Costs of Production by liaoqinmei


									CHAPTER 23 -Costs of
How  much output can a firm
        How do the costs of
production vary with the rate
                    of output
 Do larger firms have a cost
     advantage over smaller
    We are talking about the
    Production Function…i.e.
         Costs of Production
Next Step for Production
 How many inputs does it take to arrive at the
 desired mix of outputs. (from the factors)
*How many workers will it take to make the
 new Board Game… I LOVE ECONOMICS?

           of Production Function:
 Definition
 Relationship between the maximum quantity
 of a good attainable from different
 combinations of factor inputs.
Maximum Output/Minimum
Production of goods equates cost!
Idea for a firm (large or small) is to
  minimize the cost while maximizing
How best to produce?
What’s the smallest amount of resources
  needed to produce a specific product?
  *What is the least number of workers we
  can hire to handle the noon counter
  trade? (McDonalds). Can we lay off
  another 1,000 workers and still be
  competitive (IBM) Ford lays off 15,000
(Factors of production=land,labor,capital,
Answers to Production Q
The Production Function will answer
 what the maximum amount of output
 is attainable from various combinations
 of factor inputs. (this is getting the mixing
 bowl filled with right ingredients)

With a fixed amount of capital adding
 labor inputs can predict outputs---up
 to a certain point---then more capital
 needs to be added.
Law of Diminishing Returns
   *Did you ever fall asleep reading your
    economics text after a long day at work?
    Or maybe you just procrastinated on
    getting that book open.. Of course you
    have…..… you have experienced
   Diminishing returns.
 In   the short run—Production
    function defines the limit to
    output and how much each
    worker will contribute to that
 Thefactor that can be adjusted
 quickly in the SR is Labor.

 Yet…  as more labor is hired,
  each unit of labor has less
  capital and land to work with…
 Things get constrained.. Hence.
  Marginal Physical Product
 This refers to how many
Set up a small factory    If you keep adding
Fixed factor of            workers- will reach a
  production(4             point where the
  machines)                marginal worker adds
Functions of machines      nothing to our total
Add variable factors       output.
  one at a time.          A business person
                           must be aware of the
                           law of diminishing
                           returns if he wants to
                           operate efficiently.

Example/Build a City game
Machines   Workers   Total    Approx     Marginal
                     Output   Average    Product

4          0         0        0         0
4          1         20       20        20
4          2         45       22.5      25
4          3         80       26.5      35
4          4         130      32.5      50
4          5         160      32        30 ***
4           6        180      30        20
4          7         190      27.1      10
4          8         185      23.1      -5
Bottom Line
If we keep adding workers we will reach
  a Point where--- the Marginal Worker
  ads nothing to our total output * All
  the checkout lanes are filled with Tom
  Thumb Employees… very few people
  are checking out. (Is this productive
  for TT?)
What happens to their Profit Margin?
Cost exceeds any benefits of hiring
  additional workers.
Short run= period in which the quantity
 (and quality of some inputs) cannot be
General assumption: In SR labor can
 change while capital is held constant
Generally, as amount of labor used
 increases, the output will also increase
 (with reservations) See diminishing

Long run/short run productivity
MPP (marginal physical product)=
The change in total output that results from
 employment of one additional unit of

      Formula: MPP = change in total output
                      change in input quantity
          *same figure as approximate avg output.
      On diminishing returns chart…

Marginal Productivity
Employment Dilemmas
                 not justify
Marginal Physical Product
 Marginal Productivity
 When the MPP of labor (MPPL >0), then
  total output increases.
 Improving the ratio of labor to other factors
  increases the MPP of labor.
MPP = ∆Q
    MPP Chart
        Marginal Physical Product
    Fixed Input   Variable      Quantity of   MPP of
                  Input labor   Output Q      Variable
    1             0             0
    1             1             18            18
    1             2             37            19
    1             3             57            20
    1             4             76            19
    1             5             94            18
     MPP Graph(actually
diminishing marginal physical
50       Total output                E                         I
45        (per day)       D
40                              + 10 jeans
35                C
30                    Third worker
20                         Marginal physical product
15        B       c
              b             d (per worker)
 0   A
     a     1      2         3        4       5   6     7       8
 The MPP actually mirrors the
 MPP is the additional output obtained by
  employing one more unit of input..
 If MPP     each additional unit of input is
     producing less and ultimately adds
  more cost to each additional input.
 . (i.e. input cost is rising= marginal cost is

