Holland Tunnel: with and without traffic 14 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 3.3a Total and Marginal Product • For the present, suppose we focus on the shortrun link between resource use and the rate of output • Suppose the company’s fixed resources are already in place and consist of a warehouse, a moving van, and moving equipment • The only variable resource is labor • The next slide provides our illustration 15 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 3.3b Total and Marginal Product Table Labor measured in workerdays (1 worker for one day) Output measured in tons of furniture moved per day. Tons of furniture moved, or total product, at each level of employment is shown in the center column Relationship between the amount of resources employed and total product is called the firm’s production function. Last column shows the marginal product of each worker Units of Labor and Tons of Furniture Moved Units of the Variable Resource (worker-days) 0 1 2 3 4 5 6 7 8 Total Marginal Product Product (tons moved (tons moved per day) per day) 0 2 5 9 12 14 15 15 14 2 3 4 3 2 1 0 -1 16 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 3.3c Total and Marginal Product Graph Because of increasing marginal returns, marginal product increases with each of the first three workers total product is increasing at an increasing rate. However, once decreasing returns set in – adding the 4th worker – marginal product declines total product continues to increase but at a decreasing rate. As long as marginal product is positive, total product increases where marginal product turns negative, total product starts to fall. 17 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 3.4 Summary of Product Formulas • These are the Product Formulas you need to remember Label Variable Input (Labor) Total Production Average Product Marginal Product Abbreviation Formula L q AP q/L MP chg q / chg L 18 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 3.5 Self Evaluation Exercise Formulas 19 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 4.0 Short Run Costs • 4.0 Short Run Costs – – – – – 4.1 Fixed Cost & Short Run (Dn, MC) 4.2 Total Cost & Marginal Cost, (Table & Graph) 4.3 Average Cost & Marginal Cost (Table & Graph) 4.4 Summary of Formulas (*) 4.5 Self-Evaluation Exercise (Table, Graph) 20 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 4.1a Fixed Cost & the Short Run • Two components of total cost in the short run – Fixed costs: the payment for plant and equipment. It must be paid even if no output is produced, it does not vary when output varies – Variable cost: the cost of variable resources – labor and raw materials. NY & NJ Hudson River Crossings Holland Tunnel 1927: 1 Tube (WPA Project) Lincoln Tunnel 1934: 2 Tubes (WPA Project) 21 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 4.1b Marginal Cost & the Short Run • Marginal Cost: the change in total cost as output increases. It tends to decline at first and then eventually increase Holland Tunnel: with and without traffic 22 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 4.2 a Total & Marginal Cost Notice that fixed costs – column (2) – remain constant at $200 per day regardless of output. Column (3) shows the amount of labor needed to produce each rate of output based on the the productivity figures introduced previously. The variable and total cost associated with each level of output are shown in columns (4) and (5), respectively. TC = FC + VC Begin 2.Profit Tons Moved Fixed per Day cost (q) (FC) (1) (2) $0 2 5 9 12 14 15 $200 200 200 200 200 200 200 Variable Marginal Workers Cost Total Cost Cost per Day (VC) TC=FC+VC MC=TC/ q (3) (4) (5) (6) 0 1 2 3 4 5 6 $0 100 200 300 400 500 600 $200 300 400 500 600 700 800 50.00 33.33 25.00 33.33 50.00 100.00 Since total cost is the opportunity cost of all resources employed by the firm, it includes a normal profit but not an economic profit. Marginal cost is provided in the last column. Marginal cost is simply the change in total cost divided by the change in output MC = ΔTC / Δq Changes in MC reflect changes in marginal productivity of the variable resource employed 23 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 4.2b Total and Marginal Cost Curves Since total cost does not vary with output, the fixed cost curve is a horizontal line at $200. Variable cost is zero when output is zero the variable cost curve starts at zero, then increases slowly then sharply. The total cost curve sums the variable and fixed cost curves. Marginal cost declines until the 9th unit of output and then increases reflecting labor’s increasing and then diminishing marginal returns. The change in total cost resulting from a oneunit change in production equals marginal cost the slope of the total cost curve at each rate of output equals the marginal cost at that rate of output. 24 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 4.3a Average Cost • The average total cost is the per unit of output • There are average cost measures corresponding to total cost, fixed cost and variable cost • The next slide presents a table of data for a hypothetical firm 25 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 4.3b Average & Marginal Cost Data Tons Moved Variable per Day Cost (q) (VC) (1) (2) 0 2 5 9 12 14 15 • • • $0 100 200 300 400 500 600 Total Cost TC=FC+VC (3) $200 300 400 500 600 700 800 Marginal Cost MC=TC/ q (4) $0.00 50.00 33.33 25.00 33.33 50.00 100.00 Average Variable Cost AVC=VC/q (5) =(2) / (1) Average Total Cost ATC=TC /q (6)=(3) / (1) $50.00 40.00 33.33 33.33 35.71 40.00 $150.00 80.00 55.55 50.00 50.00 53.33 Average variable cost, AVC, equals variable cost divided by output AVC = VC / q Average total cost, ATC, equals total cost divided by output ATC = TC / q Both average variable cost and average total cost first decline as output expands, then increase 26 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 4.3c Average and Marginal Cost Curves Marginal cost declines as output expands because of increasing marginal returns to labor so long as marginal cost is below average cost, average cost falls as output expands. $150 125 75 Where marginal cost exceeds average cost, marginal cost 50 Average total cost Average variable cost pulls up the average. 