Ch. 9 DON’T FORGET TO DO THE LEARN SMART QUIZZES!!!! Production and Costs Ch. 9 DON’T FORGET TO DO THE LEARN SMART QUIZZES!!!!

Revenue, costs, and profit Profit and Loss Statements (P&L) Revenue – money that is paid by consumers to buy the company’s widget. Income Cost – These are monies paid for production of widgets Fixed costs – These are owed regardless of output (rent) Variable costs – These change as the quantity of widgets made change (labor)

Sample P & L Total revenue (TR) $10,000 Total fixed costs (TFC) $2,000 Total variable costs (TVC) $7,000 Total Profit (TP) $1,000 The more productive a firm is the lower the costs of production and the more competitive the firm. Why?

Short-Run vs. Long-Run Short-Run – at least one key factor of production is fixed (Ex: capital is fixed, labor is variable) Long-Run – long enough period of time that firms can adjust the quantity of any input

3 Productivity Measures Total Product – the quantity of widgets produced in a specified period of time Average Product – how many widgets the average unit of labor produces Marginal Product – additional quantity of widgets produced from the addition of 1 more unit of labor (input)

George and Martha’s Wheat Farm Quantity of Labor - L (workers) Quantity of Wheat (bushels) Average Quantity per Worker Marginal Product of L (MP = ΔQ/ΔL (Bushels per worker) 1 19 2 36 18 17 3 51 15 4 64 16 13 5 75 11 6 84 14 9 7 91 8 96 12

Diminishing Marginal Returns When an increase in the quantity of that input reduces the input’s marginal product of labor. Graph TP curve Graph MP curve Activity 3-2 part A – TPP vs. TP

7 Cost Measures Costs are a mirror view of productivity Marginal Cost – MC=ΔTC / ΔQ Average Variable Cost – AVC=VC / Q BE CAREFUL – Don’t confuse MC & AC Activity 3-2 part B

2 Ratios that connect productivity and cost measures AVC of a unit of output = wage / AP of a unit of labor MC of an extra unit of output = MP of an extra unit of labor Visual 3-2

Sample P & L Total revenue (TR) $10,000 Total fixed costs (TFC) $2,000 Total variable costs (TVC) $7,000 Total Profit (TP) $1,000

Accounting Profit vs. Economic Profit Accounting Profit is TR – TC (including depreciation) = TP This is shown on a P&L and what is reported to investors and the markets Economic Profit is TR – opportunity costs = TP Opportunity costs are composed of: Explicit costs – require an outlay of $$ Implicit costs – stated in terms of $$, the benefits foregone to produce currently

Implicit Costs Defined 2 Kinds Business’s Capital – equipment, buildings, tools, inventories, and financial assets that could have been used another way (owned – not rented) Owner devotes time and energy to business that could have been used elsewhere (other salary income) Implicit cost of capital – opportunity cost of the capital used by the business, reflects the income the business could have earned on the next best alternative

Economic Profit and Normal Profit Accounting Profit ≠ Economic Profit Economic loss means business should close (inefficient) Economic profit means efficiency Economic profit = 0 is a Normal Profit. Firm could not do any better at using its resources

7 Cost Measures Continued Page 128 of Activity 3-3 Homework: Daily Assignment Grade

Moving to the Long-Run What characteristics make a Short-Run a Short-Run? How is a Long-Run different? ALL inputs are variable in the Long-Run What can a firm do in the Long-Run that it can’t do in the Short-run? What is the relationship between ATC, AVC, and AFC? The more productive the firm, the lower the ……..?

Investing in Capital Firms can invest in machinery in the Long-Run Why would they want to invest in machinery? Are they buying the same machines they currently have? What will this investment do for production? What will this investment do to the fixed cost of the firm? What will this investment do to the variable cost of the firm? What will this investment do to the average total cost of the firm?

Use Salsa example on p. 204

Take home message For each output level there is some choice of fixed cost that minimizes the firm’s ATC for that output When considering the Long-Run where fixed costs can change, there are many possible choices of fixed costs These choices each have Short-Run Average Total Cost Curves (SRATC) This collection is called the firm’s family of SRATC At any given time, the firm will find itself on one of theses SRATC curves based on the current level of fixed cost. A change in output will cause it to move along that curve. If production increases and stays at that level, the firm will want to adjust its fixed costs in order to lower the ATC. This mix of inputs is no longer optimal.

Long-Run Average Total Cost Curves Is the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output. In the Long-Run, if a producer has had time to choose the fixed costs appropriate for its desired level of output, it will be along the LRATC curve Output level changed? Moving along the SRATC. Will return to LRATC when it adjust fixed costs

Returns to Scale The shape of LRATC is determined by the scale of the firm’s operations. How much are they producing? Economies of Scale – when LRATC declines as output increases (Downward side of the curve) Increasing Return to Scale – Output increases more than the increase of all the inputs EX: Doubling inputs creates MORE than double the output

The other side of the scale Diseconomies of scale – LRATC increases as output increases (upward part of curve) Decreasing Returns to Scale – when output increases LESS than the increase in all inputs. EX: Doubling inputs create LESS than double output

What causes Economies of Scale Increased specialization – individuals limit themselves to more specialized tasks. Efficiency and skilled Very large start up costs – High fixed costs before producing outputs. Ex: Auto manufacturing Network Externalities – more later

Diseconomies of Scale Typically happen in large firms Problems of coordination Problems of communication Economies of scale induce firms to grow larger…. Diseconomies of scale tend to limit their size Activity 3-4