17:25

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

firm’s goal:

maximize profit look at factors that affect firm’s decision

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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 resources used

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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 to buy capital owner’s forgone wages owner’s forgone profit from other venture

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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 are variable

--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

01234567

01368998

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TP

# workers5 6

9

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marginal product (MP)

change in TP due to one more worker

=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 larger

than 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

01234567

01368998

MP

1

2

3

-1

0

12

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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

01234567

01368998

MP

1

2

3

-1

0

12

AP

11.5221.81.51.1

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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 0 101 1 10 6 161.6 2 10 9.6 19.62 3 10 12 22

45

89

1010

2430

3440

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Q = output

TC

TFC10

TC

TVC

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Marginal Cost

change in TC due to one-unit increase in output (Q)

=change in TC

change in Q

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TP TFC TVC TC

0 10 0 101 10 6 162 10 9.6 19.63 10 12 22

89

1010

2430

3440

MC

63.62.4

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 0 101 10 6 162 10 9.6 19.63 10 12 22

89

1010

2430

3440

AFC AVC AC

10 6 165 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 inputs are variable

SRAC curves from different plant sizes

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Q = output

ACATC1 ATC2

ATC3ATC4

LRAC

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Q = output

ACATC1 ATC2

ATC3ATC4

economiesof scale

constantreturnsto scale

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