costs of production (ch 8)
TRANSCRIPT
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Cost of Production Short and Long Run
Chapter 8 and Week 7
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Costs
Why do we care about them so much?Costs determine:
Firm supply function
Structure of industry (competitive,monopoly,)
Profits
Costs are determined by: Production technology
Price of inputs
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Copyright 2012 John Wiley & Sons, Inc. 3
Learning Objectives
Delineate the nature of a firms cost explicit as wellas implicitOpportunity Cost.
Outline how cost is likely to vary with output in theshort run and various measures of short-run cost.
Detail the typical shapes of a firms short-run costcurves.
See how a firm will choose to combine inputs in itsproduction process in the long run when all inputs
are variable. Show how input price changes affect a firms cost
curves.(continued)
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Copyright 2012John Wiley & Sons, Inc. 4
Learning Objectives (continued)
Differentiate between a firms long-run and short-run cost curves.
Understand how the minimum efficient scale ofproduction is related to market structure.
Quick note on how cost functions can beempirically estimated through surveys andregression analysis.
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Opportunity Cost
Opportunity cost: the cost of something is whatyou have to give up to get it.
Value of the highest forsaken alternative
What is the opportunity cost of
Coming to class?
Going to university? Male vs. Female ? (Groups)
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Question
Connor is sitting at home studying microeconomicson Friday night. He says:
- If Id worked tonight, Id have made $100
- If I
d stayed at home and played on-line poker, I
dhave made $150.
- He concludes the opportunity cost of sitting athome studying is $100+$150 or $250.
Has he studied enough, or should he studysome more?
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Official Slogan for O.C.
Copyright 2012 John Wiley & Sons, Inc. 7
There is no such thing as a free lunch!
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8
The Profits of a Firm
Accounting Profits
Total Revenues Total Costs*
* Explicit costs
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Costs & the Profits of a Firm
Explicit Costs Expenses that business managers must take
account of because they must actually be paid outby the firm, e.g. purchase inputs from other parties,
wages paid to employees,
Implicit Costs
Expenses that business managers do not have topay out of pocket, e.g., cost of using own resourcesvs could have been used elsewhere.
Opportunity Cost
Reflects both explicit and implicit costs
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Economic Profit and OptimalDecision Making
Economic Profit
The difference between total revenues and
the opportunity cost of all factors ofproduction.
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Copyright 2012 Pearson Canada Inc.,Toronto, Ontario 11
The Profits of a Firm
Accounting Profits Versus Economic Profits
or
Economic profits = total revenues (explicit+implicit costs)
Economic profits = total revenues total opportunity cost of all inputs used
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Copyright 2012 Pearson Canada Inc.,Toronto, Ontario 12
The Profits of a Firm
Total revenues(gross sales)
Economiccosts =
accounting
costs+normal rateof return oninvestment(opportunity
cost of capital)
+all otherimplicitcosts
Total revenues(gross sales)
Accounting
costs
Normal rate ofreturn on
investment=
opportunity costof capital +
any otherimplicit costs
Economic profit
Accountingprofit
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Some Terminology
Sunk costs*: Once incurred, cannot berecovered.
Avoidable costs: Need not be incurred
Example: After getting 25% on your firsttest, you decide to drop ECON 2001.Which costs are sunk? Partiallyavoidable?
* unavoidable
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Ignore sunk costs.
Economic Decision Making
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More terminology
Fixed costs. Unavoidable. Have to beincurred regardless of level of outputproduced, e.g. safety testing for new
pharmaceuticals, rent paid per month
Variable costs. Avoidable. Only have toincur if you actually produce output, e.g.,
labour, raw materials
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Short-Run Cost
To produce more output in the short run, thefirm must employ more labour, which meansthat it must increase its costs.
We describe the way a firms costs changeas total product changes by using three costconcepts and three types of cost curve:
Total cost Marginal cost
Average cost
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Total Cost
A firms total cost(TC) is the cost of allresourcesused.
Total fixed cost(TFC) is the cost of the firm
s fixedinputs. Fixed costs do not change with output.
Total variable cost(TVC) is the cost of the firmsvariable inputs. Variable costs do change with output.
TC= TFC+ TVC
Short-Run Cost
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Total fixed cost is the sameat each output level.
Total variable costincreases as outputincreases.
Total cost, which is the sumof TFCand TVCalsoincreases as outputincreases.
