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Chapter 13: The Costs of Production. Econ 2100. Course Outline. Chapter 13 Outline. Total Revenue, Total Cost, Profit. We assume that the firm’s goal is to maximize profit. the amount a firm receives from the sale of its output. the market value of the inputs a firm uses in production. 0. - PowerPoint PPT Presentation
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THE COSTS OF PRODUCTION 1
Chapter 13: The Costs of Production
Econ 2100
THE COSTS OF PRODUCTION 2
Course Outline
Chapter 13 Outline
THE COSTS OF PRODUCTION 4
THE COSTS OF PRODUCTION 5
Total Revenue, Total Cost, Profit• We assume that the firm’s goal is to maximize
profit.
Profit = Total revenue – Total cost
the amount a firm receives from the sale of its output
the market value of the inputs a firm uses in production
THE COSTS OF PRODUCTION 6
Costs: Explicit vs. Implicit• Explicit costs require an outlay of money,
e.g., paying wages to workers.• Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time.• Remember one of the Ten Principles:
The cost of something is what you give up to get it.
• This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.
THE COSTS OF PRODUCTION 7
Explicit vs. Implicit Costs: An ExampleYou need $100,000 to start your business.
The interest rate is 5%. • Case 1: borrow $100,000
– explicit cost = $5000 interest on loan
• Case 2: use $40,000 of your savings, borrow the other $60,000– explicit cost = $3000 (5%) interest on the loan– implicit cost = $2000 (5%) foregone interest you
could have earned on your $40,000.In both cases, total (exp + imp) costs are $5000.
THE COSTS OF PRODUCTION 8
Economic Profit vs. Accounting Profit• Accounting profit
= total revenue minus total explicit costs
• Economic profit= total revenue minus total costs (including explicit
and implicit costs)
• Accounting profit ignores implicit costs, so it’s higher than economic profit.
Chapter 13 Outline
THE COSTS OF PRODUCTION 9
THE COSTS OF PRODUCTION 10
The Production Function• A production function shows the relationship
between the quantity of inputs used to produce a good and the quantity of output of that good.
• It can be represented by a table, equation, or graph.
• Example 1:– Farmer Jack grows wheat. – He has 5 acres of land. – He can hire as many workers as he wants.
THE COSTS OF PRODUCTION 11
Example 1: Farmer Jack’s Production Function
0
500
1,000
1,500
2,000
2,500
3,000
0 1 2 3 4 5
No. of workers
Qu
anti
ty o
f o
utp
ut
30005
28004
24003
18002
10001
00
Q (bushels of wheat)
L(no. of
workers)
THE COSTS OF PRODUCTION 12
Marginal Product• If Jack hires one more worker, his output rises by the
marginal product of labor. • The marginal product of any input is the increase in
output arising from an additional unit of that input, holding all other inputs constant.
• Notation: ∆ (delta) = “change in…”
Examples: ∆Q = change in output, ∆L = change in labor
• Marginal product of labor (MPL) = ∆Q∆L
THE COSTS OF PRODUCTION 13
EXAMPLE 1: Total & Marginal Product
30005
28004
24003
18002
10001
00
Q (bushels of wheat)
L(no. of
workers)
200
400
600
800
1000
MPL
∆Q = 1000∆L = 1
∆Q = 800∆L = 1
∆Q = 600∆L = 1
∆Q = 400∆L = 1
∆Q = 200∆L = 1
THE COSTS OF PRODUCTION 14
EXAMPLE 1: MPL = Slope of Prod Function
MPL equals the slope of the production function.
Notice that MPL diminishes as L increases.
This explains why the production function gets flatter as L increases.
