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Chapter 20 The Costs of Production THE FIRM IN THE CIRCULAR FLOW MODEL $ COSTS $ INCOMES RESOURCE MARKET RESOURCES INPUTS BUSINESSES / FIRMS HOUSEHOLDS GOODS & SERVICES GOODS & SERVICES PRODUCT MARKET $ REVENUE $ CONSUMPTION WHAT ARE COSTS? The Law of Supply states firms are willing to produce and sell a greater quantity of a good when the price of the good is high, resulting in an upward sloping curve. The economic goal of a firm is to maximize profits The firm must assess costs before it can assess profit ECONOMIC COSTS Economic Costs are AKA the Opportunity Costs Definition: The value or worth the resource would have in its best alternative use. TOTAL REVENUE, TOTAL COST, and PROFIT TOTAL REVENUE The amount a firm receives for the sale of its output. TOTAL COST The market value of the inputs a firm uses in production PROFIT The firm’s total revenue minus its total cost Profit = Total Revenue – Total Cost COSTS AS OPPORTUNITY COSTS A firm’s cost of production includes all the opportunity costs of making its output of goods and services. They are known as Explicit and Implicit Costs Explicit costs are input costs that require a direct outlay of money by the firm Implicit costs are input costs that do not require an outlay of money by the firm ARE THEY EXPLICIT OR IMPLICIT COSTS? Hiring a new worker Spending time with your significant other instead of working Taking a client to lunch Going to college instead of getting a job Studying for a test instead of plowing snow for money Buying new work clothes E I E I I E ECONOMIC PROFIT VERSUS ACCOUNTING PROFIT Economists measure a firm’s economic profit as Total Revenue – Total Cost, including both explicit and implicit costs. Accountants measure the accounting profit as the firm’s Total Revenue – only the firm’s Explicit Costs. ECONOMIC PROFIT VERSUS ACCOUNTING PROFIT When Total Revenue exceeds both explicit and implicit costs, the firm earns economic profit. Economic profit is smaller than accounting profit. ECONOMIC COSTS Economic (opportunity) Costs How an Economist Views a Firm Economic Profit Implicit costs (including a normal profit) Explicit Costs How an Accountant Views a Firm T O T A L R E V E N U E Accounting Profit Accounting costs (explicit costs only) TRY THIS PROBLEM Gomez runs a small pottery firm. His costs are: One helper at $12,000 per year Annual Rent = $5000 Expenditures on materials = $20,000 His personal investment in the company = $40,000 (he could earn $4000 per year if his money is alternatively invested) He has been offered $15,000 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $3000 per year. Total Revenue from pottery sales is $72,000 Calculate the accounting profit and the economic profit for Gomez’s pottery firm. ANSWER to the PROBLEM EXPLICIT COSTS = $37,000 $12,000 for the helper $5,000 for rent $20,000 for materials IMPLICIT COSTS = $22,000 $4000 of forgone interest $15,000 of forgone salary $3,000 of entrepreneurship ACCOUNTING PROFIT = $35,000 ($72,000 of revenue - $37,000 of explicit costs) ECONOMIC PROFIT = $13,000 ($72,000 - $37,000 of explicit costs $22,000 of implicit costs) Short-Run versus LongRun Costs The Economic Short Run vs the Long Run The Short Run is: A period too brief for a firm to alter its plant capacity, yet long enough to permit a change in the degree to which the fixed plant is used. The firm can alter the intensity with which it uses its resources. In the short run, output can change but production processes are fixed. Short-Run versus LongRun Costs The Economic Short Run vs the Long Run The Long Run is: a period of time long enough for the firm to adjust the quantities of all the resources that it employs including plant capacity. In the long run, all inputs can be varied and production processes can be changed. Short-Run versus LongRun Costs Fixed Costs and Variable Costs Fixed costs = costs that cannot be changed Variable costs = costs that can be changed In the Short Run, some costs are fixed. In the Long Run, all costs are variable. WHICH ARE SHORT-RUN AND WHICH ARE LONG-RUN? LR *Wendy’s builds a new restaurant *Harley-Davidson hires 200 more SR