Short-Run Cost
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Behind Cost Relationships
A firms costs are determined by itsproduction function: Input combinations (quantities)
Input prices
The shape of the TVC curve is determined bythe shape of the TP curve, which in turn
reflects diminishing marginal returns.
Copyright 2012 John Wiley & Sons, Inc. 20
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The TVC curve getsits shape from the TP
curve.
Notice that the TPcurvebecomes steeper at low outputlevels and then less steep athigh output levels.
In contrast, the TVCcurvebecomes less steep at lowoutput levels and steeper athigh output levels.
Short-Run Cost
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To see therelationship betweenthe TVCcurve andthe TPcurve, lets look
again at the TPcurve.
But let us add a second x-axisto measure total variable cost.
1 worker costs $25; 2 workers cost
$50: and so on, so the two x-axesline up.
Short-Run Cost
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We can replace thequantity of labour onthe x-axis with totalvariable cost.
When we do that, we mustchange the name of the curve. Itis now the TVCcurve.
But it is graphed with cost onthe x-axis and output on the y-
axis.
Short-Run Cost
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Marginal Cost
Marginal cost(MC) is the increase in total cost thatresults from a one-unit increase in total product.
Over the output range with increasing marginalreturns, marginal cost falls as output increases.
Over the output range with diminishing marginalreturns, marginal cost rises as output increases.
Short-Run Cost
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Average Cost
Average cost measures can be derived from each ofthe total cost measures:
Average fixed cost(AFC) is total fixed cost per unitof output.
Average variable cost(AVC) is total variable costper unit of output.
Average total cost(ATC) is total cost per unit ofoutput.
ATC = AFC + AVC
Short-Run Cost
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The AFCcurve shows thataverage fixed cost falls asoutput increases.
The AVCcurve is U-shaped. As
output increases, average variablecost falls to a minimum and thenincreases.
Short-Run Cost
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The ATCcurve isalso U-shaped.
The MCcurve is very special.
The outputs over which AVCisfalling, MCis below AVC.
The outputs over which AVCisrising, MCis above AVC.
The output at which AVC is attheminimum, MCequals AVC.
Short-Run Cost
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Similarly, the outputs overwhich ATCis falling, MCis
below ATC.The outputs over whichATCis rising, MCis aboveATC.
At the minimum ATC, MCequals ATC.
Short-Run Cost
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Product & CostRelationship
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Copyright 2012 John Wiley & Sons, Inc. 36
Table 8.1
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Copyright 2012 John Wiley & Sons, Inc. 37
Figure 8.2 - Short-Run Total and Per-UnitCost Curves
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Shifts in Cost Curves
The position of a firms cost curves dependon two factors:
- Technology
- Prices of factors of production
Short-Run Cost
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Technology Technological change influences both the productivity
curves and the cost curves.
An increase in productivity shifts the AP and MPcurves upward and the ATC and MC curvesdownward.
If a technological advance brings more capital andless labour into use, fixed costs increase and variable
costs decrease. In this case, ATC increases at low output levels and
decreases at high output levels.
Short-Run Cost
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Prices of Factors of Production
An increase in the price of a factor of productionincreases costs and shifts the cost curves.
An increase in a fixedcost shifts the total cost (TC)and average total cost (ATC) curves upward butdoes notshift the marginal cost (MC) curve.
An increase in a variablecost shifts the total cost
(TC), average total cost (ATC), and marginal cost(MC) curves upward.
Short-Run Cost
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Group Problem
Copyright 2012 John Wiley & Sons, Inc. 41
No Pain No Gain Inc is a dental practice advocating a naturalapproach to dentistryspecializing in root canal operations noNovocain! If output is measured as # of root canals performed on a dailybasis, define the following measures of their SR cost: TFC, TVC, TC,MC, AFC, AVC & ATC., then fill in the spaces in the table below:
Output TFC TVC TC MC AFC AVC ATC
1 $100 $50
2 $30
3 $40
4 $270
5 $70
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Answer
Copyright 2012 John Wiley & Sons, Inc. 42
TFC is total fixed cost which consists of the costs incurred by thefirm that do not depend on how much output it produces.
TVC is total variable cost and consists of the costs incurred by thefirm that depend on how much output it produces.
