ECN101 Cost of Production

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ECN101 Cost of Production

• Note
• Read Chapter 13
• Quiz 3 next Tuesday ( chapter 9, 10, 11, 13)

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Outline

• I. Definitions
• A. Types of Costs
• Normal Profit
• Production Functions
• Inputs
• Short Run and Long Run

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Outline

• II. Production in the Short Run
• A. Product Curves
• B. Law of Diminishing Marginal Returns
• C. Cost Curves
• D. Average-Marginal Rule

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Outline

• III. Production in the Long Run
• A. Economies of Scale
• B. Diseconomies of Scale
• C. Constant Returns to Scale
• D. Relationship between SATC and LATC

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Sunk Costs

• Sunk Cost - A cost, once paid, that can never be
  recovered.
• For instance, you buy a license to sell food.
  Whether you sell the food or not - you have paid
  for this cost and can not sell it or get your
  money back in any way.

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Sunk Cost

• Economics believe that Sunk Cost doesnt matter.
  The reason being that it has been paid and as
  marginal thinkers, we are always concerned with
  future costs and benefits since the past cannot
  be changed.

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Sunk Cost

• For instance, if you are in line at movie theater
  and the other line is going faster - should you
  switch lines?
• Yes. It doesnt matter how long you have
  committed to one lane - your goal is to get out
  fastest and you pick the lane that from that
  moment on, will suit you best in meeting that
  goal. What is done - is done.

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Economic Costs

• Explicit Costs (Accounting Costs) - out of pocket
  payments to owners of factors of production
• Examples wages, payment to power company
• These are the types of costs we normally think
  of. These are costs that are paid with cash.

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Economic Costs

• Implicit Costs - opportunity costs for which
  there are no explicit payments.
• Example foregone rent if own building,
  entrepreneur who gives up wages to run own
  company
• These are the types of costs we rarely think of
  when considering cost. That is because they
  involve no cash changing hands.

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Normal Profits

• Accounting Profits Total Revenue - Explicit
  Costs
• Economic Profits (p) TR - Explicit Costs -
  Implicit Costs
• Economists focus on economic profits.

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Cost Example

• Lets say I quit my job as a Prof at SU and take
  all my savings out to start a Peanut Butter and
  Jelly Company. I use my garage to produce the
  sandwiches and I hire an Assistant Manager. In
  the first year we take in a total of 200,000 in
  sales. I paid out 30,000 for materials (Jelly,
  etc) and equipment, 25,000 for my assistants
  salary, and 5,000 in advertising.

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Cost Example

• My accounting profit is
• 200,000-(30,00025,0005,000)140,000

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Cost Example

• This means I had 140,000 left in my bank account
  at the end of the year, but does this mean I made
  140,000 in economic profit?
• No
• I gave up my salary at SU - lets say, 90,000. I
  could have rented out the garage for 1,000. I
  also could have made 2,000 of interest on my
  money in the savings account.

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Cost Example

• My economic profit is 200,000-(30,00025,0005,00
  0)-(90,0001,0002,000)47,000

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Cost Example

• This means that I have 47,000 more than I would
  have had if I had not opened my company. That is
  what economists are concerned with -- economic
  profit.

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Cost Example

• This is because a rational firm is ultimately
  going to put its resources to where they are
  being compensated the highest. To find out if
  there is any other use of your resources that
  compensates you better, you need to examine the
  economic profit - NOT the accounting profit.
• When we use the word cost for the remainder of
  the course it will be economic costs (both
  explicit and implicit).

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Product Function

• Total Product (TP) (Production Function) - gives
  the maximum amount of output that can be produced
  given any level of inputs used in production.
• Q f(K,L)
• Output (Q) is a function of the amount of inputs
  used (capital (K) and labor (L))

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Marginal Product

• Marginal Product (MP) - the additional output
  that is produced by an additional unit of input.
• Marginal Product of Labor is
• MPL DTP/DL

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Inputs

• Capital and Labor are examples of inputs in
  production.
• Inputs can take on two forms - fixed and
  variable.
• A fixed input is an input that doesnt change as
  you produce more
• for example a peanut butter spreading machine. I
  buy one and use 1 whether I am making 1 or 1000
  sandwiches.