0
500
1,000
1,500
2,000
2,500
3,000
0 1 2 3 4 5
No. of workers
Qu
anti
ty o
f o
utp
ut
30005200
28004400
24003600
18002800
100011000
00
MPLQ
(bushels of wheat)
L(no. of
workers)
THE COSTS OF PRODUCTION 15
Why MPL Is Important• Recall one of the Ten Principles:
Rational people think at the margin.• When Farmer Jack hires an extra worker,
– his costs rise by the wage he pays the worker– his output rises by MPL
• Comparing them helps Jack decide whether he would benefit from hiring the worker.
THE COSTS OF PRODUCTION 16
Why MPL Diminishes• Farmer Jack’s output rises by a smaller and smaller
amount for each additional worker. Why? • As Jack adds workers, the average worker has less land
to work with and will be less productive. • In general, MPL diminishes as L rises
whether the fixed input is land or capital (equipment, machines, etc.).
• Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal)
Think of Einstein’s Bagels
• What happens if 1 person is working in the place?How many customers can be served
in a given time period?• What if 2 are working?
Greater or lesser number of customers?
•What if 25 are working?Greater or lesser number of
customers?17
Aircraft Scheduling & Marginal Product - Simplified
• ORD – LHR 10.5 hrs• Crew: 4 pilots & 11 FAs• One Crew – A/C can fly
one way in 24 hrs• Two Crews – A/C can fly
round trip in 24 hrs• Three Crews and more –
A/C can only fly round trip in 24 hrs
18
747-100Built 1971
747-100Built 1971
A/C is fixed factor of productionA/C is fixed factor of production
Chapter 13 Outline
THE COSTS OF PRODUCTION 19
THE COSTS OF PRODUCTION 20
EXAMPLE 1: Farmer Jack’s Costs
• Farmer Jack must pay $1000 per month for the land, regardless of how much wheat he grows.
• The market wage for a farm worker is $2000 per month.
• So Farmer Jack’s costs are related to how much wheat he produces….
THE COSTS OF PRODUCTION 21
EXAMPLE 1: Farmer Jack’s Costs
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total Cost
30005
28004
24003
18002
10001
$10,000
$8,000
$6,000
$4,000
$2,000
$0
$1,000
$1,000
$1,000
$1,000
$1,000
$1,00000
Cost of labor
Cost of land
Q(bushels of wheat)
L(no. of
workers)
THE COSTS OF PRODUCTION 22
EXAMPLE 1: Farmer Jack’s Total Cost Curve
Q (bushels of wheat)
Total Cost
0 $1,000
1000 $3,000
1800 $5,000
2400 $7,000
2800 $9,000
3000 $11,000
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
0 1000 2000 3000
Quantity of wheat
To
tal c
ost
THE COSTS OF PRODUCTION 23
Marginal Cost• Marginal Cost (MC)
is the increase in Total Cost from producing one more unit:
∆TC∆Q
MC =
THE COSTS OF PRODUCTION 24
EXAMPLE 1: Total and Marginal Cost
$10.00
$5.00
$3.33
$2.50
$2.00
Marginal Cost (MC)
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total Cost
3000
2800
2400
1800
1000
0
Q(bushels of wheat)
∆Q = 1000 ∆TC = $2000
∆Q = 800 ∆TC = $2000
∆Q = 600 ∆TC = $2000
∆Q = 400 ∆TC = $2000
∆Q = 200 ∆TC = $2000
THE COSTS OF PRODUCTION 25
EXAMPLE 1: The Marginal Cost Curve
MC usually rises as Q rises, as in this example.
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
TC
$10.00
$5.00
$3.33
$2.50
$2.00
MC
3000
2800
2400
1800
1000
0
Q(bushels of wheat)
$0
$2
$4
$6
$8
$10
$12
0 1,000 2,000 3,000Q
Mar
gin
al C
ost
($)
Relationship Between Marginal Product and Marginal Cost
Employee Marginal
Product
Per Hour(Sandwiches)
Total
Product
Per hour(Sandwiches)
Salary
Per Hour
Marginal Cost
Per Unit
First 10 10 $10 $1
Second 15 25 $10 $0.67
Third 10 35 $10 $1
Fourth 5 40 $10 $226
How manyEmployees?
