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Chapter 6: Production and Costs

economic costs & profits

short run

long run

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big picture

understand behavior of firm

understand & measure

production costs

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I. economic costs & profits

firms goal:

maximize profit

look at factors that affect firmsdecision

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economic costs

opportunity cost of resources used

explicit costs

paid in money wages, rent, material, etc.

implicit costs

opportunity cost of resourcesused

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example: smoothie shop

explicit costs:

wages

interest on loan rent on store

fruit, blenders

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implicit costs

forgone interest on funds used tobuy capital

owners forgone wages

owners forgone profit from otherventure

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accounting profit

total revenue explicit costs

ignores opportunity cost

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economic profit

includes opp. costs

= total revenue - total costs

= (price)(quantity)- (explicit + implicit costs)

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normal profit

occurs when

amount of accounting profit

= opportunity costs of resources if earning a normal profit,

economic profit = 0

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Short Run vs. Long Run

Short Run (SR) time frame where some resources

are fixed

-- plants, equipment

some inputs variable

-- labor SR decisions are reversible

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Long Run (LR)

time frame where all inputs arevariable

--build a bigger plant

LR decisions are hard to reverse-- cannot easily get rid of capital

-- sunk cost

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II. SR Production

measures of output

total product

marginal product average product

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total product (TP)

total quantity of good produced

in a given period

at first, increases with labor,then falls

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TP: gal. of smoothies per hour

# workers TP

01

2345

67

01

3689

98

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TP

# workers5 6

9

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marginal product (MP)

change in TP due to one moreworker

=change in TP

change in labor

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At first MP rises with workers

add more workers

greater specialization

MP of each worker added is largerthan previous worker

increasing marginal returns

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then, MP falls with more workers

keep adding workers

but same amount of capital

so eventually get in the way MP of more workers smaller than

MP of previous workers

decreasing marginal returns

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TP, MP: gal. of smoothies

# workers TP

01

2345

67

01

3689

98

MP

1

2

3

-1

0

1

2

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MP

Q = # workers

0

3

3

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law of decreasing returns

As firm uses more labor

with capital fixed,

MP of labor will eventually fall

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Average Product (AP)

=TP

labor

= productivity

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# workers TP

0123

4567

0136

8998

MP

1

2

3

-1

0

12

AP

11.52

21.81.51.1

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MP

# workers

0

3

3

AP

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MP & AP

MP intersects AP at max of AP why?

MP > AP

AP is rising MP < AP

AP is falling

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III. SR cost

measure cost 3 ways:

total cost

marginal cost average cost

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Total Cost (TC)

cost of all factors used

total fixed cost (TFC)

cost of land, capital, etc.

does not change in SR

total variable cost (TVC)

cost of labor changes in SR

TC = TFC + TVC

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example : yogurt

labor = $6/ hour

TFC = $10/ hour

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workers TP TFC TVC TC

0 0 10 0 10

1 1 10 6 16

1.6 2 10 9.6 19.6

2 3 10 12 22

45

89

1010

2430

3440

TC

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Q = output

TC

TFC10

TC

TVC

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Marginal Cost

change in TC due to one-unitincrease in output (Q)

=change in TC

change in Q

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TP TFC TVC TC

0 10 0 10

1 10 6 16

2 10 9.6 19.6

3 10 12 22

89

1010

2430

3440

MC

63.6

2.4

6

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Average Cost (ATC)

= TC/Q

average fixed cost (AFC)

(TFC/Q) average variable cost (AVC)

(TVC/Q)

ATC = AFC + AVC

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TP TFC TVC TC

0 10 0 10

1 10 6 16

2 10 9.6 19.6

3 10 12 22

89

1010

2430

3440

AFC AVC AC

10 6 16

5 4.8 9.8

3.33 4 7.33

1.25 3 4.251.11 3.33 4.44

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Q = output

AC, MC

AFC

ATC

AVC

MC

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MC & AC

MC intersects AC at its minimum

MC < AC

AC is falling MC > AC

AC is rising

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AC is U-shaped

why?

AFC falls with Q

AVC falls then rises decreasing marginal returns

so ATC falls, then rises

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cost & product curves

when MP is at maximum,

MC is at minimum

when AP is at maximum,

AVC is at minimum

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what shifts cost curves?

technology

make more with same inputs

shifts TP, MP, AP up changes ATC curve

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changes in factor prices

increase fixed costs

-- TFC, AFC shift up

-- TC shift up

increase wages (variable)-- TVC, AVC, MC shift up

-- TC shift up

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IV. LR costs

all inputs (and costs) are variable

what happens if increase plant

AND labor by 10%? ATC fall?

ATC rise?

ATC stay same?

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Economies of scale

increase inputs 10% output increase > 10%

ATC falls

why?

gains from specialization

-- labor-- capital

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Diseconomies of scale

increase inputs 10% output increase < 10%

ATC rises

why?

too hard to control large firm

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Constant returns to scale

increase inputs 10% output increase = 10%

ATC stays same

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LR Average Cost (LRAC)

lowest average cost when all inputsare variable

SRAC curves from different plantsizes

AC

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Q = output

AC

ATC1 ATC2ATC3

ATC4

LRAC

AC

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Q = output

AC

ATC1 ATC2ATC3

ATC4

economiesof scale constantreturnstoscale

diseconomiesof scale

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summary:

costs = implicit + explicit

SR, only labor variable

LR, all inputs variable

Production & costs

total, marginal, average

fixed, variable