25 Because marginal cost first pulls down average cost and then pulls up average cost, each average cost curve has a U shape. 2.Profit Marginal cost 100 At higher rates of output, marginal cost increases Begin The distance between the average variable and average total cost gets smaller as output increases because average fixed costs decline as output increases 0 5 10 15 Tons per day Notice also that the rising marginal cost curve intersects both the average variable and average total cost curves at their minimums. 27 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 4.4 Summary of Cost Formulas • These are the cost formulas you need to remember Label Variable Cost Fixed Cost Total Cost Marginal Cost Average Total Cost Average Variable Cost Average Fixed Cost Average Total Cost Abbreviation Formula VC FC TC VC + FC MC chg TC / chg q ATC TC / q AVC VC / q AFC FC / q ATC ATC = AFC + AVC 28 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 4.5a Self-Evaluation: Cost Tables • The cost tables will be in the homework Formulas Begin 2.Profit 29 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 4.5b Self-Evaluation: Cost Graphs • Click the Grey Numbered Buttons to try Questions 2 to 4 30 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 5.0 Long Run Costs • • • • 5.0 Long Run Costs 5.1 No Fixed Costs (Dn) 5.2 Planning Horizon (Graph) 5.3 Economies & Diseconomies of Scale (Graph) 31 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 5.1 Costs in the Long Run • Thus far we have focused on how costs vary as the rate of output expands in the short run for a firm of a given size • In the long run, all inputs that are under the firm’s control can be varied there are no fixed costs 32 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 5.2: Short-Run Cost Curves and the Long-Run Planning Curve The appropriate size or scale for the new plant depends on how much the firm wants to produce. Begin Cost per unit S Cost per unit For example, if q is the desired rate of output in the long run, the average cost per unit is lowest with a small plant. If the desired output rate is q', the medium plant size ensures lowest cost. The long-run average cost curve connects portions of the three-short run average cost curves that are lowest for L' each output rate S,a,b, and L' 0 M M' S' L b a q qa 33 q' qb Output per period Generally, for any output less than qa average cost is the lowest when the plant is small, for output rates between qa and qb, for the medium plant, and when output exceeds qb, the large plant has the lowest average costs. 2.0 Profit 3.0 S&L Run 4.0 Costs 5.0 Ln. Run Costs 6.0 Surplus End 5.2: Short-Run Cost Curves and the Long-Run Planning Curve The appropriate size or scale for the new plant depends on how much the firm wants to produce. For example, if q is the desired rate of output in the long run, the average cost per unit is lowest with a small plant. If the desired output rate is q', the medium plant size ensures lowest cost. Generally, for any output less than qa average cost is the lowest when the plant is small, for output rates between qa and qb, for the medium plant, and when output exceeds qb, the large plant has the lowest average costs. 34 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 5.3 Economies of Scale The rate of production must reach quantity A for the firm to achieve the minimum efficient scale, which is the lowest rate of output at which long-run average cost is a minimum. Cost per Unit Long-run average cost Output per period 0 A Economies of scale B Constant average cost Diseconomies of scale From output A to rate B, average cost is constant. Beyond output rate B, diseconomies of scale increase long-run average cost. 35 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End • 6.0 Surplus: 6.0 Surplus – 6.1 Consumer Surplus (Graph ) – 6.2 Producer Surplus (Graph ) 36 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End 6.1 : Consumer Surplus Consumer surplus is shown by the blue shaded area, which is the area below the demand curve but above the market clearing price of $10. Dollars per unit Producers also derive a net benefit, or a surplus, from market exchange because the amount they receive for their output exceeds the minimum amount they would require to supply that amount in the short run. Area below the demand curve and above the price Consumer surplus S e $10 Recall that the short-run market supply curve is the sum of that portion of each firm’s marginal cost curve at or above the 5 minimum point on its average variable cost curve point m on the market supply curve S. 0 Begin 2.Profit 3 S&L Run Producer surplus D m Quantity per period 100,000 120,000 200,000 4 Costs 5 Ln. Run Costs 6.Surplus 37 End 6.2 : Producer Surplus Point m implies a price of $5 with each firm willing to supply 100,000 units. At prices below $5, quantity supplied is zero because firms could not cover variable costs and would shut down. Dollars per unit If the price increases to $6, firms increase their quantity supplied until their marginal cost equals $6 output increases from 100,000 to 120,000, and total revenue increases from $500,000 to $720,000. Part of the increased revenue covers the higher marginal cost of production. $10 However, the balance of the increased revenue is a bonus to 6 producers, who would have been willing to supply 100,000 units for 5 only $5 producer surplus is shown by the red shaded area. Area above the supply curve and below the price Consumer surplus S e Producer surplus D m Quantity per period 0 Begin 2.Profit 3 S&L Run 100,000 120,000 200,000 4 Costs 5 Ln. Run Costs 6.Surplus 38 End END OF PRESENTATION • Pics linked to topics in lecture 39 Begin 2.Profit 3 S&L Run 4 Costs 5 Ln. Run Costs 6.Surplus End