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6 - PRODUCTION _ COSTS Powered By Docstoc

Learning Objectives:
   At the end of this chapter, students should be able
     explain the concept of opportunity cost, explicit
      cost and implicit cost
     explain   the idea of economic profit and
      accounting profit
     understand the concept and idea of short run and
      long run in production
     explain different types of business organization

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The objective of firm
  The Firm’s Goal
    A firm is an institution that hires factors of
     production and organizes them to produce and
     sell goods and services
    A firm’s goal is to maximize profit. Is anything
     wrong with it?
    Can you suggest on how firms can maximize
     their costs?

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The idea of opportunity costs
   Measuring a Firm’s Profit
     Accountants measure a firm’s profit using rules laid
      down by the Internal Revenue Service and the Financial
      Accounting Standards Board. Why it is important to
      have external auditors?
     Economists measure profit based on an opportunity cost.

     A firm’s opportunity cost of producing a good is the
      best, forgone alternative use of its factors of
      production, usually measured in monetary terms
     Opportunity cost includes both:

       Explicit Costs - involve a direct money payment for
        factors of production
       Implicit Costs - do not involve a direct money

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The idea of opportunity costs (c’td)

- Involve direct money         - The cost which incur when the
  payment as                     owner of the firm uses his own
- Example?                       capital or time for which he
                                 does not make any direct
                                 money payment
                               - Example?

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Economic Profit vs Accounting Profit
   Economic Profit
     Economic profit equals a firm’s total revenue minus

      its opportunity cost of production
     For simplification:

       A firm’s opportunity cost of production is the sum
        of the explicit costs and implicit costs
       Normal profit is part of the firm’s opportunity costs,
        so economic profit is profit over and above normal

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Economic Profit vs Accounting Profit (c’td)
 Accounting profit equals a firm’s total revenue
  minus explicit costs only. In other words, they
  ignore the implicit costs
 For simplification:

 When total revenue exceeds both explicit and
  implicit costs, the firm earns economic profit
 Normally, economic profit is smaller than
  accounting profit. Why?

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Economic Profit vs Accounting Profit (c’td)

                How an Economist                 How an Accountant
                  Views a Firm                     Views a Firm

Revenue              costs
                    Explicit                          Explicit
                     costs                             costs

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Homework 1: The idea of long-run and
short run
   Short-run refers to a time period in which at least
    one of the input used in the production remain
    fixed or constant. Provide relevant example
   On the other hand, long-run refers to a time
    period in which all of the available inputs can be
    varied. Provide relevant example

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Group Discussion 1: Exhibit 6.1 - Production
Function and Total Cost

Number of       Output    Marginal         Cost of   Cost of   Total Cost of
 Workers                 Product of        Factory   Workers      Inputs
    0             0                         $30        $0          $30
    1             50        50               30        10           40
    2             90        40               30        20           50
    3            120        30               30        30           60
    4            140        20               30        40           70
    5            150        10               30        50           80

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The Production Function
   The production function shows the relationship
    between quantity of inputs used to make a good
    and the quantity of output of that good
   Definitely, we can derive the production function
    curve by looking at total product/ total output
    column (y-axis) and labor or input column (x-axis)
   Do you know that production function curve is also
    known as total product curve?
   Now, based on Exhibit 6.1 on slide no. 10, derive
    Total Product Curve on slide no. 12. Does it exhibit
    diminishing return to labor. Why?

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    Quantity of                                                     total
        Output                                                    product
     per hour)                                                     curve
           150                              Production function
                0   1   2   3   4         5 Number of Workers Hired

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Marginal Product
   The marginal product of any input in the
    production process is the increase in the quantity of
    output obtained from an additional unit of that
   Therefore;

       Marginal   Change in total product
       Product       Change in input

   Based on Exhibit 6.1 on slide no. 10, derive marginal
    product curve on slide no. 14.

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Diminishing Marginal Product
   Diminishing marginal product is the property
    whereby the marginal product of an input declines
    as the quantity of the input increases
   Example: As more and more workers are hired at a
    firm, each additional worker contributes less and
    less to production because the firm has a limited
    amount of equipment
   The slope of the production function measures the
    marginal product of an input, such as a worker
   When the marginal product declines, the production
    function becomes flatter

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Homework 2: Deriving Total Cost Curve
   What is the formula for total cost?