THE COSTS OF PRODUCTION 27
Why MC Is Important• Farmer Jack is rational and wants to maximize
his profit. To increase profit, should he produce more or less wheat?
• To find the answer, Farmer Jack needs to “think at the margin.”
• If the cost of additional wheat (MC) is less than the revenue he would get from selling it, then Jack’s profits rise if he produces more.
THE COSTS OF PRODUCTION 28
Fixed and Variable Costs• Fixed costs (FC) do not vary with the quantity of output
produced. – For Farmer Jack, FC = $1000 for his land– Other examples:
cost of equipment, loan payments, rent• Variable costs (VC) vary with the quantity produced.
– For Farmer Jack, VC = wages he pays workers– Other example: cost of materials
• Total cost (TC) = FC + VC
THE COSTS OF PRODUCTION 29
EXAMPLE 2• Our second example is more general,
applies to any type of firm producing any good with any types of inputs.
THE COSTS OF PRODUCTION 30
EXAMPLE 2: Costs
7
6
5
4
3
2
1
620
480
380
310
260
220
170
$100
520
380
280
210
160
120
70
$0
100
100
100
100
100
100
100
$1000
TCVCFCQ
$0
$100
$200
$300
$400
$500
$600
$700
$800
0 1 2 3 4 5 6 7
Q
Co
sts
FC
VC
TC
THE COSTS OF PRODUCTION 31
EXAMPLE 2: Marginal Cost
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
Recall, Marginal Cost (MC) is the change in total cost from producing one
more unit:
Usually, MC rises as Q rises, due to diminishing marginal product.
Sometimes (as here), MC falls before rising.
(In other examples, MC may be constant.) 6207
4806
3805
3104
2603
2202
1701
$1000
MCTCQ
140
100
70
50
40
50
$70
∆TC
∆QMC =
THE COSTS OF PRODUCTION 32
EXAMPLE 2: Average Fixed Cost
1007
1006
1005
1004
1003
1002
1001
14.29
16.67
20
25
33.33
50
$100
n/a$1000
AFCFCQ Average fixed cost (AFC) is fixed cost divided by the quantity of output:
AFC = FC/Q
Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
THE COSTS OF PRODUCTION 33
EXAMPLE 2: Average Variable Cost
5207
3806
2805
2104
1603
1202
701
74.29
63.33
56.00
52.50
53.33
60
$70
n/a$00
AVCVCQ Average variable cost (AVC) is variable cost divided by the quantity of output:
AVC = VC/Q
As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7Q
Co
sts
THE COSTS OF PRODUCTION 34
EXAMPLE 2: Average Total Cost
88.57
80
76
77.50
86.67
110
$170
n/a
ATC
6207
4806
3805
3104
2603
2202
1701
$1000
74.2914.29
63.3316.67
56.0020
52.5025
53.3333.33
6050
$70$100
n/an/a
AVCAFCTCQ Average total cost (ATC) equals total cost divided by the quantity of output:
ATC = TC/Q
Also,
ATC = AFC + AVC
THE COSTS OF PRODUCTION 35
EXAMPLE 2: Average Total Cost
Usually, as in this example, the ATC curve is U-shaped.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
88.57
80
76
77.50
86.67
110
$170
n/a
ATC
6207
4806
3805
3104
2603
2202
1701
$1000
TCQ
THE COSTS OF PRODUCTION 36
EXAMPLE 2: The Various Cost Curves Together
AFCAVCATC
MC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
THE COSTS OF PRODUCTION 37
EXAMPLE 2: Why ATC Is Usually U-Shaped
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
As Q rises:
Initially, falling AFC pulls ATC down.
Eventually, rising AVC pulls ATC up.
Efficient scale:The quantity that minimizes ATC.
THE COSTS OF PRODUCTION 38
EXAMPLE 2: ATC and MC
ATCMC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
When MC < ATC,
ATC is falling.