production workers SR *A farmer increases the amount of fertilizer used on his corn crop *An Alcoa aluminum plant adds a third SR shift of workers *A farmer switched from growing corn to LR growing asparagus Section 2 - SHORT-RUN PRODUCTION RELATIONSHIPS A firm’s costs of production depend on the prices of the resources needed and the quantities of resources needed to produce their output Firm’s will analyze the cost relationships between their inputs and output Section 2 - SHORT-RUN PRODUCTION RELATIONSHIPS Total Product (TP) – AKA Total Physical Product (TPP) - The total quantity, or total output, of a particular good or service produced. Marginal Product (MP) – the extra output or added product associated with adding a unit of a variable resource, usually labor, to the production process. Change in Total Product Marginal Product = Change in Labor Input Section 2 - SHORT-RUN PRODUCTION RELATIONSHIPS Average Product (AP) is output per unit of labor input Average Product = Total Product Units of Labor TPP for Al’s Building Company How many employees is too many? TPP with Different Quantities of Carpenters 40 F Garages per Year Total Output in 35 32 30 E G TPP D 25 20 15 C 10 B 5 A 0 1 2 3 4 5 Quantity of Carpenters per Year 6 7 Al’s Product Schedule Al’s Marginal Physical (MPP) Curve Product 14 Increasing marginal returns 12 10 Diminishing marginal returns Negative marginal returns How many carpen ters should Al hire? MPP in Garages per Year 8 6 4 2 0 –2 –4 –6 MPP 0 1 2 3 4 5 Number of Carpenters 6 7 Complete the table by calculating marginal product and average product from the data given Inputs of Total Product Marginal Average Labor Complete the table by calculating marginal product and average product from the data given Product 0 0 1 15 2 34 3 51 4 65 5 74 6 80 7 83 8 82 Product Complete the table by calculating marginal product and average product from the data given Complete the table by calculating marginal product and average product from the data given Graph TP, MP and AP Inputs of Labor Total Product Marginal Product 0 0 1 15 2 34 3 51 4 65 5 74 6 80 7 83 8 82 Average Product x 15 19 x 15 17 17 14 9 6 17 16.25 14.8 13.33 3 -1 11.86 10.25 The “Law” of Diminishing Marginal Returns Diminishing Marginal Returns – definition: Is the property whereby the marginal product of an input declines as a quantity of input increases. Example: As more workers are hired at a firm, each additional worker contributes less and less to the production because the firm has a limited amount of equipment. It explains the shape of the marginal physical product curve The Flower Pot Example A farmer plants 80 acres of corn but does not weed his fields. His yield is 40 bushels per acre. If he weeds once his yield rises to 50 bushels per acre. Two weedings yield 57 bushels per acre. Three weedings yield 61 bushels per acre. Each weeding adds less and less yield per acre – Diminishing Marginal Returns The Flower Pot Example If diminishing marginal returns didn’t occur more weedings, seeds, and fertilizer would continue to yield more and more corn per acre. The world could be fed out of a flowerpot. Average Product, AP, and Marginal Product, MP Total Product, TP SHORT-RUN PRODUCTION RELATIONSHIPS Law of Diminishing Returns Total Product Quantity of Labor Quantity of Labor Increasing Marginal Returns Average Product Marginal Product Average Product, AP, and Marginal Product, MP Total Product, TP SHORT-RUN PRODUCTION RELATIONSHIPS Law of Diminishing Returns Total Product Quantity of Labor Quantity of Labor Diminishing Marginal Returns Average Product Marginal Product Average Product, AP, and Marginal Product, MP Total Product, TP SHORT-RUN PRODUCTION RELATIONSHIPS Law of Diminishing Returns Total Product Quantity of Labor Quantity of Labor Negative Marginal Returns Average Product Marginal Product Short-Run Production Costs Production information must be coupled with resource prices to determine the total and per-unit costs of producing various levels of output. In the short-run some resources, those associated with the firm’s plant, are fixed. Other resources are variable. Therefore, short-run costs are either fixed or variable. SHORT-RUN