Unit III: The Costs of Production & Theory of the Firm Chapters 13-17

First, lets review marginal returns…

How many workers should you hire?

Remember…rationale thinkers think marginally!! Marginal = 1 additional unit Go from… To….

Let’s make……

What resources do you have? There will be three factories Each factory gets the following to work with 1 desk One pair of scissors One tape stapler Workers

How do you produce the links? Fold a piece of paper 2 times (hot dog style) Cleanly cut the 4 folded strips Wrap a strip in a circle and staple it Take the next strip and place it through the previously made ring, and staple it to interconnect the two paper rings Do this as many times as you can

Special Rules Each factory begins with one worker Production periods last 60 seconds Each factory must have a quality control inspector Watches the other, competing factories Every resource must be used during production (including workers, they must have a job!) Everything must be cleaned after each round.

What everyone will do during this activity In a table, list how many acceptable links were created for each production round. Workers Links Produced Marginal Product 1 2 3 4 5 6 7

Increasing Marginal Product Diminishing Marginal Product An increase in output per input added Costs decreasing per input added Short run A decrease in output per input added Costs increasing per input added Long Run

The Production Function

Production Function Relationship between quantity of inputs used to make a good and the quantity of output of that good.

Remember what happens to marginal product when you add more inputs…

Diminishing Marginal Product

Is there a graph for that?

Production Function Quantity of output Number of Workers Hired

How much do you think that would cost to begin that business? List all the expenditures you would need to make your product Estimate how much money you believe all of these expenditures will cost (ask me for help if needed) Add all of your expenditures and that is your total cost!

Phone Line Attorney Shipping Worker Salaries Chairs Product Inventory Did you forget these…. Phone Line Attorney Shipping Worker Salaries Chairs Product Inventory Opportunity Costs Computers Fax Machine Worker Benefits

Could cost up to millions of dollars!!! Payroll Taxes Rent FILING CABINETS Could cost up to millions of dollars!!! Advertisements Copyrights Desks Internet Access Packaging Patents Money earned as a clown

The Costs of Production The money that is given up when producing a product. explicit and implicit Costs fixed vs. variable Costs fixed costs are constant variable costs change with each additional unit of production

Mortgage for a toy factory Fixed Cost Variable Cost Mortgage for a toy factory Screws for toys

The Costs of Production The money that is given up when producing a product. explicit and implicit Costs fixed vs. variable Costs fixed costs are constant variable costs change with each additional unit of production Total Cost fixed cost + variable cost this is always the firms opportunity cost

Firm’s Main Objective? To maximize profits!

Revenue is NOT profit! Total Revenue Total Cost Profit 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 their total cost Firms want to maximize profit!

Economic Profit vs Accounting Profit total revenue minus total cost, including both explicit and implicit costs. Accounting profit total revenue minus only the firm’s explicit costs. Economists, or rationale thinkers, base profit on economic profit

Quick Quiz $200 - $100= $100 $200 - $300 = -$100 Accounting Profit You’re a farmer that gives banjo lessons on the side for $20 an hour. One day, you spend 10 hours planting $100 worth of seeds. What is your opportunity cost? What cost would your accountant measure? If these seeds yield $200 worth of crops, do you earn an accounting profit? Do you earn an economic profit? $200 - $100= $100 $200 - $300 = -$100 Accounting Profit Economic Profit

The MOTHER of cost graphs! AFC, AVC, ATC, and MC Curves The MOTHER of cost graphs!

Average Fixed Cost Fixed costs ÷ Quantity of output Average Variable Cost Variable costs ÷ Quantity of output Average Total Cost Total cost ÷ Quantity of output Marginal Cost The increase in total cost that arises when one additional unit is produced

So, the marginal cost of producing the 2nd tablet is $10 If we wanted to make two tablets, it would costs our firm $110 because of the extra parts needed for the additional tablet (VC) Costs our firm $100 to make 1 tablet So, the marginal cost of producing the 2nd tablet is $10

Figuring Them Out... Before we graph these curves, lets practice figuring out each cost. Problem Set 4.2 Now, lets graph them…

Problem Set 4.2 Questions What happens to AFC as output increases? Why? What shape is the MC, ATC, and AVC? Why? From what range of output is the ATC decreasing? From what range of output is the ATC increasing? Where does MC intersect the ATC and AVC curves? What output level is the most efficient? Why?

Problem Set 4.2 Questions The AFC decreases. Fixed costs are constant, so as a firm produces more quantity, their average fixed costs will decrease. “U” shaped. Because these costs decrease initially (short run) and eventually increase (long run); the Law of Diminishing Marginal Returns! 1-7 8 – infinite At their lowest point Where MC = ATC (ATC at it’s lowest point)

Marginal Cost When do you think diminishing marginal returns sets in? Any output level greater than where MC = ATC Why?

To help you better understand, let’s think of people in a room and height… If the next person who enters the room is taller than the previous average, the average will rise If the next person who enters the room is shorter than the pervious average, the average will fall If the next person who enters the room is exactly the same than the previous average, the average will stay the same.

Same applies with marginal and average costs! If MC is less than the previous average cost, the averages fall If MC is greater than the previous average cost, the averages rise If MC is exactly the same as the previous average costs, the averages stay the same

Intersects at ATC and AVC at their lowest points To the left of the intersection is increasing marginal returns To the right is decreasing marginal returns

Short Run vs. Long Run Costs and Economies of Scale

Let me help you understand this… What is the difference? Short run cost decision There is at least one fixed cost and one variable cost Long run cost decision ALL costs are variable Let me help you understand this…

You are currently in the short run Suppose you are a business owner and you have a factory and wage workers You have at least one variable cost: the worker You have at least one fixed cost: the factory You are currently in the short run

Suppose that your factory is only operating at 75% capacity. Factory Floor Space

Suppose that your factory is only operating at 75% capacity. You have at least one fixed cost, the factory, plus at least one variable cost, the workers. This is the short run

Demand for your product increases, so you decide to hire more workers. So this is a short run cost. There is at least one fixed cost (factory) and one variable cost (workers) Did the size of the factory change? No. Did the amount of wage workers change? Yes.

Your factory is now at full capacity and demand for your product is still increasing. So, you either expand your current factory or build a new one.

Once you decide to expand your factory or build a new one, your fix costs changes. Therefore, it’s no longer a fixed cost but a variable cost. Does this change the fixed cost of the factory? Yes. When fixed cost changes, this is a long run decision Did the size of your factor change? Yes.

REVIEW: Short Run or Long Run Cost? Portillo’s is doing excellent business in Naperville and is thinking of building a new Portillo’s in Plainfield Long Run Harvard is planning to hire more professors Short Run People catch on that Red Robin is overrated so the store in Plainfield may shut down

What does this say about long run costs for all firms? Any questions?

Best explanation http://www.reffonomics.com/textbook2/microec onomics2/swiftfile/costofdoingbusiness/longrunat ccurve1.swf