chapter 20: production and costs economic costs & profits short run long run economic costs...

Chapter 20: Production and CostsChapter 20: Production and CostsChapter 20: Production and CostsChapter 20: Production and Costs

• economic costs & profits

• short run

• long run

• economic costs & profits

• short run

• long run

big picturebig picturebig picturebig picture

• understand behavior of firm

• understand & measure production costs

• understand behavior of firm

• understand & measure production costs

I. economic costs & profitsI. economic costs & profitsI. economic costs & profitsI. economic costs & profits

• firm’s goal:

maximize profit

• look at factors that affect firm’s decision

• firm’s goal:

maximize profit

• look at factors that affect firm’s decision

economic costseconomic costseconomic costseconomic costs

• opportunity cost of resources used

• explicit costs paid in money wages, rent, material, etc.

• implicit costs opportunity cost of resources used

• opportunity cost of resources used

• explicit costs paid in money wages, rent, material, etc.

• implicit costs opportunity cost of resources used

example: smoothie shopexample: smoothie shopexample: smoothie shopexample: smoothie shop

• explicit costs: wages interest on loan rent on store fruit, blenders

• explicit costs: wages interest on loan rent on store fruit, blenders

• implicit costs forgone interest on funds used to

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

venture

• implicit costs forgone interest on funds used to

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

venture

accounting profitaccounting profitaccounting profitaccounting profit

• total revenue – explicit costs

• ignores opportunity cost• total revenue – explicit costs

• ignores opportunity cost

economic profiteconomic profiteconomic profiteconomic profit

• includes opp. costs

= total revenue - total costs

= (price)(quantity)

- (explicit + implicit costs)

• includes opp. costs

= total revenue - total costs

= (price)(quantity)

- (explicit + implicit costs)

normal profitnormal profitnormal profitnormal profit

• occurs when

• amount of accounting profit

= opportunity costs of resources

• if earning a normal profit, economic profit = 0

• occurs when

• amount of accounting profit

= opportunity costs of resources

• if earning a normal profit, economic profit = 0

Short Run vs. Long RunShort Run vs. Long RunShort Run vs. Long RunShort Run vs. Long Run

• Short Run (SR) time frame where some resources

are fixed

-- plants, equipment some inputs variable

-- labor SR decisions are reversible

• Short Run (SR) time frame where some resources

are fixed

-- plants, equipment some inputs variable

-- labor SR decisions are reversible

• 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

• 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

II. SR ProductionII. SR ProductionII. SR ProductionII. SR Production

• measures of output total product marginal product average product

• measures of output total product marginal product average product

total product (TP)total product (TP)total product (TP)total product (TP)

• total quantity of good produced

in a given period

• at first, increases with labor,

then falls

• total quantity of good produced

in a given period

• at first, increases with labor,

then falls

TP: gal. of smoothies per hourTP: gal. of smoothies per hourTP: gal. of smoothies per hourTP: gal. of smoothies per hour

# workers TP

01234567

01368998

TP

# workers5 6

9

marginal product (MP)marginal product (MP)marginal product (MP)marginal product (MP)

• change in TP due to one more worker

• change in TP due to one more worker

=change in TP

change in labor

At first MP rises with workersAt first MP rises with workersAt first MP rises with workersAt first MP rises with workers

• add more workers

• greater specialization

• MP of each worker added is larger

than previous worker

• increasing marginal returns

• add more workers

• greater specialization

• MP of each worker added is larger

than previous worker

• increasing marginal returns

then, MP falls with more workersthen, MP falls with more workersthen, MP falls with more workersthen, 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

• 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

TP, MP: gal. of smoothiesTP, MP: gal. of smoothiesTP, MP: gal. of smoothiesTP, MP: gal. of smoothies

# workers TP

01234567

01368998

MP

1

2

3

-1

0

12

MP

Q = # workers

0

3

3

law of decreasing returnslaw of decreasing returnslaw of decreasing returnslaw of decreasing returns

• As firm uses more labor with capital fixed, MP of labor will eventually fall

• As firm uses more labor with capital fixed, MP of labor will eventually fall

Average Product (AP)Average Product (AP)Average Product (AP)Average Product (AP)

=TP

labor

= productivity

# workers TP

01234567

01368998

MP

1

2

3

-1

0

12

AP

11.5221.81.51.1

MP

# workers

0

3

3

AP

MP & APMP & APMP & APMP & AP

• MP intersects AP at max of AP

• why?