PRODUCTION COSTS Fixed Costs – Examples: rent, interest on Debts, insurance premiums Total Fixed Costs Total Fixed Costs Average Fixed Costs = Quantity of output Variable Costs – Examples: materials, fuels, Utilities, transportation, and labor Total Variable Costs Average Variable Costs = Total Variable Costs Quantity of output SHORT-RUN PRODUCTION COSTS Total Cost TC = Total Fixed + Variable Costs Average Total Cost = Total Costs Quantity of output Marginal Cost – the extra, or additional, cost of producing one more unit of output Total Variable Costs Marginal Cost = Change in Total Costs Change in Quantity of output SHORT-RUN PRODUCTION COSTS Summary of Definitions Total Fixed Costs = Total Variable Costs = Total Costs = Average Fixed Costs = Average Variable Costs = Average Total Costs = Marginal Cost = TFC TVC TC AFC AVC ATC MC COST CURVES AND THEIR SHAPES Marginal Cost Curve rises with the amount of output produced reflecting the property of diminishing marginal product. COST CURVES AND THEIR SHAPES The Average Total Cost Curve is U-shaped. At low levels of output ATC is high because fixed cost is spread over only a few units. ATC declines as output increases. ATC starts rising because AVC rises substantially. COST CURVES AND THEIR SHAPES The Relationship between MC and ATC When MC is less than ATC, ATC is falling. When MC is greater than ATC, ATC is rising. The MC curve crosses the ATC curve at the efficient scale (the quantity that minimizes ATC SHORT-RUN COSTS GRAPHICALLYAVERAGE AND MARGINAL MC COSTS Costs (dollars) ATC AVC AFC Quantity Costs (dollars) SHORT-RUN COSTS GRAPHICALLY Combining TVC With TFC to get Total Cost Total Cost TC TVC Fixed Cost Variable Cost TFC Quantity Average Product and Marginal Product PRODUCTIVITY AND COST CURVES AP MP Costs (dollars) Quantity of labor MC AVC Quantity of output Al’s (Variable) Cost Schedules Total Variable Cost per Year (thousands $) Al’s Total Variable Cost Curve 200 180 160 140 120 100 80 60 40 20 0 TC 2 4 6 Quantity of Garages (a) 8 10 30 Garage (thousands $) Average Variable Cost per Al’s Average Variable Cost Curve C 25 20 AVC 15 D 10 5 0 2 4 6 Quantity of Garages (b) 8 10 Marginal Variable Cost per Added Garage (thousands $) Al’s Marginal Variable Cost Curve 50 45 40 35 30 25 20 15 10 5 0 MVC 2 4 6 Quantity of Garages (c) 8 10 Fixed Costs: Total 14 Total Fixed Cost per Year (thousands of $) TFC 12 10 8 6 4 2 0 1 2 3 4 5 6 Output (a) 7 8 9 10 Al’s Fixed Costs Average Fixed Cost per Garage (thousands $) Fixed Costs: Average 14 12 10 8 6 4 AFC 2 0 1 2 3 4 5 6 Output (b) 7 8 9 10 Section 3 – Long-Run Production Costs A typical average cost curve declines at first because average fixed costs decline. It then reaches a minimum and begins to rise because of decreasing marginal returns. Section 3 – Long-Run Production Costs • Costs differ in the short and long runs, because in the long run, more adjustments can be made. For example: A firm increases the size of its plant * Because many costs are fixed in the short-run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves. Section 3 – Long-Run Production Costs The long-run average total cost curve (ATC) shows the lowest possible shortrun average cost corresponding to each output level. ATC makes no distinction between fixed and variable costs (all resource costs are variable in the long run) LONG-RUN PRODUCTION COSTS For every plant capacity size... there is a short-run ATC curve. All such plant capacities can be plotted on the same graph. Unit Costs LONG-RUN PRODUCTION COSTS Output Unit Costs LONG-RUN PRODUCTION COSTS Output Unit Costs LONG-RUN PRODUCTION COSTS The long-run ATC just “envelopes” all of the short-run ATC curves. Output Unit Costs LONG-RUN PRODUCTION COSTS long-run ATC Output Average Cost per Pound of Chicken Short-Run and Long-Run Average Cost Curves S $0.40 0.35 0 U B V T 40 L G W 100 Output in Pounds of Chicken ECONOMIES OF SCALE Economies of Scale refers to the property whereby long-run average total cost falls as the quantity of output increases. It explains the downsloping part of the longrun ATC curve. ECONOMIES OF SCALE As plant size increases, a number of factors will for a time lead to lower average costs of production. 