Falling MPP implies Rising MC
                            Diminishing marginal productivity implies . . .      Rising marginal cost
                            24                                              1.20
Marginal Physical Product

                            20         c                                                      1.00                         1/g

                                                                      Additional Labor Cost
                            16   b                                                            0.80
                            12              d                                                 0.60
                             8                                                                0.40
                                                 e                                                             1/e
                             4                                                                0.20   1/b 1/c 1/d
                Falling MPP Implies Rising
                                 g h

                Marginal Input5 6 7 8i
                 0 1 2 3 4
                                       0 1 2 3 4 5
                                            Labor Input
                                                                                                                       6     7
   What about Marginal Revenue? The
    change in total revenue associated with
    one additional unit of input.

 If marginal costs are increasing
    marginal revenue is decreasing.
Productivity- Right Mix of
   Factors of production- Resource inputs
  used to produce goods and services
  (land,labor,capital, entrepreneurship)
 Productivity-Output per unit of input
  (output per labor hour)
 Efficiency-maximum output of a good from
  the resources used in production
 Opportunity Cost-The MOST DESIRABLE
G&S that are forgone in order to obtain
  something else.
 Short Run-The period in which the quantity
  (and/or quality) of some inputs cannot be
1.   If input prices are rising, will Marginal
     cost be rising?

2.   If you have a fixed amount of capital
     and continue to add labor inputs, will
     marginal product always increase?

3.   What is marginal physical product?

Quick quiz
 All competition that is not PURE is
 Whether a firm exists in a perfectly
  competitive market or imperfectly
  competitive market, it will TRY to

Costs, Prices, Output in
Competitive Markets
  What is a definition of profit?

Fixed, Variable, Total Costs
   Which market might this carton apply today?
                TR-TC=PROFIT

 How much money am I taking in? (TR)
 How much is it costing me to produce my
  output? (TC)

Economic Profit vs Accounting
(the difference lies in how cost is
                               Accounting Costs are
                                all the costs that
Economic Cost =
                                have an explicit
 Explicit Cost +
                                dollar cost
 Implicit Cost
                                attached to it. TR-
•Economic cost represents the value of all
resources used to produce a good or service;
opportunity cost.
The two diverge whenever a factor of production is
not paid an explicit wage… (rent) (own the land)
(not paying yourself a salary)
Accounting, Economic and
Normal Profit II
Suppose a company incurs the following
   costs: labor, $400; equipment, $300;
   and materials, $100. The company
   owns the building so it doesn’t have
   to pay the usual $800 in rent.
a) What is the total accounting cost?
b) What is the total economic cost?
c) How would accounting and economic
   costs change if the company sold the
   building and then leased it back?
   All costs are classified as fixed or variable. In
    the short run, the firm can only use its
    existing facilities to increase its output.
    During the short-run, there are several
    important costs that are fixed.
   Fixed costs do not change when the firm
    changes its level of output
   Name some—
   -interest on debts of the firm, payments
    for rent, insurance premiums, taxes on
    real property, salaries.

Fixed Costs:
 Average fixed cost, AFC declines as the
  firm increases its output.
 Divide TFC by Q = AFC

          TFC/Q = AFC

Average Fixed Cost AFC
 2O   3   4   5   6   7   8   9   10
  S                               AFC

If a firm had nothing but fixed costs, the
  more it produced the lower its unit cost
  (AFC) However, the firm is also
  confronted by variable costs.
What are Variable Costs?
Variable Costs increase as the firm
  increases its output.
All costs that are not fixed---are variable!

Graph explanation
Continued Variable Costs
When a firm increases its output, it must
  acquire more productive resources.
More laborers
Paint, sugar, plastic, steel, etc.
***Variable costs: any costs that rises as
  the firm produces more; and costs that
  fall as the firm produces less.
****This is the cost that producers have
  control over.
1. Mortgage payments on a factory
2. Electric bills at a print shop
3. The cost of a new robot at General
   Motors plant
4. Premiums on liability insurance at the
   XYZ Corporation
5. Wages paid to auto workers
6. Contract paid to top management at GE

Quick Quiz
Identify which is Fixed or Variable
                             The bottom line is
                              productivity whether
Bottom Line---                it is a worker on an
                              assembly line or a
                             Remember: Harry
                              Truman said
                              recession is when a
                              neighbor loses his
                              job..depression is
                              when you lose
                              yours! 

