topic 3 production and costs
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Production and Costs
Supply and demand are the two words that economists use most often.
Supply and demand are the forces that make market economies work.
Modern microeconomics is about supply, demand, and market equilibrium.
According to the Law of Supply: Firms are willing to produce and sell a
greater quantity of a good when the price of the good is high.
This results in a supply curve that slopes upward.
The Firm’s Objective The economic goal of the firm is to maximize profits.
Total Revenue 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 its total cost.
Profit = Total revenue - Total cost
A firm’s cost of production includes all the opportunity costs of making its output of goods and services.
Explicit and Implicit Costs
A firm’s cost of production include explicit costs 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.
Example:
Helen uses $300 000 of her savings to buy her cookie factory from the previous owner.
If she had left her money in a savings account that pays an interest at a rate of 5 percent, she would have earned $15 000 a year.
Helen by buying a cookie factory has foregone $15 000 a year in interest income.
This foregone $15 000 is an implicit opportunity cost of Helen’s business.
The accountant will not show this cost.
Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs.
Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.
Accounting profit = TR – total explicit costs
Economic profit = TR – (explicit costs +
implicit costs)
How an
Economist
Views a Firm
Explicit costs
Implicit costs
Economic
profit
Explicit costs
Accounting
profit
How an
Accountant
Views a Firm
Total
Opportunity
Costs
Revenue Revenue
Zero economic profit = normal profit
Define as
the minimum profit to keep a firm in operation. A firm that earns normal profits earns total revenue equal to its total implicit costs + explicit costs.
Useful to categorize firms’ decisions into
Long-run decisions—involves a time horizon long enough for a firm to vary all of its inputs To guide the firm over the next several years (long run lens)
Short-run decisions—involves any time horizon over which at least one of the firm’s inputs cannot be varied To determine what the firm should do next week ( short run
lens)
There is nothing they can do about their fixed inputs Stuck with whatever quantity they have However, can make choices about their variable
inputs Fixed inputs
An input whose quantity must remain constant, regardless of how much output is produced For example: ???????
Variable input An input whose usage can change as the level of
output changes For example: ????????
Total product Maximum quantity of output that can be produced
from a given combination of inputs
Marginal product (MP) is the change in total product (ΔQ) divided by the change in the number of workers hired (ΔL)
ΔL
ΔQMP
– Tells us the rise in output produced when one more worker is hired
30
90
130
161
184 196 Total Product
DQ from hiring fourth worker
DQ from hiring third worker
DQ from hiring second worker
DQ from hiring first worker
increasing marginal returns
diminishing marginal
returns
Units of Output
Number of Workers 6 2 3 4 5 1
As more and more workers are hired
MP first increases
Then decreases
Pattern is believed to be typical at many types of firms
When the marginal product of labor increases as employment rises, we say there are increasing marginal returns to labor
Each time a worker is hired, total output rises by more than it did when the previous worker was hired
When the marginal product of labor is decreasing
There are diminishing marginal returns to labor
Output rises when another worker is added so marginal product is positive
But the rise in output is smaller and smaller with each successive worker
Law of diminishing (marginal) returns states that beyond some point the marginal product decreases as additional units of a variable factor are added to a fixed factor. (holding the other inputs constant)
Its marginal product will eventually decline
Fixed costs
Costs of a firm’s fixed inputs
Variable costs
Costs of obtaining the firm’s variable inputs
Types of total costs Total fixed costs
Cost of all inputs that are fixed in the short run Total variable costs
Cost of all variable inputs used in producing a particular level of output
Total cost
Cost of all inputs—fixed and variable
TC = TFC + TVC
TC
0
Dollars
135
195
255
315
375
$435
30 90 130 161
Units of Output
184 196
TFC
TFC
TVC
Average fixed cost (AFC) Total fixed cost per unit of output produced
• Average variable cost (TVC) – Total variable cost per unit of output produced
• Average total cost (TC) – Total cost per unit of output produced
Q
TFCAFC
Q
TVCAVC
Q
TCATC
Marginal Cost Increase in total cost from producing one more unit or
output
Marginal cost is the change in total cost (ΔTC) divided by the change in output (ΔQ)
ΔQ
ΔTCMC
– Tells us how much cost rises per unit increase in output
– Marginal cost for any change in output is equal to shape of total cost curve along that interval of output
MC
AVC
ATC AFC
Units of Output
Dollars
$4
3
2
1
30 90 130 161 196 0
AFC
When marginal cost is below average cost, average cost falls.