1. Labor Specialization – hiring more workers means jobs can be divided and subdivided. Workers can work full-time on the tasks for which they have special skills. ECONOMIES OF SCALE 2. Managerial Specialization – means the better and more efficient use of management. Instead of an executive performing many functions he/she can focus on his area of expertise. 3. Efficient Capital – As a firm grows it can afford more efficient and Modern equipment. 4. Other Factors – start-up costs, advertising costs, depreciation costs, and many others Economies of Scale becomes Constant Returns to Scale In some industries a wide range of output may exist between the output at which economies of scale end and the output at which Diseconomies of Scale begin. That range, where long-run average costs remains stable is called Constant Returns to Scale. Diseconomies of Scale In time the expansion of a firm may lead to higher average total costs, causing Diseconomies of Scale. When a firm becomes bigger it is more difficult to be efficient with managerial practices as bureaucratic interference evolves. Employees might feel alienated and more likely to be less attentive to their work AC Quantity of Output (a) Constant returns to scale AC Quantity of Output (b) Long-Run Average Cost Increasing returns to scale Long-Run Average Cost Long-Run Average Cost Possible Shapes for the Long-Run AC Curve Decreasing returns to scale Quantity of Output (c) AC ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Economies of scale long-run ATC Output ECONOMIES AND DISECONOMIES OF SCALE Constant returns to scale Unit Costs Economies of scale long-run ATC Output ECONOMIES AND DISECONOMIES OF SCALE Constant returns to scale Diseconomies of scale Unit Costs Economies of scale long-run ATC Output Unit Costs ECONOMIES AND DISECONOMIES OF SCALE Where extensive economies of scale exist long-run ATC Output Unit Costs ECONOMIES AND DISECONOMIES OF SCALE Where economies of scale are quickly exhausted long-run ATC Output CHAPTER SUMMARY The goal of firms is to maximize profit, which equals total revenue minus total cost. When analyzing a firm’s behavior, it is important to include all the opportunity costs of production Some opportunity costs are explicit while other opportunity costs are implicit. CHAPTER SUMMARY A firm’s costs reflect its production process. * A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product *A firms total costs are divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output. Variable costs do change with output CHAPTER SUMMARY Average total cost is total cost divided by the quantity of output. Marginal cost is the amount by which total cost would rise if output were increased by one unit. The marginal cost always rises with the quantity of output. Average cost first falls as output increases and then rises. CHAPTER SUMMARY The average-total-cost curve is U-shaped The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC A firm’s costs often depend on the time horizon being considered In particular, many costs are fixed in the short-run but variable in the longrun. Historical Costs versus Analytical Costs Curves All points on the analytical cost curve (used in economic analysis) refer to the same period of time. An historical cost curve, showing the actual relationship between cost and output at different periods of time, is probably not a good indicator of the analytical cost curve. Cost per Unit Declining HCC w/declining Analytical ACC $100 75 A 1942 analytical cost curve 50 25 Historical cost curve 2005 analytical cost curve B 0 Quantity of Output Declining HCC with Ushaped Analytical ACC Cost per Unit $100 1942 analytical cost curve 75 50 25 0 Historical cost curve 2005 analytical cost curve A Quantity of Output B Cost Minimization in Theory and Practice Real business situations are more complex than those outlined in this chapter, and the quality of the available information is less precise. Yet when managers are doing their jobs well and the market is functioning smoothly, these models are a good approximation to the real world. Character of the Production Indifference Curves Each production