TC (Total Cost) = TFC + TVC
MC (Marginal Cost) = the change in total cost that results from aone-unit change in output
AFC (Average Fixed Cost) = TFC/output.;AVC(Average Variable Cost) = TVC/output;ATC (Average Total Cost) = TC/output.ATC= AFC + AFC
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Answer Contd
Copyright 2012 John Wiley & Sons, Inc. 43
Output TFC TVC TC MC AFC AVC ATC
1 $100 $50 $150 $50 $100 $50 $150
2 $100 $80 $180 $30 $50 $40 $90
3 $100 $120 $220 $40 $33.3 $40 $73.3
4 $100 $170 $270 $50 $25 $42.5 $67.5
5 $100 $250 $350 $80 $20 $50 $70
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http://www.youtube.com/watch?v=S3iLMfm6CGY&feature=related
Cost Curves in 60 seconds!
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Copyright 2012 John Wiley & Sons, Inc. 45
Isocost LineLong Run
An isocost line is a line that identifies all thecombinations of capital and labor, two factorinputs, that can be purchased at a given totalcost.
The line intersects each axis at the quantityof that input that the firm could purchase ifonly that input were purchased.
Slope = - w (w = wage; r = rent)
r
Fi 8 4 I t Li d
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Copyright 2012 John Wiley & Sons, Inc. 46
Figure 8.4 - Isocost Lines andthe Long-Run Expansion Path
MRTS = - wr
The expansion path is a curve formed by connecting the points of tangency between isocost lines and the highestrespective attainable isoquants.
- wr
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Copyright 2012 John Wiley & Sons, Inc. 47
Least Costly Input Combination
A point of tangency between an isocostline and an isoquant show the leastcostly way of producing a given output
level. Alternatively, a point of tangency shows
the maximum output attainable at a
given cost as well as the minimum costnecessary to produce that output.
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Copyright 2012 John Wiley & Sons, Inc. 48
Interpreting the Tangency Points
Golden rule of cost minimization: Tominimize cost, the firm should employ inputsin such a way that the MP per dollar spentis equal across all inputs.
Pts A, B, C all symbolized by (5), (6), and (7).
If the firm is not prod cing at a
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Copyright 2012 John Wiley & Sons, Inc. 49
If the firm is not producing at atangency point
Whenever MPL/w > MPK/r, a firmcan increase output withoutincreasing production cost by
shifting outlays from capital to labor. Whenever MPL/w < MPK/r, a firm
can increase output without
increasing production cost byshifting outlays from labor to capital.
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Moneyball
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http://www.youtube.com/watch?v=AiAHlZVgXjk
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Copyright 2012 John Wiley & Sons, Inc. 51
Is Production Cost Minimized?
Cost minimization is a necessary conditionfor but not the same as profitmaximization
Cost minimization occurs at all points on theexpansion path, but profit maximization
involves selecting the most profitable outputfrom among those on the expansion path.
T bl 8 2 Th P d ti it G i
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Copyright 2012 John Wiley & Sons, Inc. 52
Table 8.2 The Productivity Gainsfrom Privatization
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Long-Run Cost Curves
LTC shows the minimum cost at which each rate ofoutput may be produced,just as the expansion pathdoes.
LMC and LAC are derived from the LTC in the sameway that the short-run marginal and average curvesare derived from the short-run total cost curve.
LAC is U-shapedwhy? Economies of scale
Diseconomies of scale
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Figure 8.6 - Long-Run Cost Curves
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Economies of Scale and
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Copyright 2012 John Wiley & Sons, Inc. 55
Economies of Scale andDiseconomies of Scale
Economies of scale a situation in which afirm can increase its output more thanproportionally to its total input cost
Reflects increasing returns to scale
Diseconomies of scale a situation inwhich a firms output increases less than
proportionally to its total input cost Reflects decreasing returns to scale
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The Long Run and Short Run Revisited
Long-run average cost curve (LAC): thelowest average cost attainable when allinputs are variable.
Each point on the LAC is associated with adifferent short-run scale of operation thatthe firm could choose.
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Copyright 2012 Pearson Canada Inc.,
Toronto, Ontario 57
Long Run Cost Curves
Output per Time Period
AverageCost(dollarsp
erunitofoutput)
Output per Time Period
A
verageCost(dollarsperunitofoutpu
t)
SAC1
SAC2
Q1
C2
C1
C3
C4
Q2
SAC3
Build plant 1 ifexpected output
at Q1.
Build plant 2 ifexpected output
at Q2.
