Chapter 6: Production and Costs economic costs & profits short run long run

big picture understand behavior of firm understand & measure production costs

I. economic costs & profits firm’s goal: maximize profit look at factors that affect firm’s decision

economic costs opportunity cost of resources used explicit costs paid in money wages, rent, material, etc. implicit costs

example: smoothie shop explicit costs: wages interest on loan rent on store fruit, blenders

implicit costs forgone interest on funds used to buy capital owner’s forgone wages owner’s forgone profit from other venture

accounting profit total revenue – explicit costs ignores opportunity cost

economic profit includes opp. costs = total revenue - total costs = (price)(quantity) - (explicit + implicit costs)

normal profit occurs when amount of accounting profit = opportunity costs of resources if earning a normal profit, economic profit = 0

Short Run vs. Long Run Short Run (SR) time frame where some resources are fixed -- plants, equipment some inputs variable -- labor SR decisions are reversible

Long Run (LR) time frame where all inputs are variable --build a bigger plant LR decisions are hard to reverse -- cannot easily get rid of capital -- sunk cost

II. SR Production measures of output total product marginal product average product

total product (TP) total quantity of good produced in a given period at first, increases with labor, then falls

TP: gal. of smoothies per hour # workers TP 1 2 3 4 5 6 7 1 3 6 8 9

TP 5 6 9 # workers

marginal product (MP) change in TP due to one more worker change in TP = change in labor

At first MP rises with workers add more workers greater specialization MP of each worker added is larger than previous worker increasing marginal returns

then, MP falls with more workers keep adding workers but same amount of capital so eventually get in the way MP of more workers smaller than MP of previous workers decreasing marginal returns

TP, MP: gal. of smoothies 1 2 3 4 5 6 7 1 3 6 8 9 # workers TP MP 1 2 1 2 3 4 5 6 7 1 3 6 8 9 1 2 3 2 1 -1

MP 3 Q = # workers

law of decreasing returns As firm uses more labor with capital fixed, MP of labor will eventually fall

Average Product (AP) TP = labor = productivity

AP # workers TP MP 1 2 3 4 5 6 7 1 3 6 8 9 1 2 3 -1 1 1.5 2 1.8 1.1

MP 3 AP # workers

MP & AP MP intersects AP at max of AP why? MP > AP AP is rising AP is falling

III. SR cost measure cost 3 ways: total cost marginal cost average cost

Total Cost (TC) cost of all factors used total fixed cost (TFC) cost of land, capital, etc. does not change in SR total variable cost (TVC) cost of labor changes in SR TC = TFC + TVC

example : yogurt labor = $6/ hour TFC = $10/ hour

workers TP TFC TVC TC 0 0 10 0 10 1 1 10 6 16 1.6 2 10 9.6 19.6 2 3 10 12 22 4 5 8 9 10 24 30 34 40

Q = output TC TC TVC TFC 10

Marginal Cost change in TC due to one-unit increase in output (Q) = change in Q

TP TFC TVC TC MC 0 10 0 10 6 1 10 6 16 3.6 2 10 9.6 19.6 2.4 3 10 12 22 8 9 10 24 30 34 40 6

Average Cost (ATC) = TC/Q average fixed cost (AFC) (TFC/Q) average variable cost (AVC) (TVC/Q) ATC = AFC + AVC

TP TFC TVC TC AFC AVC AC 0 10 0 10 1 10 6 16 10 6 16 2 10 9.6 19.6 5 4.8 9.8 3 10 12 22 3.33 4 7.33 8 9 10 24 30 34 40 1.25 3 4.25 1.11 3.33 4.44

Q = output AC, MC AFC ATC AVC MC

MC & AC MC intersects AC at its minimum MC < AC AC is falling AC is rising

AC is U-shaped why? AFC falls with Q AVC falls then rises decreasing marginal returns so ATC falls, then rises

cost & product curves when MP is at maximum, MC is at minimum when AP is at maximum, AVC is at minimum

what shifts cost curves? technology make more with same inputs shifts TP, MP, AP up changes ATC curve

changes in factor prices increase fixed costs -- TFC, AFC shift up -- TC shift up increase wages (variable) -- TVC, AVC, MC shift up

IV. LR costs all inputs (and costs) are variable what happens if increase plant AND labor by 10%? ATC fall? ATC rise? ATC stay same?

Economies of scale increase inputs 10% output increase > 10% ATC falls why? gains from specialization -- labor -- capital

Diseconomies of scale increase inputs 10% output increase < 10% ATC rises why? too hard to control large firm

Constant returns to scale increase inputs 10% output increase = 10% ATC stays same

LR Average Cost (LRAC) lowest average cost when all inputs are variable SRAC curves from different plant sizes

Q = output AC ATC1 ATC2 ATC3 ATC4 LRAC

Q = output AC ATC1 ATC2 ATC3 ATC4 diseconomies of scale economies of scale constant returns to scale

summary: costs = implicit + explicit SR, only labor variable LR, all inputs variable Production & costs total, marginal, average fixed, variable