Download Session 06 Production Costs

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
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Begin
2.Profit
3 S&L Run
4 Costs 5 Ln. Run Costs
6.Surplus
End
Session 6 Lecture Outline
•
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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
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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
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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
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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
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Begin
2.Profit
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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
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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
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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
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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
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Begin
2.Profit
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4 Costs 5 Ln. Run Costs
6.Surplus
End
3.0 Short&Long Run, Marginal Product
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•
•
•
•
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 (*)
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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)
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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
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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
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Begin
2.Profit
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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
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2.Profit
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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.
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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
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Begin
2.Profit
3 S&L Run
4 Costs 5 Ln. Run Costs
6.Surplus
End
3.5 Self Evaluation Exercise
Formulas
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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
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–
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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)
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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)
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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
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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
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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.
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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
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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
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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
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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)
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Begin
2.Profit
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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
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Begin
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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.
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Begin
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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.
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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 )
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4 Costs 5 Ln. Run Costs
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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
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Begin
2.Profit
3 S&L Run
4 Costs 5 Ln. Run Costs
6.Surplus
End