Why is productivity measured by the federal government?
AVC is found by dividing TVC by Q
               TVC/Q = AVC

Although Average fixed cost declines
 continually, average variable cost does
 not. At first AVC usually declines as the
 firm’s output increases. After reaching a
 minimum, then AVC begins to rise.

Total Variable Cost and
Average Variable Cost
  AVC and Diminishing Returns

The AVC curve will have the general shape
 of the letter U. This is explained by the
 Law of diminishing returns.

Law says: as more and more units of a
 variable factor of production are added to
 a fixed factor of production (such as
 capital equipment) eventually a point will
 be reached at which the output accounted
 for by each additional unit of the variable
 factor will start to decline.
  Total Cost
Total Cost is the sum of total fixed cost and
  total variable cost.
When a firm increases its output, total cost
  tends to rise
Fixed cost remains unchanged, naturally,
  but total cost will be pulled up by the
  rise in total variable cost with the rise
  in output.
ATC= TC/Q or adding AFC + AVC
 Marginal Resource Cost
 Marginal cost (MC) is the increase in
  total costs associated with a one unit
  increase in production. (see overhead
                    Change in total cost
    Marginal cost =
                     Change in output

              MC = C

Marginal Cost- controllable cost
    How to determine marginal cost
Total      Total FC   Total VC   Total Cost   Marginal
Output                                        Cost

0          $2000      $     0    $2,000       $ 0
1          $2000      $l,500     $3,500       $1,500
2          $2000      $2,600     $4,600       $1,100
3          $2000      $3,600     $5,600       $1,000
4          $2000      $4,800     $6,800       $1,200
5          $2000      $6,125     $8,125       $1,325
6          $2000      $7,800     $9,800       $1,675
7          $2000      $9,800     11,800       $2,000
8          $2000      12,000     14,000       $2,200
Costs (dollars per pair)

                                      J                                     ATC
                            16                                                 O
                                                        L              M      N

                             8                                              AVC

                             4                                              AFC

                             0   10       20           30              40         50
                                      Rate of Output (pairs per day)

 The bottom of the U-shaped average total
  cost curve represents the minimum
  average total costs.
 It identifies the lowest possible
  opportunity costs to produce the

Minimum Average Cost
   The output decision has to be based not
    only on the capacity to produce (the
    production function) but also on the costs
    of production (the cost functions).

A Cost Summary
 Themarginal cost curve
 always intersects the ATC
 curve at its lowest point.



A Cost Summary
                                Basic Cost Curves
Cost (dollars per unit)

                           12                                            ATC
                            8                    m
                                         n                               AFC
                            0    1    2    3     4     5      6   7      8    9
                                  Rate of Output (units per time period)
Friendly reminders
 If marginal is greater than average, then
  average must be rising..(your 3 exams
  average to 85.. Your 4th is 92.. Your
  average will increase above 85)
 If marginal is less than average, then
  average must be falling…(your 4th grade is
  74. This will pull down the average of 85)
 If marginal equals average, then average
  is at its extreme (neither rising or falling)
  at that point..With a grade of 85 on your
  4th test, your average grade will not
  change if you had an 85 average on the
  other three exams.
   Whenever a number added to a series of
    numbers is less than their average, the
    average must decline……….
   When a number added to a series of numbers
    is larger than their average, the average
    must rise…..

   Marginal Cost helps a firm decide
    whether to increase or decrease output.
   Marginal cost is the cost that the firm
    can control most directly.

Mathematical Rule
Adding numbers
If MC > ATC, ATC is increasing
If MC < ATC, ATC is decreasing
If MC = ATC, ATC at minimum

A Cost Summary
  Cost (dollars per unit)


                              0   1   2     3    4     5    6     7    8   9

                                      Rate of Output (units per time
Identify these curves!
   Short   Run - A period of time in which
    some inputs in the production process
    are fixed.
   Long Run - A period of time in which
    all inputs in the production process can
    be varied (no inputs are fixed).

