Costs of Production Mr. Bammel

Economic Costs  Businesses have costs for the same reason that consumers do: Scarcity; Essentially the resources that businesses need in production have many alternative uses and we must allocate these resources in the most efficient way possible;  Economic costs are the payments to obtain and retain the services of a resource;

Explicit vs. Implicit Costs  Explicit  cost of resources outside what is already owned;  Implicit  cost of using resources the business already owns rather than selling those resources elsewhere; Ex. Your wages you could have earned working elsewhere;  Economic Costs = Explicit + Implicit

Accounting vs. Economic Profits  Accounting profits only take into account your explicit costs: Accounting profits = Revenue – Explicit Costs  Economic Profits is the result of taking into account ALL costs: Economic Profits = Revenue – explicit costs – implicit costs;  Which do you suppose Economists focus on?

Economic Profits  Why?  Allows us to see true allocation of resources; if a business is generating an economic loss, then we can shift resources to other firms which have economic gain;  Resources thus flow from producing goods and services with lower net benefits toward producing goods and services with high net benefits;

Short vs. Long Run  Short – period too brief to alter plant capacities; Plant is FIXED in short run;  Long – period long enough to alter ALL resources it employs, including plant capacities;  Keep in mind these are conceptual periods, not calendar;

Production Relationships  Costs are dependent on the prices of resources and the quantity of resources (both are obviously defined by the Supply and Demand of resources) to produce output;  Total product – total quantity of good or service produced

Marginal Product  Extra output associated with added input (such as labor);  = Change in total product/change in labor input

Average Product (aka labor productivity)  Output per unit of labor input;  =total product/units of labor;

Law of Diminishing Returns  As successive units of a variable resource (ex. Labor) are added to fixed resources (ex. Capital or land) beyond a certain point the extra, or marginal, product that can be attributed to each additional unit of the variable resource will decline;  We can see the Law of diminishing returns in the Total Product, Average Product, and Marginal Products Curves;

Total Product, Average Product, and Marginal Product Graphs  Draw and label the graphs.  What does each graph tell us about production? What is the purpose of the graphs?  Explain to the side of each graph WHY the lines increase when they do or decrease when they do.  WHY does the MP line intersect the AP line where it does? Explain that point.

Comparing My Graphs to Yours  Are they drawn right?  Is everything neatly drawn and displayed?  Do you believe you explained the purpose of the graph correctly?  Did you explain the lines? Why increasing? Why decreasing? What are the intersecting points meaning?

Short-Run Production Costs  Fixed  costs that do NOT vary with output;  Variable  costs that do CHANGE with output;  Total  the sum of fixed and variable costs; *very important to business managers b/c they can alter variable costs to change TC, but have no control over TFC;

Other costs…  Per unit, or Average, Cost: more meaningful to comparisons with product prices;  AFC = TFC/Q; will decrease as output increases;  AVC = TVC/Q; initially decreases, hits min., then increases (reflects law of diminishing returns);  ATC = TC/Q = TFC/Q + TVC/Q = AFC + AVC;

Marginal Costs  The extra/additional cost to produce one more unit of output;  MC = change in TC/change in Q;  By knowing MC, firms define cost incurred in producing the last unit; which also means they know what could have been “saved;”  When paired with MR, MC allows a firm to determine profitability of expanding or contracting decisions;

Short Run Production Costs Graph  Are they drawn right?  Is everything neatly drawn and displayed?  Do you believe you explained the purpose of the graph correctly?  Did you explain the lines? Why increasing? Why decreasing? What are the intersecting points meaning?

Long-Run Production Costs  Allows sufficient time for new firms to enter and old to exit; can also change ALL inputs used;

Determinants of the Economies of Scale/LRATC  Labor Specialization – Jobs can be divided and subdivided for efficiency  Managerial Specialization – managers can now operate to their capacity  Efficient Capital – larger firms and industries have the ability to incorporate the more efficient capital;  Start up Costs – costs that will decrease per unit as output rises

Diseconomies of Scale  Major determinant is the inability to control and coordinate the firms operations as they become such a large scale producer.

Long-Run Production Costs Graph  Are they drawn right?  Is everything neatly drawn and displayed?  Do you believe you explained the purpose of the graph correctly?  Did you explain the lines? Why increasing? Why decreasing? What are the intersecting points meaning?