Chapter 20 The Costs of Production

THE FIRM IN THE CIRCULAR FLOW MODEL BUSINESSES / FIRMS HOUSEHOLDS RESOURCE MARKET RESOURCESINPUTS $ COSTS$ INCOMES PRODUCT MARKET GOODS & SERVICES GOODS & SERVICES $ CONSUMPTION$ REVENUE

WHAT ARE COSTS? The Law of Supply states firms are willing to produce and sell a greater quantity of a good when the price of the good is high, resulting in an upward sloping curve. The economic goal of a firm is to maximize profits The firm must assess costs before it can assess profit

ECONOMIC COSTS Economic Costs are AKA the Opportunity Costs Definition: The value or worth the resource would have in its best alternative use.

TOTAL REVENUE, TOTAL COST, and PROFIT TOTAL REVENUE TOTAL REVENUE The amount a firm receives for the sale of its output. output. TOTAL COST The market value of the inputs a firm uses in production productionPROFIT The firm’s total revenue minus its total cost Profit = Total Revenue – Total Cost

COSTS AS OPPORTUNITY COSTS A firm’s cost of production includes all the opportunity costs of making its output of goods and services. They are known as Explicit and Implicit Costs Explicit costs are input costs that require a direct outlay of money by the firm Implicit costs are input costs that do not require an outlay of money by the firm

ARE THEY EXPLICIT OR IMPLICIT COSTS?  Hiring a new worker  Spending time with your significant other instead of working  Taking a client to lunch  Going to college instead of getting a job  Studying for a test instead of plowing snow for money  Buying new work clothes E I E I I E

ECONOMIC PROFIT VERSUS ACCOUNTING PROFIT Economists measure a firm’s economic profit as Total Revenue – Total Cost, including both explicit and implicit costs. Accountants measure the accounting profit as the firm’s Total Revenue – only the firm’s Explicit Costs.

 When Total Revenue exceeds both explicit and implicit costs, the firm earns economic profit.  Economic profit is smaller than accounting profit. ECONOMIC PROFIT VERSUS ACCOUNTING PROFIT

Economic Profit Implicit costs (including a normal profit) Explicit Costs Accounting costs (explicit costs only) Accounting Profit Economic (opportunity) Costs TOTALREVENUETOTALREVENUE How an Economist Views a Firm How an Accountant Views a Firm ECONOMIC COSTS

TRY THIS PROBLEM Gomez runs a small pottery firm. His costs are: One helper at $12,000 per year Annual Rent = $5000 Expenditures on materials = $20,000 His personal investment in the company = $40,000 (he could earn $4000 per year if his money is alternatively invested) He has been offered $15,000 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $3000 per year. Total Revenue from pottery sales is $72,000 Calculate the accounting profit and the economic profit for Gomez’s pottery firm.

ANSWER to the PROBLEM EXPLICIT COSTS = $37,000 $12,000 for the helper $5,000 for rent $20,000 for materials IMPLICIT COSTS = $22,000 $4000 of forgone interest $15,000 of forgone salary $3,000 of entrepreneurship ACCOUNTING PROFIT = $35,000 ($72,000 of revenue - $37,000 of explicit costs) ECONOMIC PROFIT = $13,000 ($72,000 - $37,000 of explicit costs - $22,000 of implicit costs)

Short-Run versus Long- Run Costs  The Economic Short Run vs the Long Run  The Short Run is:  A period too brief for a firm to alter its plant capacity, yet long enough to permit a change in the degree to which the fixed plant is used.  The firm can alter the intensity with which it uses its resources.  In the short run, output can change but production processes are fixed.

Short-Run versus Long- Run Costs  The Economic Short Run vs the Long Run  The Long Run is:  a period of time long enough for the firm to adjust the quantities of all the resources that it employs including plant capacity.  In the long run, all inputs can be varied and production processes can be changed.

Short-Run versus Long- Run Costs  Fixed Costs and Variable Costs  Fixed costs = costs that cannot be changed  Variable costs = costs that can be changed In the Short Run, some costs are fixed. In the Long Run, all costs are variable.