When MC > ATC,
ATC is rising.
The MC curve crosses the ATC curve at the ATC curve’s minimum.
Chapter 13 Outline
THE COSTS OF PRODUCTION 39
Short-Run Versus Long-Run
• The short run is a period of time for which two conditions hold:1. The firm is operating under a fixed scale
(or fixed factor) of production, and2. Firms can neither enter nor exit the
industry.
40
But can shut downBut can shut down
Short-Run Versus Long-Run
• The long run is a period of time for which there are no fixed factors of production. Firms can increase or decrease scale of operation, and new firms can enter and existing firms can exit the industry.
41
THE COSTS OF PRODUCTION 42
Costs in the Short Run & Long Run• Short run:
Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC.
• Long run: All inputs are variable (e.g., firms can build more factories, or sell existing ones).
• In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q (e.g., the factory size with the lowest ATC).
THE COSTS OF PRODUCTION 43
EXAMPLE 3: LRATC with 3 factory Sizes
ATCSATCM ATCL
Q
AvgTotalCost
Firm can choose from 3 factory sizes: S, M, L.
Each size has its own SRATC curve.
The firm can change to a different factory size in the long run, but not in the short run.
THE COSTS OF PRODUCTION 44
EXAMPLE 3: LRATC with 3 factory Sizes
ATCSATCM ATCL
Q
AvgTotalCost
QA QB
LRATC
To produce less than QA, firm will
choose size S in the long run.
To produce between QA
and QB, firm will
choose size M in the long run.
To produce more than QB, firm will
choose size L in the long run.
THE COSTS OF PRODUCTION 45
A Typical LRATC Curve
Q
ATCIn the real world, factories come in many sizes, each with its own SRATC curve.
So a typical LRATC curve looks like this:
LRATC
Chapter 13 Outline
THE COSTS OF PRODUCTION 46
Weekly Costs Showing Economies of Scale in Egg Production
$/Egg
.050
.010
.006
.007
47
JONES FARM TOTAL WEEKLY COSTS
15 hours of labor (implicit value $8 per hour) $120Feed, other variable costs 25Transport costs 15Land and capital costs attributable to egg production 17
$177Total output 2,400 eggsAverage cost $.074 per egg
CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTS
Labor $ 5,128Feed, other variable costs 4,115Transport costs 2,431Land and capital costs 19,230
$30,904Total output 1,600,000 eggsAverage cost $.019 per egg
$/Egg
.003
.002
.002
.012
THE COSTS OF PRODUCTION 48
How ATC Changes as the Scale of Production Changes
Economies of scale: ATC falls as Q increases.
Constant returns to scale: ATC stays the same as Q increases.
Diseconomies of scale: ATC rises as Q increases.
LRATC
Q
ATC
Cost of ComplexityTwo Daughters
AgRegistrar
UnivRegistrar
Bursar
Univ.Admissions
Ag Admissions
Student
Registrar/Bursar
Admissions
49
13,000 Students 1,800 Students
THE COSTS OF PRODUCTION 50
How ATC Changes as the Scale of Production Changes
• Economies of scale occur when increasing production allows greater specialization: workers more efficient when focusing on a narrow task.– More common when Q is low.
• Diseconomies of scale are due to coordination problems in large organizations. E.g., management becomes stretched, can’t control costs. – More common when Q is high.
Test Bank Questions
THE COSTS OF PRODUCTION 51
Questions 22 & 28
THE COSTS OF PRODUCTION 52
a. explicit costs only.b. implicit costs only.c. explicit costs + implicit costs.d. explicit costs + implicit costs + total
revenue.
22. A firm's opportunity costs of production are equal to its
a. a lease payment.b. the cost of raw materials.c. the value of the business
owner’s time.d. All of the above are correct.
28. An example of an opportunity cost that is also an implicit cost is
Questions 35 & 3
THE COSTS OF PRODUCTION 53
a. wages John could earn washing windows
b. dividends John's money was earning in the stock market before John sold his stock and bought a shoe-shine booth
c. the cost of shoe polishd. Both b and c are correct.
