1. Production and Cost in the Firm
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2. Cost and Profit Producers: Maximize profit Opportunity cost
All resources have an opportunity cost
Explicit costs
Opportunity cost of resources employed by a firm
Cash payments
On the accounting statement 2
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3. Cost and Profit Implicit costs
A firm’s opportunity cost of using its own resources or those provided by its owners
Without a corresponding cash payment
Not on the accounting statement 3
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4. Alternative Measures of Profit
Accounting profit
Total revenue minus explicit costs
Economic profit
Total revenue minus all costs (implicit and explicit)
Opportunity cost of all resources
Normal profit
Accounting profit earned when all resources earn their opportunity cost
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5. Exhibit 1 Wheeler Dealer Accounts, 2010
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6. Production in the Short Run
Variable resources
Can be varied in the short run to increase or decrease production
Fixed resources
Cannot be varied in the short run
Short run
At least one resource is fixed
Long run
No resource is fixed
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7. Diminishing Marginal Returns
Total product
A firm’s total output
Production function
Relationship between amount of resources employed and total product
Marginal product
Change in total product from an additional unit of resource
Other things constant
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8. Diminishing Marginal Returns
Increasing marginal returns
Marginal product increases
Diminishing marginal returns
Marginal product decreases
Law of diminishing marginal returns
As more of a variable resource is added to a given amount of another resource
Marginal product eventually declines
Could become negative
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9. Exhibit 2
The Short-Run Relationship Between Units of Labor and Tons of Furniture Moved
Marginal product increases as the firm hires each of the first three workers, reflecting increasing marginal returns. Then marginal product declines, reflecting diminishing marginal returns. Adding more workers may, at some point, actually reduce total product (as occurs here with an eighth worker) because workers start getting in each other’s way.
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10. Exhibit 3 The Total and Marginal Product of Labor
(a) Total product
When marginal product is rising, total product increases by increasing amounts. When marginal product is falling but still positive, total product increases by decreasing amounts. 5 10 15
Total product
(tons/day)
Total
product 5 10
Workers per day
(b) Marginal product
Increasing
Marginal
returns
Diminishing but
positive
marginal returns
Negative
marginal
returns 1 3 5
Marginal product
(tons/day) 2 4
When marginal product equals 0, total product is at a maximum. When marginal product is negative, total product is falling.
Marginal product 5 10
Workers per day
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11. Costs in the Short Run Fixed cost, FC Variable cost, VC
Any production cost that is independent of the firm’s rate of output
Variable cost, VC
Any production cost that changes as the rate of output changes
Total cost, TC = FC + VC
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12. Costs in the Short Run Marginal cost, MC = ∆TC/∆q Changes in MC
Change in total cost resulting from a one-unit change in output
Changes in MC
Reflect changes in marginal productivity
Increasing marginal returns
MC falls
Diminishing marginal returns
MC increases
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13. Exhibit 4 Short-Run Total and Marginal Cost Data for Smoother Mover
Because of increasing marginal returns from the first three workers, marginal cost declines at first, as shown in column (6). Because of diminishing marginal returns beginning with the fourth worker, marginal cost starts increasing.
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14. Costs in the Short Run Fixed cost curve Variable cost curve
Straight horizontal line
Variable cost curve
Starts at the origin
Total cost curve
Fixed cost curve + variable cost curve
Slope of total cost curve
Marginal cost
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15. Exhibit 5 Total and Marginal Cost Curves for Smoother Mover
200
$500
Total dollars
Total cost
In panel (a), fixed cost is $200 at all levels of output. Variable cost starts from the origin and increases slowly at first as output increases. When the variable resource generates diminishing marginal returns, variable cost begins to increase more rapidly. Total cost is the vertical sum of fixed cost and variable cost. In panel (b), marginal cost first declines, reflecting increasing marginal returns from the variable resource (labor in this example) and then increases, reflecting diminishing marginal returns.
