CHAPTER 23 -Costs of Production How much output can a firm produce? How do the costs of production vary with the rate of output Do larger firms have a cost advantage over smaller firms? We are talking about the Production Function…i.e. Costs of Production Next Step for Production Function 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 Inputs Production of goods equates cost! Idea for a firm (large or small) is to minimize the cost while maximizing output. 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 workers (Factors of production=land,labor,capital, entrepreneurship 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 limit. 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 declines This refers to how many widgets 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 Output 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 changed. 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 returns* Long run/short run productivity MPP (marginal physical product)= The change in total output that results from employment of one additional unit of input. Formula: MPP = change in total output change in input quantity *same figure as approximate avg output. On diminishing returns chart… Marginal Productivity Employment Dilemmas Sometimes employees don’t measure up *Output does not justify Their negative inputs Marginal Physical Product MPP- 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 ∆L MPP Chart Marginal Physical Product Fixed Input Variable Quantity of MPP of Input labor Output Q Variable Input 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 product. 50 Total output E I 45 (per day) D 40 + 10 jeans 35 C 30 Third worker 25 20 Marginal physical product 15 B c b d (per worker) 10 e 5 0 A a 1 2 3 4 5 6 7 8 i The MPP actually mirrors the output/worker. 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 increasing 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 1/f 8 0.40 e 1/e 4 0.20 1/b 1/c 1/d Falling MPP Implies Rising f g h Cost Marginal Input5 6 7 8i 0 1 2 3 4 Labor 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 Output REVIEW TERMINOLOGY 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 changed. 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 IMPERFECT Whether a firm exists in a perfectly competitive market or imperfectly competitive market, it will TRY to MAXIMIZE PROFITS or MINIMIZE LOSSES. 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) ANSWER! Economic Profit vs Accounting Profit (the difference lies in how cost is defined) Accounting Costs are all the costs that Economic Cost = have an explicit Explicit Cost + dollar cost Implicit Cost attached to it. TR- TC •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 c 2O 3 4 5 6 7 8 9 10 S T S AFC Quantity Graph 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. Examples: More laborers Wages Electricity 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 Cost The bottom line is productivity whether Bottom Line--- it is a worker on an assembly line or a CEO. 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 chart) Change in total cost Marginal cost = Change in output MC = C Q 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 $24 I 20 Costs (dollars per pair) J ATC 16 O K L M N 12 8 AVC 4 AFC 0 10 20 30 40 50 Rate of Output (pairs per day) Graph ATC/AVC/AFC 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 product.****** 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. MC ATC A Cost Summary Basic Cost Curves $32 MC 28 Cost (dollars per unit) 24 20 16 12 ATC AVC 8 m 4 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 $32 28 Cost (dollars per unit) 24 20 16 12 8 4 0 1 2 3 4 5 6 7 8 9 Rate of Output (units per time period) 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 VARIABLE. 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, stability. LONG RUN Costs 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) ATC1 ATC2 ATC3 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 LMC Costs (dollars per pair) ATC2 LATC m2 Long-Run Costs with Unlimited Options 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 output. 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 efficiency Constant Returns to Scale and Diseconomies of Scale Constant returns to scale Economies of scale Diseconomies of scale COST (dollars per unit) ATC3 ATC1 ATCS ATCS ATC2 ATCS m3 m1 m2 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 competitiveness. 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- level. Question: Are trade deficits a signal that the U.S. cannot compete in the global marketplace? 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 production, 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 MPP 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 Japan. Bottom Line Productive Statement Productivity in any economy means staying competitive in the global markets and ―making more things‖ than others.
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