Chapter 8: Production and Costs

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Chapter 8 Production and Costs
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Profit Maximization

• Profit Total Revenue Total Cost
• p PQ Total Costs

Explicit Costs
Implicit Costs
Actual spent Labor Costs of
capital Electricity, Water

• Value of resource used in production with no
  actual payment
• Example Opportunity costs
• Agricultural Example Land passed down through
  generations.

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Accounting Profit vs Economic Profit
Exhibit 1 from Chapter 8.
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When is zero profit ok?

• Zero accounting profit is not so good!
• Zero economic profit is normal.

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Example Agriculture

• Example You own 1 million worth of land and
  tractors for farming
• Opportunity costs of land and capital are
  around 50,000 per year (assume next best
  investment would return 5 per yr).
• Opportunity costs of labor are 50,000 -
  100,000 per year for landowner, plus any
  additional labor by other family members.
• What do you need to make in accounting profit
  to make zero economic profits?

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Production Conversion of resources and inputs
into goods and services

• Fixed Inputs
• An input whose quantity remains the same as
  output changes.
• Examples
• Machinery
• Buildings/land
• Some service contracts (cell phones, car leases)

• Variable Inputs
• An input whose quantity can be changed as output
  changes.
• Examples
• Electricity
• Labor

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Examples

• Car factory
• Fixed Costs Plant, land and machines, Some
  management expenses, Some distribution costs,
  Some labor etc.
• Variable Costs (Costs of inputs depend on cars
  produced) Aluminum, steel, electricity,
  lightbulbs, bolts, tires, brakepads, labor, etc.
• Farm
• Fixed Costs Land, tractors, planting machines,
  buildings
• Variable Costs (Costs of inputs depends on acres
  managed) Seeds, fertilizer, pesticides, fuel,
  maintenance, hired labor, etc.

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Short Run vs. Long Run

• Short Run Some inputs are fixed
• Cant add new machines, buildings, factory, land,
  etc. quickly
• BUT, in the Long Run, ALL INPUTS CAN BE
  ADJUSTED.
• The distinction between short run and long run
  depends on the industry
• Farmers can finance new machines within the
  year in order to increase production (as long as
  they can get the additional acres)
• Car Factories (and many other factories) cannot
  be expanded in a short period of time.

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Short Run Production

• Marginal Physical Product (MPP) the change in
  output that results from changing the variable
  input by one unit, holding all other inputs
  fixed.
• Law of Diminishing Marginal Returns as ever
  larger amounts of a variable input are combined
  with fixed inputs, eventually the marginal
  physical product of the variable input will
  decline.

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Example Exhibit 2
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Costs

• Fixed Costs the costs associated with fixed
  inputs. Fixed costs do not change as output
  changes.
• Variable Costs the costs associated with
  variable inputs. A variable cost changes as
  output changes.
• Total Cost the sum of fixed and variable costs.

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Sunk Cost

• Sunk Cost a cost incurred in the past that
  cannot be changed by current decisions and
  therefore cannot be recovered.
• Economists Say Ignore sunk costs in
  decision-making.

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Graph of Costs (Exhibit 4)
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Marginal Cost

• Marginal Cost (MC) The change in total cost
  that results from a change in output.
• Marginal Cost is a reflection of the marginal
  physical product of the variable input.
• As the marginal physical product curve rises, the
  marginal cost curve falls and as the marginal
  physical product curve falls, the marginal cost
  curve rises.

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MPP MC (1)
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Marginal Cost (Exhibit 4)
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Relationship between Average Cost and Marginal
Cost(Exhibit 5)
cost per unit
cost per unit
cost per unit
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Relationship between Average Cost and Marginal
Cost

• Average costs are pulled down when marginal
  costs are below.
• Average Costs are pulled up when marginal costs
  are above

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Average Marginal Examples

• Average Concept
• Miles per gallon (miles driven/gallons used)
• Batting average (hits/times at bat)
• per acre of farm sale (value of sale/acres)
• Grade point average (sum of grades/hours)
• Marginal Concept (rarely observed)
• Additional miles on last gallon in tank
• Additional hits for an additional of salary
• Additional earned for an additional acre
• Improvement in GPA for an additional course

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Average Marginal Examples

• Suppose Sean Caseys batting average is 0.267
  after the 30th game of the baseball season.
• If in his next game (the 31st), or marginal
  game, he hits safely 2 times out of 4 at bats,
  will his seasonal batting average increase or
  decrease?
• Suppose your grade point average is 3.5.
• If in your last quarter at school, you get all
  As, so your average in that quarter is a 4.0,
  will your overall average increase or decrease?

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Average Marginal

• 2004 AZ Diamonbacks
• 69,780,750 Salary
• 1401 hits
• Average Cost per hit 49,807/hit

• 2004 CN Reds
• 46,615,250 Salary
• 1380 hits
• Average Cost per hit 33,779/hit

What Marginal Cost did the Diamondbacks Pay for
each additional additional hit? Additional hits
21 Additional Salary 23,165,500 MC
(23,165,500/21) 1,103,119 per hit
Sources USA Today MLB
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A Few Important Points

• Marginal Physical Product (MPP) can rise.
• BUT, eventually, as you try to produce more and
  more output, they will fall in the short run
• Marginal Costs can fall.
• But, as with MPP, eventually as you try to
  produce more and more output, they will rise in
  the short run.

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Long Run Average Total Cost

• Long Run Average Total Cost Curve Shows the
  lowest unit cost at which the firm can produce
  any given level of output.
• All inputs are variable IN THE LONG RUN.

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Definitions

• Economies of Scale exist when inputs are
  increased by some percentage and output increases
  by a greater percentage, causing unit costs to
  fall.
• Growing firms offer greater opportunities for
  employees to specialize.
• Growing firms can take advantage of highly
  efficient mass production techniques and
  equipment.
• Constant Returns to Scale exist when inputs are
  increased by some percentage and output increases
  by an equal percentage, causing unit costs to
  remain constant.