When marginal cost is above average cost, average cost rises.
When marginal cost is equals average cost, average cost is at its minimum point.
Add marginal cost to the table
Total
Input
(L) Q MP
TVC
(wL) MC
0 0 0
1 1,000 1,000 500 0.50
2 3,000 2,000 1,000 0.25
3 6,000 3,000 1,500 0.17
4 8,000 2,000 2,000 0.25
5 9,000 1,000 2,500 0.50
6 9,500 500 3,000 1.00
7 9,850 350 3,500 1.43
8 10,000 150 4,000 3.33
9 9,850 -150 4,500
Important Map Observations
AFC declines steadily over the range of production. Why?
In general, ATC is u-shaped. Why?
MC intersects the minimum point (q*) on ATC. Why?
Goal: earn the highest possible profit
To do this, it must follow the least cost rule To produce any given level of output the firm will
choose the input mix with the lowest cost
Firm must decide what combination of inputs to use in producing any level of output
Long-run total cost (LRTC)
The cost of producing each quantity of output when the least-cost input mix is chosen in the long run
Long-run average total cost (LRATC)
The cost per unit of output in the long run, when all inputs are variable
Q
LRTCLRATC
ATC curve tells us how average cost behaves in the short run, given plant size fixed moving along the current ATC curve
To produce any level of output in the long run, the firm will always choose that ATC curve with lowest ATC —among all of the ATC curves available move from one ATC curve to another by varying
the size of its plant Will also be moving along its LRATC curve This insight tells us how we can graph the firm’s
LRATC curve
Plant - collection of fixed inputs at a firm’s disposal
Can distinguish between the long run and the short run
In the long run, the firm can change the size of its plant
In the short run, it is stuck with its current plant size
LRATC ATC1
Use 0 automated
lines
ATC3 ATC0
C
B A
ATC2
D
E
175 196 184
Dollars
1.00
2.00
3.00
$4.00
Units of Output
30 90 130 161 250 300 0
Use 1 automated
lines
Use 2 automated
lines
Use 3 automated
lines
For some output levels, LRTC is smaller than TC
Long-run total cost of producing a given level of output can be less than or equal to, but never greater than, short-run total cost (LRTC ≤ TC)
Long-run average cost of producing a given level of output can be less than or equal to, but never greater than, short–run average total cost (LRATC ≤ ATC)
According to whether the LRATC decreases / does not change / increase as output increases, there are three types of issues: Economies of scale (decreasing LRATC) at relatively
low levels of output
Constant returns to scale (constant LRATC) at some intermediate levels of output
Diseconomies of scale (increasing LRATC) at relatively high levels of output
LRATC curves are typically U-shaped
Units of Output
LRATC
Economies of Scale Constant Returns to
Scale
Diseconomies of Scale
Dollars
1.00
2.00
3.00
$4.00
130 184 0
An increase in output causes LRATC to decrease
The more output produced, the lower the cost per unit
LRATC curve slopes downward
Long-run total cost rises proportionately less than output
Increasing return to scale
Gains from specialization Labour Managerial
Efficiency of capital Some types of inputs cannot be increased in tiny
increments, but rather must be increased in large jumps, therefore must be purchased in large lumps Low cost per unit is achieved only at high levels of
output
More efficient use of lumpy inputs will have more impact on LRATC at low levels of outputs
An increase in output causes LRATC to remain
The more output produced but the cost per unit is not change
LRATC curve remains flat
Long-run total cost rises proportionately with output
constant return to scale
LRATC increases as output increases
LRATC curve slopes upward
LRTC rises more than in proportion to output
More likely at higher output levels
As output continues to increase, most firms will reach a point where bigness begins to cause problems
As a firm become large beyond
some level
~increasing bureaucratic and red
tape (financial/accounting)
~management coordination
problems
~out of control situations