WHICH ARE SHORT-RUN AND WHICH ARE LONG-RUN? *Wendy’s builds a new restaurant *Harley-Davidson hires 200 more production workers *A farmer increases the amount of fertilizer used on his corn crop *An Alcoa aluminum plant adds a third shift of workers *A farmer switched from growing corn to growing asparagus LR SR LR

 A firm’s costs of production depend on the prices of the resources needed and the quantities of resources needed to produce their output  Firm’s will analyze the cost relationships between their inputs and output Section 2 - SHORT-RUN PRODUCTION RELATIONSHIPS

Total Product (TP) – AKA Total Physical Product (TPP) - The total quantity, or total output, of a particular good or service produced. Marginal Product (MP) – the extra output or added product associated with adding a unit of a variable resource, usually labor, to the production process. Section 2 - SHORT-RUN PRODUCTION RELATIONSHIPS Marginal Product = Change in Total Product Change in Labor Input

Average Product = Total Product Units of Labor  Average Product (AP) is output per unit of labor input Section 2 - SHORT-RUN PRODUCTION RELATIONSHIPS

TPP for Al’s Building Company How many employees is too many?

TPP with Different Quantities of Carpenters TPP G F E D C B A 5 Quantity of Carpenters per Year Garages per Year Total Output in

Al’s Product Schedule

Al’s Marginal Physical Product (MPP) Curve 6 MPP Negative marginal returns Diminishing marginal returns Increasing marginal returns Number of Carpenters –2 –4 –6 MPP in Garages per Year 0 How many carpen ters should Al hire?

Inputs of Labor Total ProductMarginal Product Average Product Complete the table by calculating marginal product and average product from the data given

Inputs of Labor Total ProductMarginal Product Average Product 00 xx Complete the table by calculating marginal product and average product from the data given Graph TP, MP and AP

The “Law” of Diminishing Marginal Returns Diminishing Marginal Returns – definition: Is the property whereby the marginal product of an input declines as a quantity of input increases. Example: As more workers are hired at a firm, each additional worker contributes less and less to the production because the firm has a limited amount of equipment.  It explains the shape of the marginal physical product curve

The Flower Pot Example A farmer plants 80 acres of corn but does not weed his fields. His yield is 40 bushels per acre. If he weeds once his yield rises to 50 bushels per acre. Two weedings yield 57 bushels per acre. Three weedings yield 61 bushels per acre. Each weeding adds less and less yield per acre – Diminishing Marginal Returns

 If diminishing marginal returns didn’t occur more weedings, seeds, and fertilizer would continue to yield more and more corn per acre. The world could be fed out of a flowerpot. The Flower Pot Example

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and Marginal Product, MP Quantity of Labor Total Product Marginal Product Average Product Increasing Marginal Returns

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and Marginal Product, MP Quantity of Labor Total Product Marginal Product Average Product Diminishing Marginal Returns

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and Marginal Product, MP Quantity of Labor Total Product Marginal Product Average Product Negative Marginal Returns

Short-Run Production Costs  Production information must be coupled with resource prices to determine the total and per-unit costs of producing various levels of output.  In the short-run some resources, those associated with the firm’s plant, are fixed. Other resources are variable. Therefore, short-run costs are either fixed or variable.

Fixed Costs – Examples: rent, interest on Debts, insurance premiums Total Fixed Costs Average Fixed Costs = Total Fixed Costs Quantity of output Variable Costs – Examples: materials, fuels, Utilities, transportation, and labor Total Variable Costs Average Variable Costs = Total Variable Costs Quantity of output SHORT-RUN PRODUCTION COSTS

Total Cost TC = Total Fixed + Variable Costs Average Total Cost = Total Costs Quantity of output Marginal Cost – the extra, or additional, cost of producing one more unit of output Total Variable Costs Marginal Cost = Change in Total Costs Change in Quantity of output SHORT-RUN PRODUCTION COSTS

Marginal Cost = MC Total Fixed Costs = TFC Total Variable Costs = TVC Average Variable Costs = AVC Total Costs = TC Average Total Costs = ATC Average Fixed Costs = AFC Summary of Definitions SHORT-RUN PRODUCTION COSTS

Marginal Cost Curve rises with the amount of output produced reflecting the property of diminishing marginal product. COST CURVES AND THEIR SHAPES

The Average Total Cost Curve is U-shaped. At low levels of output ATC is high because fixed cost is spread over only a few units. ATC declines as output increases. ATC starts rising because AVC rises substantially.

