Chapter 22 - The Costs of Production by linzhengnd

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									        Where are we going?
• Going forward we will bring product
  demand, product price, and revenue together
  and explain how firms compare revenues and
  costs in determining how much to produce.

• Ultimate goal – to show how those
  comparisons relate to economic efficiency
  The Costs of Production
         Payments and opportunity costs



Economic costs
Short-run production relationships
Short-run production costs
Long-run production costs
Applications
Topics to be covered:

Economic costs
         explicit cost and implicit costs
         normal profit as a cost
         Economic profit
         Short and long run
Short-run production relationships
         Law of diminishing returns
Short-run production costs
         Fixed, variable, and total costs
         per-unit, or variable costs
         marginal costs
         marginal decisions
         MC and marginal product
         The relation of MC to AVC and ATC
         Shifts of cost curves
Topics to be covered:

Long-run production costs
        firm size and costs
        The long-run cost curve
        Economies of scales and diseconomies of scale
        Constant, increasing, and decreasing returns to scale
        Minimum efficient scale and industry structure
      ECONOMIC COSTS
              From a general economic perspective


The measure of economic cost, or opportunity
    cost, of any resource used to produce a
    good is –

The value or worth the resource would have in
     its best alternative use.
         ECONOMIC COSTS
From the firm’s point of view

Economic costs – the payments a firm must make, or the
incomes it must provide, to attract the resources it needs away from
alternative production opportunities



                        More Specifically:
Explicit Costs – actual (payments to resource suppliers)
Implicit Costs – opportunity costs of using (self-owned or self-
employed) resources.
       - The money payments those resources could have
       earned in their best alternative use.
  Accounting profit versus Economic profit
               An example:
         How successful is this business?

You go from being an employee to a business owner

Formerly Earning $22,000 / yr as sales rep for T-shirt mfr.

Invest $20,000 of savings that were earning $1000 /yr.

Start your own T-shirt company.

Use a store that you have been renting out for $5000 / yr.

Hire a clerk at $18,000 / yr
    Explicit Costs
Total Sales Revenue               120000
Cost of T-shirts        40000
Clerk's salary          18000
Utilities                5000
Total Explicit Costs              63000
Accounting Profit                 57000

  Implicit costs
 Foregone Interest         1000
 foregone rent             5000
 foregone wages           22000

 Total implicit costs                28000
 Economic profit                     29000
      Economic costs
 Normal Profits
• Treated as a cost
• Required to attract & retain resources -
   (entrepreneurial ability)

    Economic or Pure Profits
    Economic     Total
                           Economic Cost
      Profit    Revenue
      ECONOMIC COSTS
                               Profits to an          Profits to an
                                Economist             Accountant
                                                  T
Economic (opportunity) Costs




                                  Economic        O
                                                  T
                                    Profit        A     Accounting
                                 Implicit costs   L       Profit
                                  (including a
                                 normal profit)   R
                                                  E
                                                  V
                                   Explicit              Accounting
                                                  E
                                                        costs (explicit
                                    Costs         N
                                                  U      costs only)
                                                  E
       Just to be clear

Economic profit = total revenue – economic cost

Economic cost = explicit cost + implicit cost
     Short run and long run:
       The role of Time
• When the demand for a firm’s product
  changes, the firm’s profitability may depend
  on how quickly it can adjust the amounts of
  the various resources it employs.
      SHORT RUN AND LONG RUN
 Accounting:
 Short and long run is based upon annual
 chronology.

Economics:
Short run has fixed plant capacity.
Long run all resources are variable

  •For the industry, the long run includes enough time for
  firms to enter and exit the industry
      SHORT-RUN PRODUCTION
         RELATIONSHIPS
Firm’s costs of producing a specific output are a function of
resource prices and the quantities of inputs needed to
produce that level of output.


Resource demand and supply determine resource prices.

The technological relationship between inputs and output
determine the quantities of resources needed: called
  The production function. (Google this to learn more)
    SHORT-RUN PRODUCTION
       RELATIONSHIPS
Total Product (TP) – total output of the good produced.
Marginal Product (MP) – the extra output that results
from adding a unit of a variable resource.
                          Change in Total Product
   Marginal Product =
                           Change in Labor Input

    Average Product (AP) – output per unit of
    labor input (labor productivity)
                            Total Product
     Average Product =
                              Units of Labor
    Transition to Law of Diminishing Returns


In the short run, a firm can for a time, increase its
output by adding units of labor to its fixed plant.

But by how much will output rise when the firm adds
each unit of labor?

How long will the firm be able to get increased output?

Why do we say “for a time”?
      Law of Diminishing Returns

Assumptions:
•Technology is fixed
•Production techniques do not change.
•All units of labor are of equal quality.