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Inputs

• A variable input is one that changes as you
  produce more
• for example Peanut Butter. As I make more
  sandwiches, I use more peanut butter. Labor is
  also a variable input

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Short Run and Long Run

• short run - a period of time where some inputs
  are fixed
• For example if it takes me 2 months to get a
  second PB spreading machine installed, then the
  short run is 2 months.
• long run - a period of time in which all inputs
  can be varied (no inputs are fixed)

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Short Run- Production Curves

• Diminishing Marginal Product - as more of a
  variable input is added to a fixed input, a point
  is eventually reached where the marginal product
  of the variable input starts to decline.
• Why?
• As we add more labor to a fixed amount of
  capital, each worker has fewer units of capital
  to work with. Eventually each worker will produce
  fewer output than the previous worker.

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Product Concepts and Definitions

• Total product (TP) is the number of units of
  output produced in a given time period.
• Marginal product (MP) is the increase in total
  product, TP, resulting from a one-unit increase
  in the amount of the variable factor (labor)
  employed.
• Average product (AP) is number of output produced
  per unit of the variable factor (labor) employed.

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Total Product Curve

• Total product (TP) curve for sweaters.
• The curve separates what is attainable from what
  is unattainable.

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Total Product Curve

• Derive Marginal product from Total Product Curve

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Marginal Product Curve

• Marginal product (MP) curve for sweaters.
• Marginal product increases and then diminishes.

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Average Product Curve

• Average product (AP) curve for sweaters.
• It also shows the marginal product curve.

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Average Product Curve

• Average product equals marginal product at the
  maximum of average product.

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Average Product Curve

• When marginal product exceeds average product,
  average product is increasing.

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Average Product Curve

• When marginal product is less than average
  product, average product is decreasing.

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Average Product Curve

• When marginal product equals average product,
  average product is at its maximum.

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Initial Increasing Marginal Product

• As a firm uses more of a variable input, with the
  quantity of fixed inputs held constant, the
  marginal product of the variable input at first
  increases.

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Diminishing Marginal Product

• As a firm uses more of a variable input, with the
  quantity of fixed inputs held constant, the
  marginal product of the variable input eventually
  diminishes.

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Intuition on product curves

• Marginal product and average product at first
  increase because of specialization and the
  division of labor.
• Marginal product and average product eventually
  diminish because the gains from specialization
  and the division of labor are limited and the
  plant eventually becomes congested.

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Cost Concepts and Definitions

• Total cost (TC) is the sum of the costs of all
  the inputs used in production. Total cost is
  divided into two parts
• Total fixed cost (TFC) is cost of all fixed
  inputs. Total fixed cost is independent of the
  level of output.
• Total variable cost (TVC) is cost of all variable
  inputs. Total variable cost varies with the
  level of output.

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Cost Concepts and Definitions

• TC TFC TVC

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Marginal Cost

• Marginal cost is the increase in TC resulting
  from a one-unit increase in output. It is
  calculated as the change in total cost divided by
  the change in total output.

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Average Costs

• Average cost is cost per unit of output
• Average fixed cost (AFC) is total fixed cost per
  unit of output.
• Average variable cost (AVC) is total variable
  cost per unit of output.
• Average total cost (ATC) is total cost per unit
  of output.
• ATC AFC AVC

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Average Costs
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Short-run Cost Curves

• Total cost curves
• Average cost curves
• Marginal cost curve

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Total Cost Curves

• The total cost curves for sweaters.
• TFC is constant.
• TC is the sum of TFC and TVC.

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Average and Marginal Curves

• Average cost curves and the marginal cost curve.

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Average and Marginal Curves

• ATC is the sum of AVC and AFC.
• MC intersects ATC and AVC at their minimum points.

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Average and Marginal Curves

• When marginal cost is less than average cost,
  average cost is decreasing.

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Average and Marginal Curves

• When marginal cost exceeds average cost, average
  cost is increasing.

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Average and Marginal Curves

• When marginal cost equals average cost, average
  cost is at its minimum.

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Product Curves and Cost Curves

• When marginal product is increasing, marginal
  cost is decreasing.
• When marginal product is decreasing, marginal
  cost is increasing.

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Product Curves and Cost Curves

• When average product is increasing, average cost
  is decreasing.
• When average product is decreasing, average cost
  is increasing.