• MP > AP AP is rising

• MP < AP AP is falling

• MP intersects AP at max of AP

• why?

• MP > AP AP is rising

• MP < AP AP is falling

III. SR costIII. SR costIII. SR costIII. SR cost

• measure cost 3 ways: total cost marginal cost average cost

• measure cost 3 ways: total cost marginal cost average cost

Total Cost (TC)Total Cost (TC)Total Cost (TC)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

• 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

example : yogurtexample : yogurtexample : yogurtexample : yogurt

• labor = $6/ hour

• TFC = $10/ hour• labor = $6/ hour

• TFC = $10/ hour

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

Q = output

TC

TFC10

TC

TVC

Marginal CostMarginal CostMarginal CostMarginal Cost

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

increase in output (Q)

=change in TC

change in Q

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

Average Cost (ATC)Average Cost (ATC)Average Cost (ATC)Average Cost (ATC)

• = TC/Q

• average fixed cost (AFC) (TFC/Q)

• average variable cost (AVC) (TVC/Q)

• ATC = AFC + AVC

• = TC/Q

• average fixed cost (AFC) (TFC/Q)

• average variable cost (AVC) (TVC/Q)

• ATC = AFC + AVC

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

Q = output

AC, MC

AFC

ATC

AVC

MC

MC & ACMC & ACMC & ACMC & AC

• MC intersects AC at its minimum

• MC < AC AC is falling

• MC > AC AC is rising

• MC intersects AC at its minimum

• MC < AC AC is falling

• MC > AC AC is rising

AC is U-shapedAC is U-shapedAC is U-shapedAC is U-shaped

• why?

• AFC falls with Q

• AVC falls then rises decreasing marginal returns

• so ATC falls, then rises

• why?

• AFC falls with Q

• AVC falls then rises decreasing marginal returns

• so ATC falls, then rises

cost & product curvescost & product curvescost & product curvescost & product curves

• when MP is at maximum,

MC is at minimum

• when AP is at maximum,

AVC is at minimum

• when MP is at maximum,

MC is at minimum

• when AP is at maximum,

AVC is at minimum

what shifts cost curves?what shifts cost curves?what shifts cost curves?what shifts cost curves?

• technology make more with same inputs shifts TP, MP, AP up changes ATC curve

• technology make more with same inputs shifts TP, MP, AP up changes ATC curve

• 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

• 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

IV. LR costsIV. LR costsIV. LR costsIV. LR costs

• all inputs (and costs) are variable

• what happens if increase plant

AND labor by 10%? ATC fall? ATC rise? ATC stay same?

• all inputs (and costs) are variable

• what happens if increase plant

AND labor by 10%? ATC fall? ATC rise? ATC stay same?

Economies of scaleEconomies of scaleEconomies of scaleEconomies of scale

• increase inputs 10% output increase > 10% ATC falls

• why? gains from specialization

-- labor

-- capital

• increase inputs 10% output increase > 10% ATC falls

• why? gains from specialization

-- labor

-- capital

Diseconomies of scaleDiseconomies of scaleDiseconomies of scaleDiseconomies of scale

• increase inputs 10% output increase < 10% ATC rises

• why? too hard to control large firm

• increase inputs 10% output increase < 10% ATC rises

• why? too hard to control large firm

Constant returns to scaleConstant returns to scaleConstant returns to scaleConstant returns to scale

• increase inputs 10% output increase = 10% ATC stays same

• increase inputs 10% output increase = 10% ATC stays same

LR Average Cost (LRAC)LR Average Cost (LRAC)LR Average Cost (LRAC)LR Average Cost (LRAC)

• lowest average cost when all inputs are variable

• SRAC curves from different plant sizes

• lowest average cost when all inputs are variable

• SRAC curves from different plant sizes

Q = output

ACATC1 ATC2

ATC3ATC4

LRAC

Q = output

ACATC1 ATC2

ATC3ATC4

economiesof scale

constantreturnsto scale

diseconomiesof scale

summary:summary:summary:summary:

• costs = implicit + explicit

• SR, only labor variable

• LR, all inputs variable

• Production & costs total, marginal, average fixed, variable

• costs = implicit + explicit

• SR, only labor variable

• LR, all inputs variable

• Production & costs total, marginal, average fixed, variable