COST CURVES AND THEIR SHAPES The Relationship between MC and ATC When MC is less than ATC, ATC is falling. When MC is greater than ATC, ATC is rising. The MC curve crosses the ATC curve at the efficient scale (the quantity that minimizes ATC

SHORT-RUN COSTS GRAPHICALLY- AVERAGE AND MARGINAL COSTS Costs (dollars) Quantity AFC AVC ATC MC

SHORT-RUN COSTS GRAPHICALLY Quantity Costs (dollars) TC Total Cost Fixed Cost TVC Variable Cost TFC Combining TVC With TFC to get Total Cost

PRODUCTIVITY AND COST CURVES Costs (dollars) Average Product and Marginal Product Quantity of labor Quantity of output MP AP MC AVC

Al’s (Variable) Cost Schedules

Al’s Total Variable Cost Curve TC (a) Total Variable Cost per Year (thousands $) Quantity of Garages

Al’s Average Variable Cost Curve C D AVC (b) Average Variable Cost per Garage (thousands $) Quantity of Garages

Al’s Marginal Variable Cost Curve (c) Marginal Variable Cost per Added Garage (thousands $) Quantity of Garages MVC

Fixed Costs: Total TFC (a) Total Fixed Cost per Year (thousands of $) Output

Al’s Fixed Costs

Fixed Costs: Average AFC (b) Average Fixed Cost per Garage (thousands $) Output

Section 3 – Long-Run Production Costs  A typical average cost curve declines at first because average fixed costs decline.  It then reaches a minimum and begins to rise because of decreasing marginal returns.

Section 3 – Long-Run Production Costs Costs differ in the short and long runs, because in the long run, more adjustments can be made. For example: A firm increases the size of its plantCosts differ in the short and long runs, because in the long run, more adjustments can be made. For example: A firm increases the size of its plant * Because many costs are fixed in the short-run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.

Section 3 – Long-Run Production Costs  The long-run average total cost curve (ATC) shows the lowest possible short- run average cost corresponding to each output level.  ATC makes no distinction between fixed and variable costs (all resource costs are variable in the long run)

LONG-RUN PRODUCTION COSTS All such plant capacities can be plotted on the same graph. For every plant capacity size... there is a short-run ATC curve.

LONG-RUN PRODUCTION COSTS Unit Costs Output

LONG-RUN PRODUCTION COSTS Unit Costs Output

LONG-RUN PRODUCTION COSTS The long-run ATC just “envelopes” all of the short-run ATC curves. Unit Costs Output

LONG-RUN PRODUCTION COSTS Unit Costs Output long-run ATC

Short-Run and Long-Run Average Cost Curves V B S Average Cost per Pound of Chicken $ Output in Pounds of Chicken U L W G T

ECONOMIES OF SCALE Economies of Scale refers to the property whereby long-run average total cost falls as the quantity of output increases. It explains the downsloping part of the long- run ATC curve.

ECONOMIES OF SCALE As plant size increases, a number of factors will for a time lead to lower average costs of production. 1. Labor Specialization – hiring more workers means jobs can be divided and subdivided. Workers can work full-time on the tasks for which they have special skills.

ECONOMIES OF SCALE 2. Managerial Specialization – means the better and more efficient use of management. Instead of an executive performing many functions he/she can focus on his area of expertise. 3. Efficient Capital – As a firm grows it can afford more efficient and Modern equipment. 4. Other Factors – start-up costs, advertising costs, depreciation costs, and many others

Economies of Scale becomes Constant Returns to Scale  In some industries a wide range of output may exist between the output at which economies of scale end and the output at which Diseconomies of Scale begin.  That range, where long-run average costs remains stable is called Constant Returns to Scale.

Diseconomies of Scale  In time the expansion of a firm may lead to higher average total costs, causing Diseconomies of Scale.  When a firm becomes bigger it is more difficult to be efficient with managerial practices as bureaucratic interference evolves.  Employees might feel alienated and more likely to be less attentive to their work

Possible Shapes for the Long-Run AC Curve Long-Run Average Cost (c) Quantity of Output Decreasing returns to scale Long-Run Average Cost (b) Quantity of Output Constant returns to scale Long-Run Average Cost (a) Quantity of Output Increasing returns to scale AC

ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output long-run ATC Economies of scale

ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output long-run ATC Economies of scale Constant returns to scale

ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output long-run ATC Economies of scale Diseconomies of scale Constant returns to scale

ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output long-run ATC Where extensive economies of scale exist

ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output long-run ATC Where economies of scale are quickly exhausted

CHAPTER SUMMARY  The goal of firms is to maximize profit, which equals total revenue minus total cost.  When analyzing a firm’s behavior, it is important to include all the opportunity costs of production  Some opportunity costs are explicit while other opportunity costs are implicit.

