Topic 5Business and Costs of

Production

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

Types of CostThree 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 costOpportunity cost = Explicit cost + Implicit cost

•3

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

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

Wheeler Dealer Accounts, 2007

•6

Total revenue $105,000

Less explicit costs:Assistant’s salaryMaterial and equipment

- $21,000- $20,000

Equals accounting profit $64,000

Less implicit costs:Wanda’s forgone salaryForgone interest on savingsForgone 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

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

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

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

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: MPL = ∆TP / ∆L

Marginal product of capital: MPK = ∆TP / ∆K

•10

In Class Practice 1

Compute the MPL

•11

Units of thevariable resource

(labor or L)

TP(tons moved

per day)

MPL

(tons moved per day per labor hired)

012345678

02591214151514

In Class Practice 2

Compute the MPL

•12

Units of thevariable resource

(labor or L)

TP(tons moved

per day)

MPL

(tons moved per day per labor hired)

0135710152030

05193555100135160140

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 MPL or productivity of each additional worker will rise first (synthesis effect)

•13

Law of Diminishing Marginal Returns

However, after a while, the MPL

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

Marginal Returns

•15

Units of thevariable resource

(Labor or L)

TP(tons moved per day)

MPL

(tons moved per day)

Return

012345678

02591214151514

Marginal Returns

•16

Units of thevariable resource

(Labor or L)

TP(tons moved per day)

MPL

(tons moved per day)

Return

012345678

02591214151514

-2343210-1

------Increasing

““

Diminishing“““

Diminishing and Negative Diminishing Marginal Return kicks in at 4th unit labor

But total product keeps rising until 7th unit labor Total product is rising at a “decreasing rate” from 4th to 7th unit

Total product falls at the 8th unit of labor when MPL is negative

TP and MPL

•17

5

10

15

TP

5

7

Labor0

5 10

1

3

5

MPL

0

2

4

Total

product

Marginal product

Negative

marginal

returns

Diminishing but

positive

marginal returns

Increasing

marginal

returns

107

Labor

Total Product (TP)5 labors produce 500 unit does not

mean that each worker produce 100 unitAlthough 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

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 3rd worker’s contribution to the production process

Actually, 3rd worker’s contribution is different for different series. We can see it in the associated MP table

•19

Labor (L) TP1 TP2 TP3 TP4

0 0 0 0 01 100 50 100 1502 200 120 220 2803 300 220 330 3804 400 350 430 4505 500 500 500 500

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) TP1 MP1 TP2 MP2 TP3 MP3 TP4 MP4

0 0 - 0 0 01 100 100 50 100 1502 200 100 120 220 2803 300 100 220 330 3804 400 100 350 430 4505 500 100 500 500 500

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) TP1 MP1 TP2 MP2 TP3 MP3 TP4 MP4

0 0 - 0 - 0 - 0 -

1 100 100 50 50 100 100 150 150

2 200 100 120 70 220 120 280 130

3 300 100 220 100 330 130 380 100

4 400 100 350 130 430 100 450 70

5 500 100 500 150 500 70 500 50

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

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 orTotal Product

(TP or Q)

TC($)

MC($)

Marginal Cost

012345678

010182535476282107

- ------

Falling, MPL rising“

Rising (MPL falling)““““

MC and MPL

MC and MPL are related

Increasing marginal product (MPL) Implies that MC must be falling

Diminishing marginal product (MPL) Implies MC must be rising

•24

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)

MPL Fixed cost(FC)

Variable cost(VC)

Total Cost(TC)

TC=FC+VC

Marginal Cost(MC)

MC=∆TC/∆q

0259

121415

0123456

-234321

$200 300 400 500 600 700 800

-

For first 3 labors, Increasing marginal returns (MPL rises): MC falls

With the 4th labor, Diminishing marginal returns hits (MPL rises): MC rises

In Class Practice 4

•26

Total Product or

Output(TP or Q)

Workers per day

(L)

MPL Fixed cost(FC)

Variable cost(VC)

Total Cost(TC)

TC=FC+VC

Marginal Cost(MC)

MC=∆TC/∆q

0259

121415

0123456

-234321

$200 200 200 200 200 200 200

$0100200300400500600

$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 (MPL rises): Therefore, MC is fallingStarting with the 4th labor, Diminishing marginal returns kicks in (MPL rises): Therefore, MC is rising

