Micro Review Day 2

Production and Cost Analysis I 12 Firms Maximize Profit For economists, total cost is explicit payments to the factors of production plus the opportunity cost of the factors provided by the owners of the firm For economists, total revenue is the amount a firm receives for selling its product or service plus any increase in the value of the assets owned by the firm Profit = total revenue – total cost The goal of a firm is to maximize profits 12-2

Production and Cost Analysis I 12 Firms Maximize Profit Accountants focus on explicit costs and revenues Accounting profit = explicit revenue – explicit cost Economists and accountants measure profit differently Economists focus on both explicit and implicit costs and revenue Economic profit = (explicit and implicit revenue) – (explicit and implicit cost) 12-3

Production and Cost Analysis I 12 The Production Process A firm chooses from all possible production techniques All inputs are variable The production process can be divided into the long run and the short run The terms long run and short run do not necessarily refer to specific periods of time, but to the flexibility the firm has in changing the level of output Short runLong run A firm is constrained in regard to what production decisions it can make Some inputs are fixed 12-4

Production and Cost Analysis I 12 A Production Table # of workers Total Output Marginal Product Average Product Marginal product is the additional output that will be forthcoming from an additional worker, other inputs constant Average product is the output per worker 12-5

Production and Cost Analysis I 12 Graphing a Production Function Q Increasing marginal productivity Diminishing marginal productivity Diminishing Absolute productivity Number of workers TP A production function is the relationship between then inputs and the outputs

Production and Cost Analysis I 12 Graphing Marginal and Average Productivity Increasing marginal productivity Diminishing marginal productivity Diminishing Absolute productivity Number of workers AP MP Q Marginal productivity first increases Then marginal productivity declines Eventually marginal productivity is negative

Production and Cost Analysis I 12 Law of Diminishing Marginal Productivity # of workers Total Output Marginal Product Average Product Law of diminishing marginal productivity states as more of a variable input is added to an existing fixed input, after some point the additional output from the additional input will fall Increasing marginal productivity Diminishing marginal productivity Diminishing Absolute productivity 12-8

Production and Cost Analysis I 12 The Costs of Production Fixed costs (FC) are those that are spent and cannot be changed in the period of time under consideration In the long run, there are no fixed costs since all inputs (and therefore their costs) are variable In the short run, a number of inputs and their costs will be fixed Workers are an example of variable costs (VC) which are costs that change as output changes The sum of the variable and fixed costs are total costs (TC) TC = FC + VC 12-9

Production and Cost Analysis I 12 The Costs of Production Average fixed costs (AFC) equals fixed cost divided by quantity produced, AFC = FC/Q Marginal cost (MC) is the increase in total cost when output increases by one unit, MC = ΔTC/ΔQ Average variable costs (AVC) equals variable cost divided by quantity produced, AVC = VC/Q Average total costs (ATC) equals total cost divided by quantity produced, ATC = TC/Q or ATC = AFC + AVC 12-10

Production and Cost Analysis I 12 Graphing Total Cost Curves FC Total Cost FC curve is constant TC and VC curves increase as Q increases Q VC TC 12-11

Production and Cost Analysis I Per Unit Output Cost Curves Cost $ Quantity of earrings AFC AVC ATC MC

Production and Cost Analysis I 12 The Relationship Between Marginal Productivity and Marginal Costs AVC Q MC Q Output per worker Costs per unit If marginal productivity is rising, marginal costs are falling If average productivity is falling, average costs are rising MP of workers AP of workers 12-13

Production and Cost Analysis I 12 If MC > ATC, then ATC is rising If MC > AVC, then AVC is rising If MC < ATC, then ATC is falling If MC < AVC, then AVC is falling If MC = AVC and MC = ATC, then AVC and ATC are at their minimum points The Relationship Between Marginal Cost and Average Cost 12-14

Production and Cost Analysis II 13 Determinants of the Shape of the Long-Run Cost Curve What Gives the Short-run ATC curve its shape? Law of diminishing marginal productivity The Law of Diminishing Marginal Productivity does not apply in the long run Why? All Inputs are variable in the long run –There are no fixed inputs to create diminishing MP The Long-Run ATC gets its shape from Economies and Diseconomies of Scale McGraw-Hill/Irwin Colander, Economics 15

Production and Cost Analysis II 13 Economies of Scale An indivisible setup cost is the cost of an indivisible input for which a certain minimum amount of production must be undertaken before the input becomes economically feasible to use The cost of a blast furnace or an oil refinery is an example of an indivisible setup cost Production exhibits economies of scale when long-run average total costs decrease as output increases Indivisible setup costs create many real-world economies of scale These are shown by the downward sloping portion of the long-run average total cost curve 13-16

Production and Cost Analysis II 13 Economies of Scale The minimum efficient level of production is the amount of production that spreads setup costs out sufficiently for firms to undertake production profitably The minimum efficient level of production is reached once the size of the market expands to a size large enough for firms to take advantage of all economies of scale Because of the importance of economies of scale, business people often talk about the minimum efficient level of production 13-17

Production and Cost Analysis II 13 Diseconomies of Scale Diseconomies of scale usually, but not always, start occurring as firms get large Production exhibits diseconomies of scale when long- run average total costs increase as output increases These are shown by the upward sloping portion of the long-run average total cost curve 13-18

Production and Cost Analysis II 13 Diseconomies of Scale Two reasons for diseconomies of scale are: 1.Increased monitoring costs (the costs incurred by the organizer of production in seeing to it that the employees do what they’re supposed to do) 2.Loss of team spirit (the feelings of friendship and being part of a team that bring out people’s best efforts) 13-19

Production and Cost Analysis II 13 Constant Returns to Scale Constant returns to scale are shown by the flat portion of the long-run average total cost curve Constant returns to scale occur when production techniques can be replicated again and again to increase output Production exhibits constant economies of scale when average total costs do not change as output increases This occurs before monitoring costs rise and team spirit is lost 13-20

Production and Cost Analysis II 13 A Typical Long-Run Average Total Cost Table Q TC of Labor ($) TC of Machines ($) TC ($)ATC ($) ATC falls because of economies of scale ATC is constant because of constant returns to scale ATC rises because of diseconomies of scale 13-21

Production and Cost Analysis II 13 A Typical Long-Run Average Total Cost Curve Q Costs per unit 11 $50 $55 17 $ Long-run average total cost (LRATC) ATC falls because of economies of scale ATC is constant because of constant returns to scale ATC rises because of diseconomies of scale Minimum efficient level of production 13-22

Production and Cost Analysis II 13 Learning by doing means that as we do something, we learn what works and what doesn’t, and over time we become more proficient at it Technological change is an increase in the range of production techniques that leads to more efficient ways of producing goods and the production of new and better goods Production techniques available to real-world firms are constantly changing These changes occur over time and cannot be predicted accurately Using Cost Analysis in the Real World Learning by Doing and Technological Change 13-23