Production and Cost:
Short and Long Run
   Over the long-run---ALL COSTS ARE
   Taxes, interest rates, and other costs that are
    fixed in the SR can change.
   The size of the firm can also affect costs.
    The principle that explains this is called:

ECONOMIES OF SCALE- (means as firms
 enlarge their plants, their unit costs decline
 because of mass production and other factors
 such as:
Specialization, factor substitution, better
 equipment, research, marketing advantages,

Long- Run Costs Continued
   There are no fixed costs in the long-run
   The long-run cost curve is just a summary
    of our best short-run cost possibilities
    using existing technology facilities.

   Like all average cost curves, the long-run
    LATC curve has its own marginal cost
    curve. The long-run marginal cost LMC
    curve is not a composite of short-run
    marginal cost curves. Rather it is
    computed on the basis of the costs
    reflected in the long-run ACT curve itself.
Marginal Physical Product and
Marginal Cost I
Notice that as the
MPP curve rises,
the MC curve falls;
and as the MPP
curve falls, the MC
curve rises.
     A cost incurred in the past that cannot
    be changed by current decisions and
    therefore cannot be recovered.

Sunk Cost
                                Best for output levels below a
                                                                              Best for output levels in
                                                                              Excess of b
     Costs (dollars per pair)


                                                                        Long-run average
                                                                        total cost (LATC)
Long-Run Average Costs c
      0    40 a 60         b
              determined jeans per day)
LR Costs are Rate of Output (pairs of by SR options.
   The long-run marginal costs curve
    intersects our long-run cost curve at its
    lowest point.

Long-Run Marginal Costs
    Costs (dollars per pair)




Long-Run Costs with Unlimited
   0      q2
           Rate of Output (jeans per day)
   There are many optional plant sizes
    available in long-run production.

          One  option is the decision
          to use one large plant or
          several smaller plants to
          produce a given amount of
Economies of Scale
Constant Returns= increases in plant size
 do not affect minimum average cost…
 minimum per-unit costs are identical for
 small plants and large plants.
Diseconomies of Scale=increase in plant
 size results in reducing operating

Constant Returns to Scale and
Diseconomies of Scale
                          Constant returns to scale       Economies of scale         Diseconomies of scale
COST (dollars per unit)

                               ATCS                        ATCS           ATC2          ATCS     m3
                               c                           c                           c

                          0               QM          0              QM          0                QM
                              RATE OF OUTPUT              RATE OF OUTPUT              RATE OF OUTPUT
                               (units per period)          (units per period)          (units per period)
                 Economies of Scale
 Answer – No and Yes respectively. Low wages
  are not a reliable measure of global
 Competition regardless of where it takes place,
  has to produce MORE OUTPUT for a given
  quantity of INPUTS.
 *****A worker’s contribution to the production
  process is measured by MPP. A worker’s MPP
  depends on the quantity and quality of
  other resources in the production process
  plus the worker’s educational skills and skill-
Question: Are trade deficits a signal that the
U.S. cannot compete in the global
Is Outsourcing Good?
   U.S. Labor vs Mexico Labor
                                   The higher wages
                                    paid in America as
                                    opposed to Mexico
                                    reflects the capital
                                    used in American
                                    education of the
                                    worker, advanced
                                    technology, etc.---
                                    must measure
                                    UNIT LABOR COST
Should the federal government be criticized for NAFTA?
America:              Mexico:
Unit Labor Cost =     Unit Labor Cost =
$12.00 per hour       $3.00 per hour
6 units per hour      1 unit/hr
= $2/unit of output   = $3/unit of output

Checking unit labor cost
Unit Labor cost = wage rate
 Low wage rate does not always indicate
  lower unit output cost. *Service jobs are
  an exception if education stays
  level…China has lower wage rate…so
  should HP produce printers there?
 Mexican labor in the previous example
  would be more costly to use even though
  the wage rate is lower.

Real World Labor Cost/wage rate
Japan – supply chain halt
             Think of the many
              products in the U.S.
              that are dependent
              on parts and
              products from
Bottom Line Productive

   Productivity in any economy means
    staying competitive in the global
    markets and ―making more things‖
    than others.

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