Unit III: The Costs of Production

& Theory of the Firm

Chapters 13-17

The Production Function

Production Function

• Relationship between quantity of inputs used to make a good and the quantity of output of that good.

Remember…rationale thinkers (Econville Residents) think marginally!!

Marginal = 1 additional unit

Go from… To….

Let’s make……

Reflect

• With how many workers did it seem easiest to make cards? Why?

• With how many workers did it seem hardest to make cards? Why?

Increasing Marginal Returns

• An increase in output per worker

• Short run

Diminishing Marginal Returns

• A decrease in output per worker

• Long Run

Diminishing Marginal Returns• Why does this happen in the workplace? Isn’t

more workers better for production?

Is there a graph for that?

Production Function

0102030405060708090100110120130140150160

0 1 2 3 4 5 6 7Number of Workers Hired

Quantity of output

The Costs of Production

Pick a card…any card…

How much do you think that would cost to begin that business?

• List all the expenditures you would need to make your product

• Estimate how much money you believe all of these expenditures will cost (ask me for help if needed)

• Add all of your expenditures and that is your total cost!

Did you forget these….

Could cost up to millions of dollars!!!

The Costs of Production

• Everything that is given up (usually money) when producing a product–Explicit and Implicit Costs–Fixed vs. Variable Costs• Fixed costs are constant•Variable costs change with each

additional unit of production

Mortgage for a toy factory Screws for toys

Fixed Cost Variable Cost

Firm’s Main Objective?

• To maximize profits!

Revenue is NOT profit!• 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 their total cost

Firms want to maximize profit!

Profit Example• Lets say you make a homemade pizza that you

are selling for $30. Here are your costs below:– $10 for dough– $11 for toppings– $ 4 for sauce– $20 you could have made mowing your neighbors

lawn – $1 for borrowing your mom’s pizza cutter

$30 - $46 = -$16

Economic Profit vs Accounting Profit

• Economic profit– total revenue minus total cost, including both

explicit and implicit costs.

• Accounting profit – total revenue minus only the firm’s explicit costs.

Economists, or rationale thinkers, usually base profit on economic profit

This kid is NOT a rational thinker

Profit Example• Lets say you make a homemade pizza that you

are selling for $30. Here are your costs below:– $10 for dough (explicit)– $11 for toppings (explicit)– $ 4 for sauce (explicit)– $20 you could have made mowing your neighbors

lawn (implicit)– $1 for borrowing your mom’s pizza cutter

(explicit)$30 - $46 = -$16 $30 - $26 = $4

Economic Profit Accounting Profit

AFC, AVC, ATC, and MC Curves

The MOTHER of cost graphs!

Average Fixed Cost Fixed costs ÷ Quantity of output

Average Variable Cost Variable costs ÷ Quantity of output

Average Total Cost Total cost ÷ Quantity of output

Marginal CostThe increase in total cost that arises when one additional unit is produced

Marginal Cost

Costs our firm $100 to make 1 tablet

If we wanted to make two tablets, it would costs our firm $110 because of the

extra parts needed for the additional tablet (VC)

So, the marginal cost of producing the 2nd tablet is $10

Figuring Them Out...

• Before we graph these curves, lets practice figuring out each cost.– Problem Set 4.2

• Now, lets graph them…

Average Fixed Cost

• What shape is it?– Curve decreases

• Why do you think it is shaped that way?– Fixed costs are constant, so as a firm produces

more quantity, their average fixed costs will decrease.

Average Variable Cost

• What shape is it?– Curve first decreases, then increases– A subtle “U” shape

• Why do you think it is shaped this way?– Show increasing marginal returns (short run) followed

by diminishing marginal returns (long run)

Average Total Cost• What shape is it?– Curve first decrease, then increases

• What relationships does it have with AFC and AVC?– It must always be greater than AFC and AVC• ATC = AFC + AVC

– AFC is equal to the difference between ATC and AVC

Marginal Cost

• What shape is it?– Curve decreases, then increases– Shows increasing/diminishing marginal returns

• When do you think diminishing marginal returns sets in?– When the curve increases (costs increase)

• What relationship does MC have with the ATC and AVC curves?– It intersects them at their lowest points.

Why?

To help you better understand, let’s think of people in a room and height…• If the next person who enters the room is

taller than the previous average, the average will rise

• If the next person who enters the room is shorter than the pervious average, the average will fall

• If the next person who enters the room is exactly the same than the previous average, the average will stay the same.

Same applies with marginal and average costs!

• If MC is less than the previous average cost, the averages fall

• If MC is greater than the previous average cost, the averages rise

• If MC is exactly the same as the previous average costs, the averages stay the same

•Intersects at ATC and AVC at their lowest points•To the left of the intersection is increasing marginal returns •To the right is decreasing marginal returns

Short Run vs. Long Run Costs and Economies of Scale

What is the difference?

• Short run cost decision– There is at least one fixed cost and one variable

cost

• Long run cost decision– ALL costs are variable

Let me help you understand this…

Suppose you are a business owner and you have a factory and wage workers

You have at least one fixed cost: the factory

You have at least one variable cost: the worker

You are currently in the short run

Suppose that your factory is only operating at 75% capacity.

Factory Floor Space

Suppose that your factory is only operating at 75% capacity.

You have at least one fixed cost, the factory, plus at least one variable cost, the workers.

This is the short run

Demand for your product increases, so you decide to hire more workers.

Did the size of the factory change? No.Did the amount of wage workers change? Yes.

So this is a short run cost. There is at least one fixed cost (factory) and one variable cost (workers)

Your factory is now at full capacity and demand for your product is still increasing. So, you either expand your current factory or build a new one.

Once you decide to expand your factory or build a new one, your fix costs changes. Therefore, it’s no longer a fixed cost but a variable cost.

Did the size of your factor change? Yes.

Does this change the fixed cost of the factory? Yes.

When fixed cost changes, this is a long run decision

REVIEW: Short Run or Long Run Cost?

• Portillo’s is doing excellent business in Naperville and is thinking of building a new Portillo’s in Plainfield– Long Run

• Harvard is planning to hire more professors– Short Run

• People catch on that Jersey’s Subs is overrated so the store in Plainfield may shut down– Long Run

What does this say about long run costs for all firms?

Any questions?

Best explanation

• http://www.reffonomics.com/textbook2/microeconomics2/swiftfile/costofdoingbusiness/longrunatccurve1.swf