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Product Curves and Cost Curves

• When average product is at its maximum, average
  variable cost is at its minimum.

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Costs in the Long Run

• In the short run some costs are fixed.
• In the long run, every input is variable

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Costs in the Long Run

• Because many costs are fixed in the short run but
  variable in the long run, a firms long-run cost
  curves differ from its short-run cost curves.

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Average Total Cost in the Short and Long Runs...
Average
Total
Cost
0
Quantity of
Cars per Day
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Economies and Diseconomies of Scale

• Economies of scale occur when long-run average
  total cost declines as output increases.
• Diseconomies of scale occur when long-run average
  total cost rises as output increases.
• Constant returns to scale occur when long-run
  average total cost does not vary as output
  increases.

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Economies and Diseconomies of Scale
Average
Total
Cost
0
Quantity of
Cars per Day
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Specific Example Each of the following
represent SATC curves at 3 different factory
sizes that are fixed in the short run

• Suppose we initially have a small factory and
  were producing one unit of output. If we want
  to increase output in the short run, how do we
  have to do it?
• add more variable inputs

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Specific Example

• In the long run, is that the only option?
• No, build a bigger factory 

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Specific Example three possible factory (K)
sizes

• The least expensive way to produce Q 1 is with
  a ___________ factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 1 is with
  a small factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 2 is with
  a ___________ factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 2 is with
  a small factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 3 is with
  a ___________ factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 3 is with
  a medium factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 4 is with
  a ___________ factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 4 is with
  a medium factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 5 is with
  a ___________ factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 5 is with
  a medium factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 6 is with
  a ___________ factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 6 is with
  a large factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 7 is with
  a ___________ factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q 7 is with
  a large factory.

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Specific Example 3 possible factory (K) sizes

• The least expensive way to produce Q gt7 is with
  a ___________ factory.

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In the long run, you can choose any size factory
you want...what is the LATC curve?
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In the long run, you can choose any size factory
you want...what is the LATC curve?
LATC Minimum of the SATCs!
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What is the relationship between short run and
long run average costs and why?
LATC Minimum of the SATCs!
SATC LATC
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As another example,

• suppose you have three dorm parties throughout
  the year. You find out that the first one is
  tomorrow and you are constrained in the short run
  to buy all your supplies at the bookstore. How
  will your costs/person (average costs) differ in
  the long run, when you have more time to shop
  around?
• Short run costs are always at least as high as
  long run costs because you have more flexibility
  in the long run.

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Where do increasing economies of scale exist?
LATC
Economies of Scale
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Where do diseconomies of scale exist?
LATC
Diseconomies of Scale
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General Example many possible levels of fixed
inputs
If these are many SATC, what does the LATC look
like?
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If these are many SATC, what does the LATC look
like?
LATC - minimum of SATC
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The U-shape LATC curve
LATC
Diseconomies of Scale
Economies of Scale
Constant Returns to Scale
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Where is the optimal firm size?
LATC
Minimum Efficient Scale - lowest average costs
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Relationship between economies of scale and
industry structure
If Large ECONOMIES OF SCALE Diseconomies of
Scale set in only when the firm is very large
LATC
Q
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Relationship between economies of scale and
industry structure
If Large ECONOMIES OF SCALE Diseconomies of
Scale set in only when the firm is very large
LATC
Optimal Firm Size Big Few or Many Firms in the
industry few
Q
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Relationship between economies of scale and
industry structure
If DISECONOMIES OF SCALE set in when the firm is
very small
LATC
Optimal Firm Size Small Few or Many Firms in
the industry Many
Q
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Exercise ( Page 288,Prblem 5)A worker costs 100
a day. Fixed cost is 200
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Answer ATCTC/Q, MC DTC/DQ
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Answer

• a. Marginal product rises at first, then declines
  because of diminishing marginal product.
• b. See table for total cost.
• c. Average total cost is U-shaped. When quantity
  is low, average total cost declines as quantity
  rises when quantity is high, average total cost
  rises as quantity rises.
• d. Marginal cost is also U-shaped.
• e. When marginal product is rising, marginal cost
  is falling, and vice versa.
• f. When marginal cost is less than average total
  cost, average total cost is falling when
  marginal cost is greater than average total cost,
  average total cost is rising.