1. Topic 5 Business and Costs of Production

2. Definition: Cost and Profit As consumers maximize utility, Producers maximize profit Profit is the reward for the entrepreneur for organizing the production process by pooling land, labor and capital and taking risk Profit is the residual that is left after all resource providers are paid for and goes to the entrepreneur Profit = Total Revenue – Total Cost 2

3. Types of Cost Three types of cost: Explicit costs –Payments for resources –Shows up in the accounting book Implicit costs –cost of the resources owned by the firm owners –No cash payment is transferred Opportunity cost Opportunity cost = Explicit cost + Implicit cost 3

4. Alternative Measures of Profit Since Profit = Total Revenue – Total Cost and there are three types of cost, we have three alternative measures of profit. Accounting profit =Total revenue - Explicit costs Economic Profit = Total Revenue – O.C. Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs) 4

5. Normal Profit  When total revenue is just equal to explicit and implicit cost, the economic profit is zero  In this case, all resource owners are just paid for and no excess profit left.  Including entrepreneur who receives his opportunity cost (highest value forgone)  In this case (economic profit = 0), we say firm is earning a normal profit  When economic profit > 0, firm is earning above normal or excess profit

6. Wheeler Dealer Accounts, 2007 6 Total revenue$105,000 Less explicit costs: Assistant’s salary Material and equipment - $21,000 - $20,000 Equals accounting profit$64,000 Less implicit costs: Wanda’s forgone salary Forgone interest on savings Forgone garage rental -$50,000 - $1,000 - $1,200 Equals economic profit$11,800 Since the economic profit is more than zero, this firm is earning above normal profit or excess profit

7. Types of Resources  Variable Resources: Resources that must vary with output produced  Raw materials  Labors  Electricity or Energy  Fixed Resources: Resources that remain unchanged regardless of output  Rent  Interest payment for fixed resources 7

8. Short Run and Long Run Short Run or Long Run has nothing to do with time. They are based on how quickly resources can be varied. Short run: At least one of the resources is fixed or cannot be varied Long run: None of the resource is fixed or all resources can be varied 8

9. Production Function Production function  Describes the relationship between amount of resources employed and total output  Y= f(L,K) Here, Y = total output or total product L = Amount of labor used K = Amount of Capital used  For example, Y=2.L + 5K  Calculate the total product or Y when  L=100 and K=50 9

10. Total and Marginal Product  Total Product: Cumulative amount of output produced at different levels of inputs (resources)  Marginal product: Additional amount of output produced from an additional unit of input (resource)  Marginal product of labor:  MP L = ∆TP / ∆L  Marginal product of capital:  MP K = ∆TP / ∆K 10

11. In Class Practice 1  Compute the MP L 11 Units of the variable resource (labor or L) TP (tons moved per day) MP L (tons moved per day per labor hired) 012345678012345678 0 2 5 9 12 14 15 14

12. In Class Practice 2  Compute the MP L 12 Units of the variable resource (labor or L) TP (tons moved per day) MP L (tons moved per day per labor hired) 0 1 3 5 7 10 15 20 30 0 5 19 35 55 100 135 160 140

13. Law of Diminishing Marginal Returns  When one of the resources is fixed, marginal product of the variables resource fall  When more and more labor (variable resource) is employed to a same grill (fixed resource) to produce hamburger MP L or productivity of each additional worker will rise first (synthesis effect) 13

14. Law of Diminishing Marginal Returns  However, after a while, the MP L or the labor productivity will fall  This happens due to fixed resource and known as the Law of Diminishing Marginal Returns  Therefore, this is essentially a short run phenomenon 14

15. Marginal Returns 15 Units of the variable resource (Labor or L) TP (tons moved per day) MP L (tons moved per day) Return 012345678012345678 0 2 5 9 12 14 15 14

16. Marginal Returns 16 Units of the variable resource (Labor or L) TP (tons moved per day) MP L (tons moved per day) Return 012345678012345678 0 2 5 9 12 14 15 14 - 2 3 4 3 2 1 0 ------ Increasing “ Diminishing “ Diminishing and Negative  Diminishing Marginal Return kicks in at 4 th unit labor  But total product keeps rising until 7 th unit labor  Total product is rising at a “decreasing rate” from 4 th to 7 th unit  Total product falls at the 8 th unit of labor when MP L is negative