SAC1
SAC2
SAC3SAC4
SAC5SAC6
SAC7SAC8
LAC
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Long Run Cost Curves
Long-Run Average Cost Curve
Differ among firms and industries.
The locus of points representing theminimum unit cost of producing any givenrate of output, given current technology andresource prices.
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Long Run Cost Curves
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Output per Year
Long-RunAverageCosts
(dollarspe
runit)
LAC
Economies of scale are features of afirms technology that lead to fallinglong-run average cost as outputincreasese.g. specialization,
innovation,
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Long Run Cost Curves
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Output per Year
Long-RunAverageCosts
(dollarsperunit)
LAC
Constant returns to scale arefeatures of a firms technology thatlead to constant long-run average costas output increases.
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Long Run Cost Curves
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Output per
Long-RunAverageCosts
(dollarspe
runit)
LAC
Diseconomies of scale are features of afirms technology that lead to rising long-run
average cost as output increases
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Copyright 2012 Pearson Canada Inc.,
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Long Run Cost Curves
Reasons for Diseconomies of Scale
Limits to the efficient functioning of
management. A more than proportionate increase in
managers and staff people may be neededas plant size grows, because of increasing
costs of information and communication.
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Copyright 2012 Pearson Canada Inc.,
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Long Run Cost Curves
Output per Time Period
Long-RunAverageCosts
(dollarspe
ryear)
0 10 1,000
A B
Point A is the minimum efficientscale because it is the point at whichthe output reaches minimum costs.
Importance of Cost Curves to Market
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Importance of Cost Curves to MarketStructure
Minimum efficient scale the scale ofoperations at which average cost per unitreaches a minimum
Impact on industry structure Number of firms
Proportion of industry output by each firm
Degree of competition
Copyright 2012 John Wiley & Sons, Inc. 64
Figure 8 3 Minimum Efficient Plant
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Figure 8.3 Minimum Efficient PlantScales
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Group Problem
Copyright 2012 John Wiley & Sons, Inc. 66
In the U.S., more than 50 firms produce textiles, but only3 produce automobiles. This statistic shows that theGovernment anti-monopoly policy has been applied moreharshly to the textile industry than to the automobile industry.
Can you give an alternative explanation for the differencein the number of firms in the 2 industries?
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Answer
Copyright 2012 John Wiley & Sons, Inc. 67
The minimum efficient scale is much larger for the
automobile industry than it is for textiles, so there is not
room for many car companies while a larger number of
textile companies can exist in the same market.
L i b D i
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Learning by Doing
Learning by doing is associated with improvements inproductivity resulting from a firms cumulative outputexperience
Advantages of Learning by Doing to Pioneering Firms Attainment of lower production costs
Incentive to produce more in any given period
Limits to Advantages: Benefits spill over to other firms
New products can give newer firms a competitive advantage
Copyright 2012 John Wiley & Sons, Inc. 68
Figure 8 8 - Learning by Doing Versus
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Figure 8.8 Learning by Doing VersusEconomies of Scale
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Copyright 2012 John Wiley & Sons, Inc. 70
Estimating Cost Functions
Techniques: Surveys
New entrant/survivor technique method fordetermining the minimum efficient scale of
production in an industry based oninvestigating the plant sizes either being builtor used by firms in the industry
Econometric specification
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Appendix
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Additional Info for you!
Th P fi f Fi
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The Profits of a Firm
Opportunity Cost of Capital
The normal rate of return*, or theavailable return on the next-best
alternative investment.
*Normal Rate of Return: The amount that must be paid to aninvestor to induce investment in a
business.
E A P fi E l
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Here is an example of how economic profits and accounting profits differ. Imagine that two years after receiving yourcollege degree your annual salary as an assistant store manager is $28,000, you own a building that rents for $10,000
yearly, and your financial assets generate $3,000 per year in interest. On New Years Day, after deciding to be your ownboss, you quit your job, evict your tenants, and use your financial assets to establish a pogo-stick shop. At the end of the
year, your books tell the following story:
Salary $28,000Rent $10,000Interest $3,000
Total Implicit Costs$41,000;
Congratulations, your
bookkeeper pipes up, youmade aHold it just a moment, you say, I have studied economics. You forgot to subtract my implicit costs. Being in this
business caused me to lose as income:Salary $28,000Therefore, Ive had an
economic profit thatsnegative, a loss of $36,000This business is a loser!
Econ vs. Acctg Profit Example