CHAPTER SUMMARY  A firm’s costs reflect its production process.  * A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product  *A firms total costs are divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output. Variable costs do change with output

 Average total cost is total cost divided by the quantity of output.  Marginal cost is the amount by which total cost would rise if output were increased by one unit.  The marginal cost always rises with the quantity of output.  Average cost first falls as output increases and then rises. CHAPTER SUMMARY

 The average-total-cost curve is U-shaped  The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC  A firm’s costs often depend on the time horizon being considered  In particular, many costs are fixed in the short-run but variable in the long- run. CHAPTER SUMMARY

Historical Costs versus Analytical Costs Curves  All points on the analytical cost curve (used in economic analysis) refer to the same period of time.  An historical cost curve, showing the actual relationship between cost and output at different periods of time, is probably not a good indicator of the analytical cost curve.

Declining HCC w/declining Analytical ACC B A 2005 analytical cost curve 1942 analytical cost curve Historical cost curve $ Cost per Unit Quantity of Output

Declining HCC with U- shaped Analytical ACC A B 2005 analytical cost curve 1942 analytical cost curve Historical cost curve $ Cost per Unit Quantity of Output

Cost Minimization in Theory and Practice  Real business situations are more complex than those outlined in this chapter, and the quality of the available information is less precise.  Yet when managers are doing their jobs well and the market is functioning smoothly, these models are a good approximation to the real world.

Character of the Production Indifference Curves  Each production indifference curve shows all combinations of input quantities capable of producing a given quantity of output.  Higher curves correspond to higher outputs on a production indifference map.

A Production Indifference Map C B Quantity of Land in Acres Quantity of Labor in Years ,000 bushels 240,000 bushels 260,000 bushels D E A

Character of the Production Indifference Curves  Budget line: a curve that shows all the combinations of inputs that keep total costs constant.  Slope of the budget line: the trade-off between one input and another, which keeps total costs constant.  Constant input prices  constant slope of a budget line

Cost Minim., Expansion Path, and Cost Curves  The least costly way to produce any given level of output is shown by the point of tangency between a budget line and the production indifference curve corresponding to that level of output.  The combination of these points shows the firm’s expansion path.

A Budget Line K J Quantity of Land in Acres Number of Workers

Cost Minimization 240,000 bushels $270,000 $450, K J Quantity of Land in Acres Number of Workers A B T $360,000

Effects of Changes in Input Prices   input prices   slope of the budget line  Optimal input proportions then change.  Point at which the budget line is tangent to an indifference curve also changes.

The Firm’s Expansion Path $270, ,000 bushels 300,000 bushels B B ,000 bushels 15 B' K J Quantity of Land in Acres Number of Workers E E S S' T

Optimal Input at a Different Set of Input Prices V W Quantity of Land in Acres Quantity of Labor in Years 240,000 bushels E

Chapter 8 Output, Price, and Profit

Economic Profit Implicit costs (including a normal profit) Explicit Costs Accounting costs (explicit costs only) Accounting Profit Economic (opportunity) Costs TOTALREVENUETOTALREVENUE Profits to an Economist Profits to an Accountant ECONOMIC COSTS

Price and Quantity: One Decision, Not Two  Firms face a demand curve on which price and quantity are related.  They can choose either price or quantity, but not both.

Demand Curve for Al’s Garages D D Profit maximum 5 5 Output, Garages Marketed per Year Price per Garage (thousands $) i h g e f d c b a j

Total Profit: Keep Your Eye on the Goal  Simplifying assumption: maximum total profit is the firm’s goal.  Total profit = total revenue - total costs  Economic profit  accounting profit

Total Profit: Keep Your Eye on the Goal  Total, Average, and Marginal Revenue  Total Revenue = P  Q  Average Revenue = TR/Q = (P  Q)/Q = P  Marginal Revenue =  total revenue from one more unit of output.

Demand for Al’s Garages

Total Revenue Curve for Al’s Garages TR A B C D E F G H I J 5 Total Revenue per Year (thousands $) Output, Garages Sold per Year

Total Profit: Keep Your Eye on the Goal  Total, Average, and Marginal Cost  The shapes of the cost curves mean that there is some size for the firm that is most efficient.  Firms that are smaller or larger than this optimal size will have higher average costs.