Variable cost
Fixed
cost
Fixed cost 9 15
Tons per day 6 3 12 25
Cost per ton
$50
Marginal cost
Tons per day 9 15 6 3 12
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16. Average Cost in the Short Run
Average variable cost, AVC = VC/q
Variable cost divided by output
Average fixed cost, AFC = FC/q
Fixed cost divided by quantity
Average total cost, ATC = TC/q
Total cost divided by output
ATC = AFC + AVC
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17. Average Cost in the Short Run
When MC < average cost
The marginal pulls down the average
When MC > average cost
The marginal pulls up the average
U-shape of average cost curves
Law of diminishing marginal returns
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18. Exhibit 6
Short-Run Total, Marginal, and Average Cost Data for Smoother Mover
Marginal cost first falls then increases because of increasing then diminishing marginal returns from labor. As long as marginal cost is below average cost, average cost declines. Once marginal cost exceeds average cost, average cost increases. Columns (4), (5), and (6) show the relation between marginal and average costs.
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19. Exhibit 7 Average and Marginal Cost Curves for Smoother Mover
Average variable cost and average total cost curves first decline, reach low points, and then rise. Overall, they have U shapes. When marginal cost is below average variable cost, average variable cost is falling. When marginal cost equals average variable cost, average variable cost is at its minimum. When marginal cost is above average variable cost, average variable cost is increasing. The same relationship holds between marginal cost and average total cost.
$150
125
100 75 50 25
Cost per ton MC
ATC
AVC 5 10 15
Tons per day
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20. Costs in the Long Run Long run Firms plan for the long run
Planning horizon
All resources can be varied
Firms plan for the long run
Firms produce in the short run
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21. Costs in the Long Run Economies of scale Diseconomies of scale
Forces that reduce a firm’s average cost
As the scale of operation increases in the long run
Diseconomies of scale
Forces that may eventually increase a firm’s average cost
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22. Costs in the Long Run Long-run average cost curve
Indicates the lowest average cost of production
At each rate of output when the scale of the firm varies
Planning curve
U-shaped
Economies of scale
Diseconomies of scale
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23. Exhibit 8
Short-Run Average Total Cost Curves Form the Long-Run Average Cost Curve, or Planning Curve
Cost per unit S S’ L L’ M M’ a b q qa q’
Output per period qb
Curves SS’, MM’, and LL’ show short-run average total costs for small, medium, and large plants, respectively. For output less than qa, average cost is lowest when the plant is small. Between qa and qb, average cost is lowest with a medium-size plant. If output exceeds qb, the large plant offers the lowest average cost. The long-run average-cost curve connects these low cost segments of each curve and is identified as SabL’.
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24. Exhibit 9 Many Short-Run Average Total Cost Curves Form a Firm’s
Long-Run Average Cost Curve, or Planning Curve
Cost per unit
$11 10 9
ATC10
ATC1
Long-run
average cost
ATC9
ATC2 b a
ATC8
ATC3
ATC7 c
ATC4
ATC6
ATC5 q q’
Output per period
With many possible plant sizes, the long-run average cost curve is the envelope of portions of the short-run average cost curves. Each short-run curve is tangent to the long-run average cost curve. Each point of tangency represents the least-cost way of producing that rate of output.
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25. Scale economies & diseconomies at the movies
Movie theaters
Economies of scale
Decrease in LRAC as the number of screens initially increases
Diseconomies of scale
Adding even more screens
Traffic congestion
Not enough supply of popular films
Only certain hours are popular
LRAC starts to increase
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26. Costs in the Long Run Constant long-run average cost
Over some range of output
Long-run average cost neither increases nor decreases with changes in firm size
No economies of scale
No diseconomies of scale
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27. Exhibit 10 A Firm’s Long-Run Average Cost Curve Cost per unit Long-runA
Output per period B
Economies
of scale
Constant
average cost
Diseconomies
of scale
Up to output level A, long-run average cost falls as the firm experiences economies of scale. Output level A is the minimum efficient scale—the lowest rate of output at which the firm takes full advantage of economies of scale. Between A and B, the average cost is constant. Beyond output level B, long-run average cost increases as the firm experiences diseconomies of scale.
