Review of the previous lecture

• The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve.

• When the price of a good falls, the impact on the consumer’s choices can be broken down into an income effect and a substitution effect.

• The income effect is the change in consumption that arises because a lower price makes the consumer better off.

• The income effect is reflected by the movement from a lower to a higher indifference curve.

Review of the previous lecture

• The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper.

• The substitution effect is reflected by a movement along an indifference curve to a point with a different slope.

• The theory of consumer choice can explain:– Why demand curves can potentially slope upward.– How wages affect labor supply.– How interest rates affect household saving.

Lecture 7

The Costs of Production- I

Instructor: Prof.Dr.Qaisar AbbasCourse code: ECO 400

Lecture Outline

1. What Are Costs?

2. Costs as Opportunity Costs

3. Production and Costs

Costs

•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.

Profit is the firm’s total revenue minus its total cost.Profit = Total revenue - Total costProfit = Total revenue - Total cost

Economic Profit versus Accounting Profit•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.

Costs•When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.•Economic profit is smaller than accounting profit.

Economic versus Accountants

Production and CostsThe Production Function

• The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.

•Production FunctionQ = F(K,L)

Q is quantity of output produced.K is capital input.L is labor input

• F is a functional form relating the inputs to output.• The maximum amount of output that can be produced with K units of

capital and L units of labor.

•Short-Run vs. Long-Run Decisions

•Fixed vs. Variable Inputs

Production and Costs

• Linear production function: inputs are perfect substitutes.

• Leontief production function: inputs are used in fixed proportions.

• Cobb-Douglas production function: inputs have a degree of substitutability.

bLaKLKFQ ,

cLbKLKFQ ,min,

baLKLKFQ ,

Productivity Measures: Total Product

• Total Product (TP): maximum output produced with given amounts of inputs.

• Example: Cobb-Douglas Production Function:

Q = F(K,L) = K.5 L.5

– K is fixed at 16 units.

– Short run Cobb-Douglass production function:

Q = (16).5 L.5 = 4 L.5

– Total Product when 100 units of labor are used?

Q = 4 (100).5 = 4(10) = 40 units

Productivity Measures: Average Product of an Input

• Average Product of an Input: measure of output produced per unit of input.

– Average Product of Labor: APL = Q/L.• Measures the output of an “average” worker.

• Example: Q = F(K,L) = K.5 L.5

– If the inputs are K = 16 and L = 16, then the average product of labor is APL = [(16) 0.5(16)0.5]/16 = 1.

– Average Product of Capital: APK = Q/K.• Measures the output of an “average” unit of capital.

• Example: Q = F(K,L) = K.5 L.5

– If the inputs are K = 16 and L = 16, then the average product of capital is APK = [(16)0.5(16)0.5]/16 = 1.

Productivity Measures: Marginal Product of an Input

• Marginal Product on an Input: change in total output attributable to the last unit of an input.

– Marginal Product of Labor: MPL = DQ/DL

• Measures the output produced by the last worker.

• Slope of the short-run production function (with respect to labor).

– Marginal Product of Capital: MPK = DQ/DK

• Measures the output produced by the last unit of capital.

• When capital is allowed to vary in the short run, MPK is the slope of the production function (with respect to capital).

Increasing, Diminishing and Negative Marginal Returns

Production and CostsFrom the Production Function to the Total-Cost Curve

•The relationship between the quantity a firm can produce and its costs determines pricing decisions.

•The total-cost curve shows this relationship graphically.

Production and Costs

A Production Function and Total Cost: Cookie factory

Production and Costs

Cookie factory Production Function Total-Cost Curve: Cookie factory

Summary

• The goal of firms is to maximize profit, which equals total revenue minus total cost.

• When analyzing a firm’s behavior, it is important to include all the opportunity costs of production.

• Some opportunity costs are explicit while other opportunity costs are implicit.

• A firm’s costs reflect its production process.

• Linear production function: inputs are perfect substitutes.

• Leontief production function: inputs are used in fixed proportions.

• Cobb-Douglas production function: inputs have a degree of substitutability.

Summary

• A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product.