Al’s Total, Average, and Marginal Costs

Cost Curves for Al’s Garages TC (a) Total Cost Output, Garages per Year 5 Total Cost per Year (thousands $)

Cost Curves for Al’s Garages (b) Average Cost Output, Garages per Year 5 Average Cost per Garage (thousands $) AC

Cost Curves for Al’s Garages MC (c) Marginal Cost Output, Garages per Year 5 Marginal Cost per Added Garage (thousands $)

Marginal Analysis and Profit Marginal cost =  in TC /  in Q Marginal Revenue =  total revenue (TRa – TRb) from one more unit of output.

Marginals Analysis For The Producer Firm  Inputs  Costs  How much does one more unit of input change output?  Input Costs  Output  Will one more unit of output increase MR?  Output  Profit  Will one more unit of output increase or decrease profit?  If MR > MC,  production   profits  If MR < MC,  production   profits  Profit maximizing level output: MR = MC TR – TC = Total Profit

Total Profit: Keep Your Eye on the Goal  Maximization of Total Profits  Profits typically increase with output, then fall.  Some intermediate level of output, therefore, generates the maximum profit.

TR, Costs, and Profit for Al’s Garages

Marginal Analysis and Maximization of Total Profit  Marginal profit is the slope of the total profit curve.  Profit is at a maximum when the marginal profit is zero.

Profit Maximization TC TR 22,000 Profit (a) Total Revenue. Total Cost Output, Garages per Year 5 Total Revenue, Total Cost per Year (thousands $) B 96 A

Profit Maximization 5 (b) Total Profit Output, Garages per Year Total profit F D E C –80 –60 –40 – Total Profit per Year (thousands $) M 34

Marginal Analysis and Maximization of Total Profit  Optimum Marginal Revenue and Marginal Cost  If MR > MC,  production   profits  If MR < MC,  production   profits  Profit maximizing level output: MR = MC

Al’s Marginal Revenue and Marginal Cost

Profit Maxim: Another Graphical Interpretation Output, Garages per Year (a) Marginal Revenue and Marginal Cost 5 MR and MC per Garage per Year (thousands $) – MR MC E

Profit Maxim: Another Graphical Interpretation TC TR 22,000 Profit (a) Total Revenue. Total Cost Output, Garages per Year 5 Total Revenue, Total Cost per Year (thousands $) B 96 A

Profit Maxim: Another Graphical Interpretation 5 (b) Total Profit Output, Garages per Year Total profit F D E C –80 –60 –40 – Total Profit per Year (thousands $) M 34

Marginal Analysis and Maximization of Total Profit  Finding the Optimal Price from Optimal Output  MR = MC: rule for determining the level of output  Demand curve  price buyers will pay to purchase that level of output  Both output and price are now determined for the profit maximizing firm.

Logic of Marginal Analysis & Maximization  If a decision is to be made about the quantity of some variable, then maximize net benefit.  Net benefit = total benefit - total cost  To maximize net benefit, select a value of the variable at which marginal benefit = marginal cost.

Logic of Marginal Analysis & Maximization  Application: Fixed Cost and Profit Maximization  An increase in fixed costs does not change optimal output or price because it does not affect marginal costs.

Rise in Fixed Cost: Total Profits Before and After

Fixed Cost Does Not Affect Profit-Maximizing Output Profit with a fixed cost Profit with zero fixed cost N Total Profit per Year (thousands $) Output in Garages per Year M

The Role of Marginal Analysis  Marginal analysis can be used to illuminate many everyday problems, in business and elsewhere, sometimes with surprising results.  For example, a new activity will add to profits if it more than covers its marginal cost, not the fully allocated average cost.

The Role of Marginal Analysis  Any problem involving optimization can be illuminated with marginal analysis.  The logic of marginal analysis can be applied to government, universities, hospitals and other organizations as well as businesses.

Theory and Reality  Business people seldom use marginal analysis in a literal sense.  They often rely on intuition and hunches.  But these theories can be used to understand and predict behavior.

 Average = total  the number of units  Total = average  the number of units Relationships Among Total, Average, and Marginal Data

 Marginal value of the xth unit = total value of x units - total value of (x - 1) units.  Total value of x units =  marginal values of the first x units.

 The marginal, average and total values for the first unit are usually equal.  If marginal < average, the average is falling.  If marginal > average, the average is rising.  If marginal = average, the average is constant; that is, the average is at a maximum or minimum. Relationships Among Total, Average and Marginal Data

Relationship Between Marginal and Average Curves F E A D B C Average weight Marginal weight Marginal and Average Weight (pounds) Number of Persons