indifference curve shows all combinations of input quantities capable of producing a given quantity of output. Higher curves correspond to higher outputs on a production indifference map. Quantity of Land in Acres A Production Indifference Map B 600 D 400 200 260,000 bushels A C E 0 3 5 7 240,000 bushels 220,000 bushels 10 Quantity of Labor in Years Character of the Production Indifference Curves Budget line: a curve that shows all the combinations of inputs that keep total costs constant. Slope of the budget line: the trade-off between one input and another, which keeps total costs constant. Constant input prices constant slope of a budget line Cost Minim., Expansion Path, and Cost Curves The least costly way to produce any given level of output is shown by the point of tangency between a budget line and the production indifference curve corresponding to that level of output. The combination of these points shows the firm’s expansion path. Quantity of Land in Acres A Budget Line 360 J K 40 Number of Workers Cost Minimization Quantity of Land in Acres 450 360 J $450,000 270 A T 225 $360,000 240,000 bushels $270,000 15 B 30 K 40 50 Number of Workers Effects of Changes in Input Prices input prices slope of the budget line Optimal input proportions then change. Point at which the budget line is tangent to an indifference curve also changes. The Firm’s Expansion Path Quantity of Land in Acres B' J E S' B T 300,000 bushels S E 0 240,000 bushels 200,000 bushels 10 15 $270,000 B K Number of Workers B' Quantity of Land in Acres Optimal Input at a Different Set of Input Prices 300 240 W 180 E 45 V 60 240,000 bushels 75 Quantity of Labor in Years Chapter 8 Output, Price, and Profit ECONOMIC COSTS Economic (opportunity) Costs Profits to an Economist Economic Profit Implicit costs (including a normal profit) Explicit Costs Profits to an Accountant T O T A L R E V E N U E Accounting Profit Accounting costs (explicit costs only) Price and Quantity: One Decision, Not Two Firms face a demand curve on which price and quantity are related. They can choose either price or quantity, but not both. Price per Garage (thousands $) Demand Curve for Al’s Garages 35 30 26 19 16 Da b c d 25 22 20 e Profit maximum f g h i 15 j D 10 5 0 1 2 3 4 5 6 7 8 9 Output, Garages Marketed per Year 10 Total Profit: Keep Your Eye on the Goal Simplifying assumption: maximum total profit is the firm’s goal. Total profit = total revenue - total costs Economic profit accounting profit Total Profit: Keep Your Eye on the Goal Total, Average, and Marginal Revenue Total Revenue = P Q Average Revenue = TR/Q = (P Q)/Q = P Marginal Revenue = total revenue from one more unit of output. Demand for Al’s Garages Total Revenue per Year (thousands $) Total Revenue Curve for Al’s Garages 140 F 120 G H I J TR E D 100 C 80 B 60 40 A 20 0 1 2 3 4 5 6 Output, Garages Sold per Year 7 8 9 10 Total Profit: Keep Your Eye on the Goal Total, Average, and Marginal Cost The shapes of the cost curves mean that there is some size for the firm that is most efficient. Firms that are smaller or larger than this optimal size will have higher average costs. Al’s Total, Average, and Marginal Costs Cost Curves for Al’s Garages 200 TC Total Cost per Year (thousands $) 180 160 140 120 100 80 60 40 20 0 1 2 3 4 5 6 7 8 Output, Garages per Year (a) Total Cost 9 10 Cost Curves for Al’s Garages Average Cost per Garage (thousands $) 45 40 35 30 25 AC 20 15 10 5 0 1 2 3 4 5 6 7 Output, Garages per Year (b) Average Cost 8 9 10 Marginal Cost per Added Garage (thousands $) Cost Curves for Al’s Garages 50 MC 45 40 35 30 25 20 15 10 5 0 1 2 3 4 5 6 7 8 Output, Garages per Year (c) Marginal Cost 9 10 Marginal Analysis and Profit Marginal cost = in TC / in Q Marginal Revenue = total revenue (TRa – TRb) from one more unit of output. Marginals Analysis For The Producer Firm Inputs Costs How much does one more unit of input change output? Input Costs Output Will one more unit of output increase MR? Output Profit Will one more unit of output increase or decrease profit? If MR > MC, production profits If MR < MC, production profits Profit maximizing level output: MR = MC TR – TC = Total Profit Total Profit: Keep Your