As successive units of a variable resource are added to a
fixed resource, beyond some point the extra, or marginal,
product that can be attributed to each additional unit of
the variable resource will decline.
    Law of Diminishing Returns

                                          (3)               (3)
       (1)                          Marginal Product     Average
   Units of the           (2)            (MP),           Product
Variable Resource   Total Product    Change in (2)/        (AP),
     (Labor)            (TP)         Change in (1)        (2)/(1)
       0                  0]         10    Increasing
                                                           -
       1                 10 ]        15
                                            Marginal
                                            Returns
                                                         10.00
       2                 25 ]        20                  12.50
                            ]              Diminishing
       3                 45 ]        15     Marginal
                                                         15.00
       4                 60 ]        10
                                             Returns     15.00
       5                 70 ]         5
                                            Negative
                                                         14.00
                            ]               Marginal
                                            Returns
       6                 75           0                  12.50
       7                 75          -5                  10.71
       8                 70                               8.75
SHORT-RUN PRODUCTION
    RELATIONSHIPS
Law of Diminishing Returns
           Total Product, TP




                                                   Total Product


                                                     Increasing
                                                      Marginal
Average Product, AP, and




                               Quantity of Labor
 Marginal Product, MP




                                                       Returns

                                                   Average
                                                   Product
                                                   Marginal
                               Quantity of Labor   Product
SHORT-RUN PRODUCTION
    RELATIONSHIPS
Law of Diminishing Returns
           Total Product, TP



                                                   Total Product


                                                   Diminishing
                                                    Marginal
Average Product, AP, and




                               Quantity of Labor     Returns
 Marginal Product, MP




                                                   Average
                                                   Product
                                                   Marginal
                               Quantity of Labor   Product
SHORT-RUN PRODUCTION
    RELATIONSHIPS
Law of Diminishing Returns
           Total Product, TP



                                                   Total Product


                                                      Negative
                                                      Marginal
Average Product, AP, and




                               Quantity of Labor
 Marginal Product, MP




                                                      Returns

                                                   Average
                                                   Product
                                                   Marginal
                               Quantity of Labor   Product
Law of Diminishing Returns

                          30
   Total Product, TP
                                                                            TP

                          20


                          10


                           0
                                  1    2    3     4    5      6   7     8        9
   Marginal Product, MP




                               Increasing       Diminishing           Negative
                                Marginal         Marginal             Marginal
                          20    Returns           Returns             Returns


                          10                                                AP

                                  1    2    3     4    5      6   7   8  9
                                                                      MP
       SHORT-RUN PRODUCTION COSTS
 Fixed Costs – do not vary with changes in output
 Total Fixed Costs – rent, insurance, interest
                            Total Fixed Costs
      Average Fixed Costs = Quantity of output


Variable Costs – change with level of output.
 Total Variable Costs – materials, fuel, transportation, labor
                                       Total Variable Costs
      Average Variable Costs          = Quantity of output
       SHORT-RUN PRODUCTION COSTS
        Total Cost
Total of Fixed and Variable Costs at each level of output
                                       Total Costs
      Average Total Cost = Quantity of output


Marginal Cost
The extra cost of producing 1 more unit of output
                            Change in Total Costs
      Marginal Cost =        Change in Quantity of output
  Fixed costs and variable costs from the
   point of view of the business manger


1. Variable costs can be controlled in the short-run by
   changing production levels.

2. In the short-run, fixed costs are beyond the control
   of the business manager.

3. Those costs must be paid regardless of output level.
   SHORT-RUN PRODUCTION COSTS
Summary of Definitions
                          Total Fixed Costs = TFC
                       Total Variable Costs = TVC

               Total Costs = TC = TFC + TVC
    Average Fixed Costs = AFC = TFC / quantity
  Average Variable Costs = AVC = TVC / quantity

      Average Total Costs = ATC = TC / quantity

   Marginal Cost = MC = change in TC / change in quantity
            Production Relationships
• Marginal cost and diminishing returns
    – The shape of the MC curve is a consequence of the law of diminishing
      returns.
• Marginal cost and marginal product
    – As MP increases, MC decreases
• Marginal cost and average variable cost
• Marginal cost and average total cost
    – MC curve intersects both at their respective minimum points.
• Productivity curves and cost curves
    – When MP is rising, MC is falling and when MP is falling, MC is rising
• Shifts in cost curves
    – Changes in either resource prices or technology will cause costs to change
      and cost curves to shift.
SHORT-RUN COSTS GRAPHICALLY
                                         TC
                  Combining TVC
                  With TFC to get        TVC
                    Total Cost            Fixed Cost
Costs (dollars)




                          Total     Variable Cost
                          Cost
                                             TFC
                                         Quantity
SHORT-RUN COSTS GRAPHICALLY

                                  MC
                  Plotting Average and
                    Marginal Costs
Costs (dollars)




                                       ATC
                                       AVC




                                        AFC
                                    Quantity
       PRODUCTIVITY AND COST CURVES



                           Average product and
                            marginal product
If all units of a
Variable resource
(labor) are the same
price, The MC of each
each extra unit of
output will fall as long
                                                                        AP
as the Marginal product                                               MP
of each additional
worker is rising.                                     Quantity of labor
                                                                          MC
                                    Costs (dollars)




                                                                               AVC




                                                      Quantity of output
  LONG-RUN PRODUCTION COSTS



For every plant capacity size...
there is a short-run ATC curve.

