Production & Cost in the Firm ECO 2013 Chapter 7 Created: M. Mari Fall 2007

Economic Costs Costs exists because resources are scarce and have alternative uses When society uses a combination of resources to produce a particular product, it foregoes all alternative opportunities to use those resources for other purposes. The measure of the economic cost or the opportunity cost of any resource used to produce a good is the value or worth the resource would have in its best alternative.

Economic Costs (opportunity costs) are those payments a firm must make or income it must provide to resource suppliers to attract the resources away from alternative production.

Costs Two types of costs –Explicit –Implicit Total costs = Explicit Costs + Implicit CostsTotal costs = Explicit Costs + Implicit Costs

Explicit Costs are monetary payments to non- owners of the firm for the resources they supply. –Rent –Labor –Materials –Utilities

Implicit Costs costs of self-owned, self-employed resources. –Salary of owner not taken –Capital invested by owners –Foregone rent, interest, wages Not seen in accounting profit analysis

Profits Accounting profit –A firm’s total revenue minus its explicit costs –Total revenue – explicit costs Economic profit –A firm’s total revenue minus explicit and implicit costs –Earn more than expected –Normal profit The accounting profit earned when all resources earn their opportunity costs What you expect to earn

Production in the Short Run Long run –A period during which all resources under the firm’s control are variable Short run –A period during at least one of a firm’s resources is fixed

Short-run Production Relationships A firm’s costs of producing a specific output depend not only on the price of needed resources but also on the quantities of resources needed to produce that output. Resource supply and demand determine the resource prices The technological aspects of production specifically the relationship between inputs and outputs, determine the quantity of resources needed.

Law of Diminishing Marginal Returns Total product –The total output produced by a firm Production function –The relationship between the amount of resources employed and a firm’s total product Marginal product –The change in total product that occurs when the sue of a particular resource increases by one unit

Marginal Returns Law of diminishing marginal returns –As more of a variable resource is added to a given amount of a fixed resource, marginal product eventually declines and could become negative

Graphical Total product Workers per day MPMP Increasing Diminishing but positive Negative marginal returns

Costs in the Short run Fixed costs –Any production cost that is independent of the firm’s rate of output Depreciation on building Insurance Property taxes Variable costs –An production cost that changes as the rate of output changes –Labor –Materials –utilities

Formula Total Costs = Fixed Costs + Variable Cost Variable costs = Variable cost per unit x units At zero output then: Total costs = Fixed costs

Formula Average Fixed Costs (AFC) = Total Fixed Costs Output (Q) Average Variable Costs (AVC) = Total Variable Costs Output (Q) Average Total Costs (ATC) = Total Costs Output (Q) Marginal Costs = Change in total cost Change in quantity

Chart Tons per day Fixed Costs Workers per day Variable costs Total Costs Marginal Costs 0$ $100$300$50 5$2002 $400$ $2003$300$500$25 12$2004$400$600$ $2005$500$700$50 15$2006$600$800$100

Curves Fixed Costs $200 Tons per day Total cost Variable costs 0

Curves Marginal cost

Costs in the Long Run No fixed costs exists Can increase facility size Long run Average cost curve –A curve that indicates the lowest average cost of production at each rate of output when the size or scale of the firm varies

Economies of Scale Explain the downward sloping part of the long run ATC curve Economies of mass production Capital intensive firms As plant size increases, a number of factors will for a time lead to lower average costs of production Labor specialization Managerial specialization Efficient capital

Diseconomies of Scale Caused by the difficulty of efficiently controlling and coordinating a firm’s operations, as it becomes a large- scale producer. Alienation of workers

Constant Returns to Scale Long-run average costs do not change as output changes. Example: textbooks