17. TP and MP L 17 5 10 15 TP 5 7 Labor 0 510 1 3 5 MP L 0 2 4 Total product Marginal product Negative marginal returns Diminishing but positive marginal returns Increasing marginal returns 107 Labor

18. Total Product (TP)  5 labors produce 500 unit does not mean that each worker produce 100 unit  Although this can a possible way, but this is very improbable, why?  Law of diminishing return may be at work, especially when we are in the short run (at least one of the inputs is fixed)  To know the contribution of individual labors into the production process, we need to look at the Marginal Product (MP) information 18

19. Total Product (TP)  For example, consider the following table:  In all four TP series, TP=500 when L=5  But, this table says nothing about 3 rd worker’s contribution to the production process  Actually, 3 rd worker’s contribution is different for different series. We can see it in the associated MP table 19 Labor (L)TP1TP2TP3TP4 000 00 110050 100150 2200120 220280 3300220 330380 4400350 430450 5500

20. Marginal Product (MP)  Looking at the associated MP series, we can tell:  TP1 exhibits constant marginal return for labor  TP2 exhibits increasing marginal return for labor  TP3 exhibits both increasing and decreasing marginal return for labor  TP4 exhibits decreasing marginal return for labor  Which TP series you think represents a typical short run production function? 20 Labor (L)TP1MP1TP2MP2TP3MP3TP4MP4 00-0 00 1100 50 100150 2200100120 220280 3300100220 330380 4400100350 430450 5500100500

21. Marginal Product (MP)  Looking at the associated MP series, we can tell:  TP1 exhibits constant marginal return for labor  TP2 exhibits increasing marginal return for labor  TP3 exhibits both increasing and decreasing marginal return for labor  TP4 exhibits decreasing marginal return for labor  Which TP series you think represents a typical short run production function? 21 Labor (L)TP1MP1TP2MP2TP3MP3TP4MP4 00-0- 0-0 - 1100 50 100 150 220010012070 220120280 130 3300100220100 330130380 100 4400100350130 430100450 70 5500100500150 50070500 50

22. Production Costs  Costs are simply the payments to resource providers  There are three types in short run:  Fixed cost (FC): Payment for the fixed resources.  No fixed cost in the long run (why?)  Variable cost (VC): Payment for variable resources  Total cost TC = FC + VC 22

23. In Class Practice 3  Marginal Cost: Change in Total Cost to produce one more unit of output. Formula: MC = ∆TC/∆Q  Compute the Marginal Cost 23 Output or Total Product (TP or Q) TC ($) MC ($) Marginal Cost 012345678012345678 0 10 18 25 35 47 62 82 107 ------- Falling, MPL rising “ Rising (MPL falling) “

24. MC and MP L  MC and MP L are related  Increasing marginal product (MP L )  Implies that MC must be falling  Diminishing marginal product (MP L )  Implies MC must be rising 24

25. In Class Practice 4 Short-run TC and MC data for Smoother Mover 25 Total Product or Output (TP or Q) Workers per day (L) MP L Fixed cost (FC) Variable cost (VC) Total Cost (TC) TC=FC+VC Marginal Cost (MC) MC=∆TC/∆q 0 2 5 9 12 14 15 01234560123456 -234321-234321 $200 300 400 500 600 700 800 - For first 3 labors, Increasing marginal returns (MP L rises): MC falls With the 4 th labor, Diminishing marginal returns hits (MP L rises): MC rises

26. In Class Practice 4 26 Total Product or Output (TP or Q) Workers per day (L) MP L Fixed cost (FC) Variable cost (VC) Total Cost (TC) TC=FC+VC Marginal Cost (MC) MC=∆TC/∆q 0 2 5 9 12 14 15 01234560123456 -234321-234321 $200 200 $0 100 200 300 400 500 600 $200 300 400 500 600 700 800 - $50.00 33.33 25.00 33.33 50.00 100.00 For first 3 labors, Increasing marginal returns (MP L rises): Therefore, MC is falling Starting with the 4 th labor, Diminishing marginal returns kicks in (MP L rises): Therefore, MC is rising