    All such plant capacities
        can be plotted.
LONG-RUN PRODUCTION COSTS
Unit Costs




             Output
LONG-RUN PRODUCTION COSTS
Unit Costs




             Output
LONG-RUN PRODUCTION COSTS


             The long-run ATC curve just “envelopes”
                  all of the short-run ATC curves.
Unit Costs




                           Output
LONG-RUN PRODUCTION COSTS
Unit Costs




                  long-run ATC


             Output
        Economies of Scale
                                    Nhgp start here 3/25

Reductions in the average total cost of
producing a product, as the firm expands the
size of its plant (its output) in the long run;

The economies of mass production
Factors that influence Economies of Scale


  •Labor specialization
  •Managerial specialization
  •Efficient use of capital
  •Declining start-up costs
  •Learning by doing

  •All lead to lower long run ATC as the firm
  expands
          Diseconomies of Scale

     Increases in the average total cost of
     producing a product as the firm expands the
     size of its plant (its output) in the long run.

   Factors that influence Diseconomies of Scale

•Increasing levels of complexity.
•Increasing # of management levels
•Worker alienation
 Constant Returns to Scale


The range over which long – run
average total cost does not change
                      Long-Run ATC Shapes

Average Total Costs
                      Economies        Constant Returns        Diseconomies
                       Of Scale            To Scale              Of Scale




                                                                Long-Run
                                                                  ATC



                                  q1                      q2
                                           Output
Long-run ATC curve where economies
of scale exist
                                                                              8-40
                      Long-Run ATC Shapes
Average Total Costs
                            Economies       Diseconomies
                             Of Scale         Of Scale




                                            Long-Run
                                              ATC


                                   Output
Long-run ATC curve where costs are
lowest only when large numbers are
participating
                      Long-Run ATC Shapes
Average Total Costs
                       Economies   Diseconomies
                        Of Scale     Of Scale

                                                   Long-Run
                                                     ATC




                                          Output
Long-run ATC curve where economies
of scale exist, are exhausted quickly,
and turn back up substantially
                                                              8-42
    MINIMUM EFFICIENT SCALE
    AND INDUSTRY STRUCTURE

Minimum Efficient Scale - MES

The lowest level of output at which a
firm can minimize long – run average total costs.

Why would this be a good level of output to achieve?
    ECONOMIES AND
DISECONOMIES OF SCALE

             Economies
              of scale
Unit Costs




                           long-run ATC

                         Output
    ECONOMIES AND
DISECONOMIES OF SCALE

             Economies   Constant returns
              of scale      to scale
Unit Costs




                                   long-run ATC

                              Output
    ECONOMIES AND
DISECONOMIES OF SCALE


                                      Where economies
                   Case for many
Unit Costs




                   Small firms in        of scale are
                   An industry        quickly exhausted
                                    Many retail trades, some farming

                                       long-run ATC
             MES achieved quickly


                                Output
MINIMUM EFFICIENT SCALE
AND INDUSTRY STRUCTURE

    Natural Monopoly

A relatively rare situation in which
average total cost is minimized when
only one firm produces the particular
good or service

Example: electricity generation
The shape of the long-run ATC curve




Determined by:
•Technology
•Economies of scale
•Diseconomies of scale
         Applications & Illustrations
Rising Cost of Insurance and Security, the 9/11 case
   •In the short run they are fixed – independent of output
   levels. Short-run ATC shifted upward.
Successful Start-Up Firms
   •Specialization, new technology
   •Short-run cost curves shift downward with output
   expansion.
   •Economies of scale
The Verson Stamping Machine
   •large firm size leads to achievement of economies of scale
Aircraft and Concrete Plants
   •MES radically different in the two industries
   •Economies of scale extensive in aircraft manufacture
   •Economies of scale exhausted quickly in cement plants
   •Different geographic market sizes
economic (opportunity) cost   variable costs
explicit costs                total cost
implicit costs                average fixed cost (AFC)
normal profit                 average variable cost
economic profit                  (AVC)
short run                     average total cost (ATC)
long run                      marginal cost (MC)
total product (TP)            economies of scale
marginal product (MP)         diseconomies of scale
average product (AP)          constant returns to scale
law of diminishing returns    minimum efficient scale
fixed costs                   natural monopoly

								
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