1. Unit III: The Costs of Production & Theory of the Firm
Chapters 13-17

2. First, lets review marginal returns…

3. How many workers should you hire?

4. Remember…rationale thinkers think marginally!!
Marginal = 1 additional unit
Go from…
To….

5. Let’s make……

6. What resources do you have?
There will be three factories
Each factory gets the following to work with
1 desk
One pair of scissors
One tape stapler
Workers

7. How do you produce the links?
Fold a piece of paper 2 times (hot dog style)
Cleanly cut the 4 folded strips
Wrap a strip in a circle and staple it
Take the next strip and place it through the previously made ring, and staple it to interconnect the two paper rings
Do this as many times as you can

8. Special Rules Each factory begins with one worker
Production periods last 60 seconds
Each factory must have a quality control inspector
Watches the other, competing factories
Every resource must be used during production (including workers, they must have a job!)
Everything must be cleaned after each round.

9. What everyone will do during this activity
In a table, list how many acceptable links were created for each production round.
Workers
Links Produced
Marginal Product 1 2 3 4 5 6 7

11. Increasing Marginal Product Diminishing Marginal Product
An increase in output per input added
Costs decreasing per input added
Short run
A decrease in output per input added
Costs increasing per input added
Long Run

12. The Production Function

13. Production Function
Relationship between quantity of inputs used to make a good and the quantity of output of that good.

14. Remember what happens to marginal product when you add more inputs…

15. Diminishing Marginal Product

16. Is there a graph for that?

17. Production Function
Quantity of output
Number of Workers Hired

18. How much do you think that would cost to begin that business?
List all the expenditures you would need to make your product
Estimate how much money you believe all of these expenditures will cost (ask me for help if needed)
Add all of your expenditures and that is your total cost!

19. Phone Line Attorney Shipping Worker Salaries Chairs Product Inventory
Did you forget these….
Phone Line
Attorney
Shipping
Worker Salaries
Chairs
Product Inventory
Opportunity
Costs
Computers
Fax Machine
Worker Benefits

20. Could cost up to millions of dollars!!!
Payroll Taxes
Rent
FILING CABINETS
Could cost up to millions of dollars!!!
Advertisements
Copyrights
Desks
Internet Access
Packaging
Patents
Money earned as a clown

21. The Costs of Production
The money that is given up when producing a product.
explicit and implicit Costs
fixed vs. variable Costs
fixed costs are constant
variable costs change with each additional unit of production

22. Mortgage for a toy factory
Fixed Cost
Variable Cost
Mortgage for a toy factory
Screws for toys

23. The Costs of Production
The money that is given up when producing a product.
explicit and implicit Costs
fixed vs. variable Costs
fixed costs are constant
variable costs change with each additional unit of production
Total Cost
fixed cost + variable cost
this is always the firms opportunity cost

24. Firm’s Main Objective?
To maximize profits!

25. Revenue is NOT profit! Total Revenue Total Cost Profit
The amount a firm receives for the sale of its output.
Total Cost
The market value of the inputs a firm uses in production.
Profit
The firm’s total revenue minus their total cost
Firms want to maximize profit!

26. Economic Profit vs Accounting Profit
total revenue minus total cost, including both explicit and implicit costs.
Accounting profit
total revenue minus only the firm’s explicit costs.
Economists, or rationale thinkers, base profit on economic profit

27. Quick Quiz $200 - $100= $100 $200 - $300 = -$100 Accounting Profit
You’re a farmer that gives banjo lessons on the side for $20 an hour. One day, you spend 10 hours planting $100 worth of seeds.
What is your opportunity cost?
What cost would your accountant measure?
If these seeds yield $200 worth of crops, do you earn an accounting profit?
Do you earn an economic profit?
$200 - $100= $100
$200 - $300 = -$100
Accounting Profit
Economic Profit

29. The MOTHER of cost graphs!
AFC, AVC, ATC, and MC Curves
The MOTHER of cost graphs!

30. Average Fixed Cost
Fixed costs ÷ Quantity of output
Average Variable Cost
Variable costs ÷ Quantity of output
Average Total Cost
Total cost ÷ Quantity of output
Marginal Cost
The increase in total cost that arises when one additional unit is produced

31. So, the marginal cost of producing the 2nd tablet is $10
If we wanted to make two tablets, it would costs our firm $110 because of the extra parts needed for the additional tablet (VC)
Costs our firm $100 to make 1 tablet
So, the marginal cost of producing the 2nd tablet is $10

32. Figuring Them Out...
Before we graph these curves, lets practice figuring out each cost.
Problem Set 4.2
Now, lets graph them…

33. Problem Set 4.2 Questions
What happens to AFC as output increases? Why?
What shape is the MC, ATC, and AVC? Why?
From what range of output is the ATC decreasing?
From what range of output is the ATC increasing?
Where does MC intersect the ATC and AVC curves?
What output level is the most efficient? Why?

34. Problem Set 4.2 Questions
The AFC decreases. Fixed costs are constant, so as a firm produces more quantity, their average fixed costs will decrease.
“U” shaped. Because these costs decrease initially (short run) and eventually increase (long run); the Law of Diminishing Marginal Returns!
1-7
8 – infinite
At their lowest point
Where MC = ATC (ATC at it’s lowest point)

35. Marginal Cost
When do you think diminishing marginal returns sets in?
Any output level greater than where MC = ATC
Why?

36. To help you better understand, let’s think of people in a room and height…
If the next person who enters the room is taller than the previous average, the average will rise
If the next person who enters the room is shorter than the pervious average, the average will fall
If the next person who enters the room is exactly the same than the previous average, the average will stay the same.

37. Same applies with marginal and average costs!
If MC is less than the previous average cost, the averages fall
If MC is greater than the previous average cost, the averages rise
If MC is exactly the same as the previous average costs, the averages stay the same

38. Intersects at ATC and AVC at their lowest points
To the left of the intersection is increasing marginal returns
To the right is decreasing marginal returns

39. Short Run vs. Long Run Costs and Economies of Scale

40. Let me help you understand this…
What is the difference?
Short run cost decision
There is at least one fixed cost and one variable cost
Long run cost decision
ALL costs are variable
Let me help you understand this…

41. You are currently in the short run
Suppose you are a business owner and you have a factory and wage workers
You have at least one variable cost: the worker
You have at least one fixed cost: the factory
You are currently in the short run

42. Suppose that your factory is only operating at 75% capacity.
Factory Floor Space

43. Suppose that your factory is only operating at 75% capacity.
You have at least one fixed cost, the factory, plus at least one variable cost, the workers.
This is the short run

44. Demand for your product increases, so you decide to hire more workers.
So this is a short run cost. There is at least one fixed cost (factory) and one variable cost (workers)
Did the size of the factory change? No.
Did the amount of wage workers change? Yes.

45. Your factory is now at full capacity and demand for your product is still increasing. So, you either expand your current factory or build a new one.

46. Once you decide to expand your factory or build a new one, your fix costs changes. Therefore, it’s no longer a fixed cost but a variable cost.
Does this change the fixed cost of the factory? Yes.
When fixed cost changes, this is a long run decision
Did the size of your factor change? Yes.

47. REVIEW: Short Run or Long Run Cost?
Portillo’s is doing excellent business in Naperville and is thinking of building a new Portillo’s in Plainfield
Long Run
Harvard is planning to hire more professors
Short Run
People catch on that Red Robin is overrated so the store in Plainfield may shut down

48. What does this say about long run costs for all firms?
Any questions?

49. Best explanation
onomics2/swiftfile/costofdoingbusiness/longrunat ccurve1.swf