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28. Economies & Diseconomies of Scale
Plant level
Particular location
Firm level
Collection of plants
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29. Scale economies & diseconomies at McDonald's
Economies of scale
At plant level (restaurant level)
Specialization of labor and machines
At firm level
Sharing information (experience)
Efficient production techniques
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30. Scale economies & diseconomies at McDonald's
Diseconomies of scale
At firm level
Reasonably uniform menu – difficult to maintain
Increasingly complex to plan across many markets
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31. Technologically efficient production
Production and Cost
Production function
Identifies the most that can be produced
Per time period
Using various combinations of resources
For a given state of technology
Technologically efficient production
Producing the maximum possible output given the combination of resources used
That same output could not be produced with fewer resources
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32. Exhibit 11
A Firm’s Production Function Using Labor and Capital: Production per Month
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33. Properties of isoquants
Production and Cost
Isoquant
All technologically efficient combinations of two resources
That produce a certain (constant) rate of output
Properties of isoquants
Farther from origin: greater output rates
Negative slope
Don’t intersect
Convex to the origin
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34. Exhibit 12 A Firm’s Isoquants Units of capital per month 5 10 Q3 (475)g b e c d 5
Units of labor per month 10
Isoquant Q1 shows all technologically efficient combinations of labor and capital that can be used to produce 290 units of output. Isoquant Q2 reflects 415 units, and Q3 reflects 475 units. Each isoquant has a negative slope and is convex to the origin
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35. Production and Cost Slope of an isoquant
Measures the ability of additional units of one resource
To substitute in production for another resource
Negative
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36. Marginal rate of technical substitution
Production and Cost
Marginal rate of technical substitution
MRTS
Rate at which labor substitutes for capital without affecting output
Absolute value of the slope of the isoquant
MRTS = MPL/MPC
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37. Production and Cost Isocost lines Slope of isocost line
All combinations of capital and labor a firm can hire for a given total cost
Are parallel – reflect the same relative resource prices
Slope of isocost line
Negative
Price of labor divided by price of capital
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38. Exhibit 13 A Firm’s Isocost Lines 5 10 Units of capital per month
Slope = -w/r = -$1,500/$2,500 = -0.6
TC = $22,500
TC = $19,000
TC = $15,000 5 10 15
Units of labor per month
Each isocost line shows combinations of labor and capital that can be purchased for a given amount of total cost. The slope of each equals the negative of the monthly wage rate divided by the rental cost of capital per month. Higher costs are represented by isocost lines farther from the origin.
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39. Minimum cost to produce a given output
Production and Cost
Minimum cost to produce a given output
Tangency between isocost line and isoquant
Same slope = MRTS = ratio of input prices = w/r
The firm adjusts resource use so that
Rate at which one input substitutes for another in production = rate at which one resource exchanges for another in resource markets
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40. Exhibit 14 A Firm’s Optimal Combination of Inputs 5 10
Units of capital per month
TC = $19,000
Q2 (415)
Q3 (475)
Q1 (290) a f e 5 10
Units of labor per month
At point e, isoquant Q2 is tangent to the isocost line. The optimal combination of inputs is 6 units of labor and 4 units of capital. The most that can be produced for $19,000 is 415 units. Another way of looking at this is that point e identifies the least costly way of producing 415 units.
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41. Production and Cost Expansion path
Connect the tangency points between isoquants and isocost lines
Least-cost input combinations for producing several output rates
Slopes upward
Lowest long-run total cost for each rate of output
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42. Exhibit 15 A Firm’s Expansion Path C Units of capital per month
Points of tangency between isoquants and isocost lines identify the least costly resource combination of producing each particular quantity of output. Connecting these tangency points traces out the firm’s expansion path, which usually slopes up to the right, indicating that more of both goods is needed to increase output. Q4 Q3
TC4
Expansion path
TC3 Q2 Q1 d
TC2 c
TC1 b h a L L’
Units of labor per month
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