Production and Cost in the Short Run Chapter 7 Production and Cost in the Short Run © 2006 Thomson/South-Western

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

Alternative Measures of 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 and assistant and uses a spare bay in her garage that had been renting for $1,200 a year Exhibit 1 shows the results after the first year

Exhibit 1: Accounts of Wheeler Dealer 2004

Normal Profit Alternatively, the accounting profit just sufficient to ensure that all resources used by the firm earn their opportunity cost  normal profit Recall that the accounting profit = $64,000 Normal profits = $50,000 + $1,200 + $1,000 = $52,200: normal profit $11,800:economic profit

Fixed and Variable Resources Variable resources can be varied quickly to change the output rate Fixed resources are those resources which cannot be easily changed This provides us the distinction between the short run and the long run Short run: at least one resource is fixed Long run: all resources are variable Varies from industry to industry

Exhibit 2: Short-Run Relationship

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

Exhibit 3: Total and Marginal Product of Labor Because of increasing marginal returns, marginal product increases with each of the first three workers: total product is increasing at an increasing rate Once diminishing returns sets in with the 4th worker, marginal product declines: total product increases at a decreasing rate As long as marginal product is positive, total product increases, and when marginal product turns negative, total product starts to fall

Costs in the Short Run Fixed costs pay for fixed resources and must be paid even if no output is produced – they do not vary when output varies Variable cost is the cost of variable resources – labor in our example – and vary with the amount of labor employed in the production process: as more labor is employed, output and variable cost both increase The firm can hire labor at $100 per worker day: variable cost equals $100 times the number of workers hired

Exhibit 4: Short-Run Cost Data Tons Moved Fixed Variable Marginal per Day cost Workers Cost Total Cost Cost (q) (FC) per Day (VC) TC=FC+VC MC=TC/ q (1) (2) (3) (4) (5) (6) $0 $200 0 $0 $200 - 2 200 1 100 300 50.00 5 200 2 200 400 33.33 9 200 3 300 500 25.00 12 200 4 400 600 33.33 14 200 5 500 700 50.00 15 200 6 600 800 100.00 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 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

Marginal Cost and Marginal Productivity When the firm experiences increasing marginal returns – marginal product is increasing – the marginal cost decreases When the firm experiences diminishing marginal returns – marginal product begins to decline – the marginal cost of output increases Exhibit 5 provides a graphical illustration of our cost curves

Exhibit 5: Total and Marginal Cost Curves

Exhibit 5: Total and Marginal Cost Curves ( Exhibit 5: 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 The total cost curve sums the variable and fixed cost curves Because a constant fixed cost is added to variable cost, the total cost curve is the variable cost curve shifted vertically by the amount of fixed cost Marginal cost declines until the 9th unit of output and then increases This reflects labor’s increasing, and then diminishing, marginal returns $1,000 Total cost Total dollars Variable cost 500 Fixed cost Fixed cost 200 3 6 9 12 15 Tons per day $100 Cost per ton Marginal cost 50 25 3 6 9 12 15 Tons per day

Average Cost in the Short Run The average cost per unit of output is another of the useful cost measures There are average cost measures corresponding to variable cost, fixed cost and variable cost Exhibit 6 provides a detailed listing of the variable costs for our example

Exhibit 6: Short Run Cost Data Tons Moved Variable Marginal Average Average per Day Cost Total Cost Cost Variable Cost Total Cost (q) (VC) TC=FC+VC MC=∆TC/∆q AVC=VC/q ATC=TC /q (1) (2) (3) (4) (5) =(2) / (1) (6)=(3) / (1) 0 $0 $200 $0.00 -  2 100 300 50.00 $50.00 $150.00 5 200 400 33.33 40.00 80.00 9 300 500 25.00 33.33 55.55 12 400 600 33.33 33.33 50.00 14 500 700 50.00 35.71 50.00 15 600 800 100.00 40.00 53.33 Average variable cost, AVC, equals variable cost divided by output  AVC = VC / q Average total cost, ATC = TC / q Both average variable cost and average total cost first decline as output expands, then increase

Marginal and Average Cost The relationship between marginal and average cost is also important When marginal cost is below or less than average cost it pulls average cost down When marginal cost is above or higher than average cost it pulls average cost up Exhibit 7 depicts this relationship

Exhibit 7: Average and Marginal Cost Curves $150 The distance between the average variable and total cost gets smaller as output increases because average fixed costs decline as output increases 125 Marginal cost 100 Cost per ton 75 Average total cost 50 Average variable cost Notice also that the rising marginal cost curve intersects both the average variable and total cost curves at their minimums. 25 0 5 10 15 Tons per day

Costs in the Long Run All inputs that are under the firm’s control can be varied  there are no fixed costs Long run is best thought of as a planning horizon Choice of input combinations is flexible, but that flexibility is available only to firms that have not yet acted on their plans Firms plan for the long run, but they produce in the short run

Long-Run Average Cost Curve Suppose that, because of the special nature of technology in the industry, a firm must choose among only three possible sizes Small Medium Large

Long-Run Average Cost Curve Now suppose there are many possible plant sizes Exhibit 9 presents a sample of short-run average total cost curves shown in purple The long-run average cost curve, shown in red, is formed by connecting the points on the various short-run average cost curves that represent the lowest per-unit cost for each rate of output

Exhibit 8: Long-Run Planning Curve

Exhibit 9: Firm’s Long-Run Planning Curve

Economies of Scale Notice that the long-run average curve is U-shaped, a result of economies and diseconomies of scale Economies of scale imply that long-run average costs decline as output expands while diseconomies of scale imply that long-run average costs increase as output increases

Economies of Scale A larger size often allows for larger, more efficient, machines and allows workers a greater degree of specialization  Production techniques such as the assembly line can be utilized only if the rate of output is large enough Typically, as the scale of the firm increases, capital substitutes for labor and complex machines substitute for simpler machines

Diseconomies of Scale As a firm expands, diseconomies of scale, eventually take over: long-run average cost increase as output expands Additional layers of management are needed to monitor production The more levels of management in an organization, the more difficult it is for top management to communicate with those that perform most of the production tasks

Exhibit 10: A Firm’s Long-Run Average Cost Curve