27. Total Cost (TC)  Total Cost (TC) simply means total expenditure on inputs used  Total cost is a function of number of output produced (not inputs used, a common mistake)  We may find that total cost is $500 when 5 units of output is produced  This is an information about total cost  But, this information says nothing about the cost of producing the 3 rd unit of output 27

28. Shapes of TC and MC Curves 28 200 $500 Total dollars 25 Cost per ton $50 Marginal cost 915 Tons per day 0 63 12 Fixed cost Total cost Tons per day 0 9156312 Variable cost Fixed cost FC = $200 at all levels of output VC starts from origin; increases slowly at first; with diminishing returns, VC increases rapidly TC is the vertical sum of FC and VC MC first declines: TC increasing at decreasing rate [From 0-9] Then after 9, MC increases:  TC increases at an increasing rate  Diminishing marginal returns

29. Average Cost (AC)  Although MC for each unit varies, sometime it is important to know the per unit cost  Average Cost is calculates this per unit cost  Consider a part of the preceding table 29 Total Produc t or Output (Q) Fixed cost (FC) Variable cost (VC) Total Cost (TC) TC=FC+V C Marginal Cost (MC) = ∆TC ∆Q Average Total Cost (ATC) = TC Q 00200-- 2 5 8

30. Average Cost (AC)  Although MC for each unit varies, sometime it is important to know the per unit cost  Average Cost is calculates this per unit cost  Consider a part of the preceding table 30 Total Product or Output (Q) Fixed cost (FC) Variable cost (VC) Total Cost (TC) TC=FC+VC Marginal Cost (MC) = ∆TC ∆Q Average Total Cost (ATC) = TC Q 02000 -- 2 10030050.00 5200 40033.33 920030050025.00

31. Average Cost (AC)  Although MC for each unit varies, sometime it is important to know the per unit cost  Average Cost is calculates this per unit cost  Consider a part of the preceding table 31 Total Produc t or Output (Q) Fixed cost (FC) Variable cost (VC) Total Cost (TC) TC=FC+V C Marginal Cost (MC) = ∆TC ∆Q Average Total Cost (ATC) = TC Q 02000 -- 2 10030050.00300/2 = 150 5200 40033.33400/5 = 80 920030050025.00500/9 = 55.55

32. Average Cost (AC)  Important question is what do MC and ATC really mean?  MC=$33.33 simply means that the 5 th unit costs $50  ATC=$80 means:  when 5 units are produced, on an average each unit costs $80  In other words, when Q=5, per unit cost is $80 32 Total Product or Output (Q) Fixed cost (FC) Variable cost (VC) Total Cost (TC) TC=FC+V C Marginal Cost (MC) = ∆TC ∆Q Average Total Cost (ATC) = TC Q 02000 -- 2 10030050.00300/2 = 150 5200 40033.33400/5 = 80 920030050025.00500/9 = 55.55

33. Average Cost (AC) We know, AC=Cost/Quantity There are three types of costs:  Fixed cost (FC)  Variable cost (VC)  Total cost (TC) Consequently, there are three types of Average Costs  Average Fixed Cost (AFC=FC/Q)  Average Variable Cost (AVC=VC/Q)  Average Total Cost (ATC=TC/Q) 33

34. ATC = AFC +AVC  Total Cost = Fixed Cost + Variable Cost  TC = FC +VC  Show that ATC = AFC +AVC  ATC = TC/Q ………………………….[Definition of ATC] = (FC + VC)/Q = FC/Q +VC/Q = AFC + AVC ………………..[Definition of AFC and AVC] Therefore, ATC = AFC + AVC 34

35. FC, VC, TC, AFC, AVC and ATC Short run TC, MC, and AC data for Smoother Mover 35 Total Output Or Product (Q) Variable Cost (VC) Total Cost TC=FC+VC Average Fixed Cost AFC=FC/Q Average Variable Cost AVC=VC/Q Average Total Cost ATC=TC/Q 0 2 3 5 10 12 14 $0 100 200 350 430 550 580 200  Note, ATC = AFC + AVC