35. John owns a shoe-shine business. His accountant most likely includes which of the following costs on his financial statements?
a. The production function depicts the relationship between the quantity of labor and the quantity of output.
b. The slope of the production function measures marginal cost.
c. The quantity of output determines the maximum amount of labor the firm will hire.
d. All of the above are correct.
3. Which of the following statements about a production function is correct for a firm that uses labor to produce output?
Questions 6 & 8
THE COSTS OF PRODUCTION 54
Number of
Workers
Output (number of pet visits)
0 01 202 453 604 70
Alyson’s Pet Sitting Service
a. 15b. 20c. 22.5d. 25
6. Refer to Table 13-1. What is the marginal product of the second worker?
a. first worker.b. second worker.c. third worker.d. fourth worker.
8. Refer to Table 13-1. Alyson’s pet sitting service experiences diminishing marginal productivity with the addition of the
Question 13 & 8
THE COSTS OF PRODUCTION 55
a. The firm can vary both the size of its factory and the number of workers it employs.
b. The firm can vary the size of its factory but not the number of workers it employs.
c. The firm can vary the number of workers it employs but not the size of its factory.
d. The firm can vary neither the size of its factory nor the number of workers it employs.
13. Which of these assumptions is often realistic for a firm in the short run?
a.
author royalties of 5% per book
b.
the costs of paper and binding
c.
shipping and postage expenses
d.
composition, typesetting, and jacket design for the book
8. Which of the following costs of publishing a book is a fixed cost?
Questions 11 &43
THE COSTS OF PRODUCTION 56
a.
building the lemonade stand.
b.
hiring an artist to design a logo for her sign.
c.
lemons and sugar.
d.
All of the above are correct.
11. Suppose Jan started up a small lemonade stand business last month. Variable costs for Jan's lemonade stand now include the cost of
(i) change in total cost divided by change in quantity produced.
(ii) change in variable cost divided by change in quantity produced.
(iii) the average fixed cost of the current unit.
a. (i) and (ii) onlyb. (ii) and (iii) onlyc. (i) onlyd. (i), (ii), and (iii)
43. Marginal cost equals
Questions 139, 141 and 143
THE COSTS OF PRODUCTION 57
A
B
C
D
1 2 3 4 5 6 7 8 9 10 11 12 Quantity
1
2
3
4
5
6
7
8
9
10
11
Costa. marginal costb. average total costc. average variable costd. average fixed cost
139. Curve A represents which type of cost curve?
a. marginal costb. average total costc. average variable costd. average fixed cost
141.Curve C represents which type of cost curve?
a. marginal costb. average total costc. average variable costd. average fixed cost
143. Curve D represents which type of cost curve?
Questions 3 & 19
THE COSTS OF PRODUCTION 58
a. it cannot alter variable costs.
b. total cost and variable cost are usually the same.
c. average fixed cost rises as output increases.
d. it cannot adjust the quantity of fixed inputs.
3. When a factory is operating in the short run,
19. Economies of scale arise when
a. an economy is self-sufficient in production.
b. individuals in a society are self-sufficient.
c. fixed costs are large relative to variable costs.
d. workers are able to specialize in a particular task.
Questions 47, 49 & 50
THE COSTS OF PRODUCTION 59
a. time horizons.b. products.c. firms.d. factory sizes.
47. The three average total cost curves on the diagram labeled ATC1, ATC2, and
ATC3 most likely correspond to three
different
a. Q1 to Q2.b. Q2 to Q3.c. Q3 to Q4.d. Q4 to Q5.
49. The firm experiences diseconomies of scale if it changes its level of output from
a. Q1 to Q2.b. Q2 to Q4.c. Q1 to Q3.d. Q4 to Q5.
50. The firm experiences constant returns to scale if it changes its level of output from
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