   Based on Exhibit 6.1on slide no. 10,derive total
    cost curve on slide no.17

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                          cost curve

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The Firm and Its Economic Problem
   The Firm’s Constraints
     The five basic decisions of a firm are limited by

      the constraints it faces. There are three constraints
      a firm faces:
     Technology

     Information

     Market

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The Firm and Its Economic Problem (c’td)

   Technology Constraints
     Technology is any method of producing a good or

     Technology advances over time.

     Using the available technology, the firm can

      produce more only if it hires more resources,
      which will increase its costs and limit the profit of
      additional output.

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The Firm and Its Economic Problem (c’td)
   Information Constraints
     A firm never possesses complete information

      about either the present or the future.
     It is constrained by limited information about the

      quality and effort of its work force, current and
      future buying plans of its customers, and the
      plans of its competitors.
     The cost of coping with limited information limits


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The Firm and Its Economic Problem (c’td)
   Market Constraints
     What a firm can sell and the price it can obtain are

      constrained by its customers’ willingness to pay
      and by the prices and marketing efforts of other
     The resources that a firm can buy and the prices it

      must pay for them are limited by the willingness
      of people to work for and invest in the firm.
     The expenditures a firm incurs to overcome these

      market constraints will limit the profit the firm
      can make.

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Technology and Economic Efficiency
   Technological Efficiency
     Technological efficiency occurs when a firm
      produces a given level of output by using the least
      amount inputs.
     If  it is impossible to maintain output by
      decreasing any one input, holding all other inputs
      constant, then production is technologically
   Economic Efficiency
     Economic    efficiency occurs when the firm
      produces a given level of output at the least cost.

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Technology and Economic Efficiency
   The difference between technological and economic
    efficiency is that technological efficiency concerns the
    quantity of inputs used in production for a given level
    of output, whereas economic efficiency concerns the
    cost of the inputs used.
     An economically efficient production process also is
       technologically efficient.
     A    technologically efficient process may not be
       economically efficient.
     Changes in the input prices influence the value of the
       inputs, but not the technological process for using
       them in production.

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Information and Organization

   Types of Business Organization
     There are three types of business organization:

     Proprietorship

     Partnership

     Corporation

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Information and Organization (c’td)
   Proprietorship
     A proprietorship is a firm with a single owner

      who has unlimited liability, or legal responsibility
      for all debts incurred by the firm—up to an
      amount equal to the entire wealth of the owner.
     The    proprietor also makes management
      decisions and receives the firm’s profit.
     Profits are taxed the same as the owner’s other

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Information and Organization (c’td)
   Partnership
     A partnership is a firm with two or more owners

      who have unlimited liability.
     Partners must agree on a management structure

      and how to divide up the profits.
     Profits from partnerships are taxed as the

      personal income of the owners.

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Information and Organization (c’td)
   Corporation
     A    corporation is owned by one or more
      stockholders with limited liability, which means
      the owners who have legal liability only for the
      initial value of their investment.
     The personal wealth of the stockholders is not at

      risk if the firm goes bankrupt.
     The profit of corporations is taxed twice—once as
      a corporate tax on firm profits, and then again as
      income taxes paid by stockholders receiving their
      after-tax profits distributed as dividends.

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Information and Organization

   Pros and Cons of Different Types of Firms
       Each type of business organization has
        advantages and disadvantages.
       Table 9.4 lists the pros and cons of different types
        of ownership.

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Information and Organization

  Proprietorships are easy to set up
  Managerial decision making is simple

  Profits are taxed only once

  But bad decisions made by the manager are not
   subject to review
  The owner’s entire wealth is at stake

  The firm dies with the owner

  The cost of capital and labor can be high

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Pros and Cons of different business types
    Partnerships are easy to set up
    Employ diversified decision-making processes
    Can survive the death or withdrawal of a partner
    Profits are taxed only once
    But partnerships make attaining a consensus about
     managerial decisions difficult
    Place the owners’ entire wealth at risk
    The cost of capital can be high, and the withdrawal
     of a partner might create a capital shortage

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Pros and Cons of different business types (c’td)
  A corporation offers perpetual life
  Limited liability for its owners

  Large-scale and low-cost capital that is readily

  Professional management

  Lower costs from long-term labor contracts

  But a corporation’s management structure may lead
   to slower and expensive decision-making
  Profit is taxed twice—as corporate profit and

   shareholder income.

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Tags: economy
Description: microeconomics