Total Cost (TC) Total Cost (TC) simply means total

expenditure on inputs usedTotal 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 3rd unit of output •27

Shapes of TC and MC Curves

•28

200

$500

Total dollars

25

Cost per ton

$50Marginal cost

9 15

Tons per day0

63 12

Fixed cost

Total cost

Tons per day

0 9 1563 12

Variable costFixed 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 rateDiminishing marginal returns

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+VC

Marginal Cost(MC) =

∆TC∆Q

Average Total Cost(ATC) =

TCQ

0 0 200 - -

2

5

8

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) =

TCQ

0 200 0 200 - -

2 200 100 300 50.00

5 200 200 400 33.33

9 200 300 500 25.00

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+VC

Marginal Cost(MC) =

∆TC∆Q

Average Total Cost(ATC) =

TCQ

0 200 0 200 - -

2 200 100 300 50.00 300/2 = 150

5 200 200 400 33.33 400/5 = 80

9 200 300 500 25.00 500/9 = 55.55

Average Cost (AC)

Important question is what do MC and ATC really mean?

MC=$33.33 simply means that the 5th 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+VC

Marginal Cost(MC) =

∆TC∆Q

Average Total Cost(ATC) =

TCQ

0 200 0 200 - -

2 200 100 300 50.00 300/2 = 150

5 200 200 400 33.33 400/5 = 80

9 200 300 500 25.00 500/9 = 55.55

Average Cost (AC)We know, AC= Cost/QuantityThere 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

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

FC, VC, TC, AFC, AVC and ATC

• Short run TC, MC, and AC data for Smoother Mover

•35

TotalOutput

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

0235

101214

$0100200350430550580

200

Note, ATC = AFC + AVC

FC, VC, TC, AFC, AVC and ATC

• Short run TC, MC, and AC data for Smoother Mover

•36

TotalOutput

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

0259

121415

$0100200300400500600

$200300400500600700800

-100.00 40.00 22.22 16.67 14.29 13.33

-$50.0040.0033.3333.3335.7140.00

∞$150.00

80.0055.5550.0050.0053.33

Note, ATC = AFC + AVC

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

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

MC and ATC

• Short run TC, MC, and AC data for Smoother Mover

•39

TotalOutputOr

Product(Q)

Fixed Cost

(FC)

Variable Cost

(VC)

Total Cost

TC=FC+VC

Marginal cost

MC=∆TC/∆Q

Average Total Cost

ATC=TC/Q

0259121415

$200200200200200200200

$0100200300400500600

$200300400500600700800

-$50.00 33.33 25.00 33.33 50.55 100.00

∞$150.0080.0055.5550.0050.0053.33

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

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 (MPL) and increases the Total Cost

Therefore, ATC is of U-shape

•40

Shape of ATC and AVC

•41

0 5 10 15 Q

$150

125

100

75

50

25

Cost ($)

ATC

AVC

ATC, AVC and MC

•42

0 5 10 15 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.

Costs in the Long RunDefinition: It is a time period in which all resources or inputs can be variedLong is often considered as a Planning HorizonBecause, Firms plan in the long runBut, produce in the short runLong run is generated by aggregating many possible short run cost curves

•43

LRATC curve from SRATC

•44

Cost per unit

0 qa q’ Q per periodqb

S

S’

M M’

L

L’

Consider three short run ATC curve:

SS’, MM’ and LL’

Long run ATC curve:

SabL’

a b

ATC1

ATC2

LRAC is an Envelop of SRAC

• curve

•45

0 q q’ 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

Cos

t pe

r un

it

$11

10

9

b

ATC3

ATC4

ATC5

ATC6

ATC7

ATC8

ATC9

ATC10Long-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

Costs in the Long RunU-shaped long-run average cost curve has three components that represent:Economies of scale (Increasing Returns to Scale)

LRAC falls as output expandsDiseconomies of scale (Increasing Returns to Scale)

LRAC increases as output expandsConstant Returns to Scale

LRAC is constant or horizintal

•46

Economies of Scale in Long Run

•47

Cos

t pe

r un

it

0 A Output per periodB

Economies

of scale

Long-run

average cost

Diseconomies

of scale

Constant

average cost