36. FC, VC, TC, AFC, AVC and ATC Short run TC, MC, and AC data for Smoother Mover 36 Total Output Or Product (Q) Variable Cost (VC) Total Cost TC=FC+VC Average Fixed Cost AFC=FC/Q Average Variable Cost AVC=VC/Q Average Total Cost ATC=TC/Q 0 2 5 9 12 14 15 $0 100 200 300 400 500 600 $200 300 400 500 600 700 800 - 100.00 40.00 22.22 16.67 14.29 13.33 - $50.00 40.00 33.33 35.71 40.00 ∞ $150.00 80.00 55.55 50.00 53.33  Note, ATC = AFC + AVC

37. Relationship Between MC and AC Consider a NBA player with a career average score of 30.  In his next game, if he scores 40. What will happen to his career average?  When MC > AC The marginal pulls his average UP 37

38. Relationship Between MC and AC Consider a NBA player with a career average score of 30.  Conversely, if he scores 20. What will happen to his career average?  When MC < AC The marginal pulls the average DOWN 38

39. MC and ATC Short run TC, MC, and AC data for Smoother Mover 39 Total Output Or Product (Q) Fixed Cost (FC) Variable Cost (VC) Total Cost TC=FC+VC Marginal cost MC=∆TC/∆Q Average Total Cost ATC=TC/Q 0 2 5 9 12 14 15 $200 200 $0 100 200 300 400 500 600 $200 300 400 500 600 700 800 - $50.00 33.33 25.00 33.33 50.55 100.00 ∞ $150.00 80.00 55.55 50.00 53.33  When MC < ATC, the ATC Falls  When MC > ATC, the ATC Rises  This means, when MC=ATC, the ATC does not change  Graphically, this means MC must go through the lowest point of ATC

40. Shape of ATC=TC/Q As Q goes up, ATC falls initially  Because we are dividing by a larger number  Note, Fixed Cost is being distributed across many units However, as Q goes further up ATC rises  Because the Law of diminishing marginal returns reduces labor productivity (MP L ) and increases the Total Cost  Therefore, ATC is of U-shape 40

41. Shape of ATC and AVC 41 051015Q $150 125 100 75 50 25 Cost ($) ATC AVC

42. ATC, AVC and MC 42 051015 Q $150 125 100 75 50 25 Cost ($) ATC AVC MC  When MC is above AVC and ATC, AVC and ATC is increasing  When MC is below AVC (ATC), the AVC and ATC is falling  When MC = AVC (ATC), AVC (ATC) is at its minimum.

43. Costs in the Long Run Definition: It is a time period in which all resources or inputs can be varied  Long is often considered as a Planning Horizon Because,  Firms plan in the long run  But, produce in the short run  Long run is generated by aggregating many possible short run cost curves 43

44. LRATC curve from SRATC 44 Cost per unit 0qaqa q’ Q per period qbqb S S’ M M’ L L’ Consider three short run ATC curve: SS’, MM’ and LL’ Long run ATC curve: SabL’ a b

45. ATC 1 ATC 2 LRAC is an Envelop of SRAC curve 45 0qq’Output per period  10 possible plant sizes are shown  Each point of tangency represents the least cost way of producing that level of output in the short run Cost per unit $11 10 9 b ATC 3 ATC 4 ATC 5 ATC 6 ATC 7 ATC 8 ATC 9 ATC 10 Long-run average cost c a  The long run average cost curve is drawn by connecting the lowest point of SRATC.  Therefore, LRATC is an envelop of SRATC

46. Costs in the Long Run U-shaped long-run average cost curve has three components that represent:  Economies of scale (Increasing Returns to Scale)  LRAC falls as output expands  Diseconomies of scale (Increasing Returns to Scale)  LRAC increases as output expands  Constant Returns to Scale  LRAC is constant or horizintal 46

47. Economies of Scale in Long Run 47 Cost per unit 0AOutput per periodB Economies of scale Long-run average cost Diseconomies of scale Constant average cost