Eye on the Goal Maximization of Total Profits Profits typically increase with output, then fall. Some intermediate level of output, therefore, generates the maximum profit. TR, Costs, and Profit for Al’s Garages Marginal Analysis and Maximization of Total Profit Marginal profit is the slope of the total profit curve. Profit is at a maximum when the marginal profit is zero. Total Revenue, Total Cost per Year (thousands $) Profit Maximization 200 TC 180 160 140 TR 120 A 100 96 80 74 60 Profit B 22,000 40 20 0 1 2 3 4 5 6 7 Output, Garages per Year (a) Total Revenue. Total Cost 8 9 10 Total Profit per Year (thousands $) Profit Maximization 40 34 20 Total profit M F E C D 0 –20 1 2 3 4 5 6 –40 –60 –80 Output, Garages per Year (b) Total Profit 7 8 9 10 Marginal Analysis and Maximization of Total Profit Optimum Marginal Revenue and Marginal Cost If MR > MC, production profits If MR < MC, production profits Profit maximizing level output: MR = MC Al’s Marginal Revenue and Marginal Cost Profit Maxim: Another Graphical Interpretation MR and MC per Garage per Year (thousands $) 50 MC 40 30 20 E 10 0 1 2 3 4 5 6 7 8 9 10 MR –10 Output, Garages per Year (a) Marginal Revenue and Marginal Cost Total Revenue, Total Cost per Year (thousands $) Profit Maxim: Another Graphical Interpretation 200 TC 180 160 140 TR 120 A 100 96 80 74 60 Profit B 22,000 40 20 0 1 2 3 4 5 6 7 Output, Garages per Year (a) Total Revenue. Total Cost 8 9 10 Total Profit per Year (thousands $) Profit Maxim: Another Graphical Interpretation 40 34 20 Total profit M F E C D 0 –20 1 2 3 4 5 6 –40 –60 –80 Output, Garages per Year (b) Total Profit 7 8 9 10 Marginal Analysis and Maximization of Total Profit Finding the Optimal Price from Optimal Output MR = MC: rule for determining the level of output Demand curve price buyers will pay to purchase that level of output Both output and price are now determined for the profit maximizing firm. Logic of Marginal Analysis & Maximization If a decision is to be made about the quantity of some variable, then maximize net benefit. Net benefit = total benefit - total cost To maximize net benefit, select a value of the variable at which marginal benefit = marginal cost. Logic of Marginal Analysis & Maximization Application: Fixed Cost and Profit Maximization An increase in fixed costs does not change optimal output or price because it does not affect marginal costs. Rise in Fixed Cost: Total Profits Before and After Total Profit per Year (thousands $) Fixed Cost Does Not Affect Profit-Maximizing Output Profit with zero fixed cost 40 M Profit with a fixed cost N 20 0 1 2 3 4 5 6 7 8 Output in Garages per Year 9 10 The Role of Marginal Analysis Marginal analysis can be used to illuminate many everyday problems, in business and elsewhere, sometimes with surprising results. For example, a new activity will add to profits if it more than covers its marginal cost, not the fully allocated average cost. The Role of Marginal Analysis Any problem involving optimization can be illuminated with marginal analysis. The logic of marginal analysis can be applied to government, universities, hospitals and other organizations as well as businesses. Theory and Reality Business people seldom use marginal analysis in a literal sense. They often rely on intuition and hunches. But these theories can be used to understand and predict behavior. Relationships Among Total, Average, and Marginal Data Average = total the number of units Total = average the number of units Relationships Among Total, Average, and Marginal Data Marginal value of the xth unit = total value of x units - total value of (x - 1) units. Total value of x units = marginal values of the first x units. Relationships Among Total, Average and Marginal Data The marginal, average and total values for the first unit are usually equal. If marginal < average, the average is falling. If marginal > average, the average is rising. If marginal = average, the average is constant; that is, the average is at a maximum or minimum. Marginal and Average Weight (pounds) Relationship Between Marginal and Average Curves B 150 100 E C A D F Marginal weight 50 0 Average weight 1 2 3 4 Number of Persons 5 6