Chapter 22: The Costs of Production

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Chapter 22 The Costs of Production

• Content and Visuals from McConnell/Brues
  Economics

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Overview

• Economic costs of making something
• Production costs of making something
• Long-Run production costs of making something
• 30 total slides

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Economists are not normal

• Normal people think of costs as being the amount
  of money required to get something
• Economists also do, but consider OPPORTUNITY COST
  as well
• The best thing given up in order to choose
  something else

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Two kinds of costs

• That being said, we economists consider both
  EXPLICIT and IMPLICIT COSTS
• EXPLICIT costs are the monetary ones that most
  people normally think of
• IMPLICIT costs are the opportunity costs, or what
  you dont get when choosing

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Going to the Movies

• Normal people might think that going to the
  movies costs 7
• Economists might think that going to the movies
  costs 7 plus you cannot study for the big
  economics test
• But what difference does it make?

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Consider two thinkers

• Mr. Accountant evaluates cost, and therefore
  profit, solely in terms of REVENUE EXPLICIT
  COSTS, or in other words amount taken in minus
  amount paid out

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Economist thinker

• Mr. Economist is going to agree with the
  accountant, but also insist that we also subtract
  the IMPLICIT COSTS
• PROFIT REVENUE (EXPLICIT IMPLICIT COSTS)
• What difference does it make?

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Assume you make lunch

• The cost of making a sandwich in dollar values is
  probably .50 (normal costs)
• If you include the fact that you would really
  like a cheesesteak the cost becomes .50 the
  cheesesteak you really want (economic costs)

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Long Story Short

• Basically all that matters with this is the idea
  that you pay money to get stuff, but also give up
  other thingswhich must add to your
  interpretation of the overall total cost

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Bunch of Letters

• So far in this course we have discussed GDP, GNP,
  NDP, DI, PI, APC, APS, MPS, MPC, and so on
• Today we also get to add TP, AP, MP, FC, TC, VC,
  AFC, ATC, AVC, MC
• Plus we get to turn them into a graph, which is
  the single biggest thing we do in micro!!!

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Start at the End

• Product is the amount of stuff you produce
• If we are talking about total product (TP) we
  mean the entire amount produced
• Average product (AP) is the amount produced per
  unit of input
• ALWAYS MEASURED IN TERMS OF ONE INPUTfor
  example, the AP of labor
• Marginal product (MP) is the EXTRA amount gained
  from adding one more
• Like AP, also specified in terms of ONE INPUT,
  MEASURING THE AMOUNT ADDED FROM ADDING ONE MORE
  UNIT OF SOMETHING

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Marginal is the KEY

• What we have already done or already have means
  absolutely nothing when making a choiceits what
  we have to gain that matters
• The Marginal, or extra, will be the driving force
  behind all of the Micro rules laws
• You make decisions seeking to maximize your
  future utility, through the MARGINAL

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Diminishing Marginal again

• The concept of diminishing marginal utility is
  used to explain the downward sloping demand curve
• The same concept applies here in regards to
  production, but with a different name

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Law of Diminishing Returns

• Assumption that if you keep everything else the
  same, and continue adding one more unit of
  something, eventually the MP, or marginal return,
  will begin to decrease
• It doesnt necessarily mean your overall total
  product will decrease, but definitely the extra
  you gain from the last one

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Think about taking vitamins

• If you take a vitamin you are more likely to be
  healthy, maybe for a value of 25
• If you take a second vitamin it might not help a
  lot, or with everything, but it might provide
  some benefit for a value of 10
• The third vitamin might be too much and provide
  no benefit
• The fourth might make you sick and actually
  produce a negative benefit of 5 (hurt you)

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Marginal Product

• The MP of the first vitamin is 25 (25-0)
• The MP of the second is 10, followed by 0 and 5
• The total product is 30

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BREAK

• If we havent taken a break in awhile, relax for
  a few minutes
• If we took about 70 so far and only spent 3 1/3
  minute on task then take a 1 minute SAT-style
  stand and stretch without moving or talking break

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The actual costs of production

• Lets say we are going to make some cookies
• We would need (to be simple) the following
• Cookie dough, electricity, pan, oven, labor

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Fixed and Variable Costs

• Everything can be divided into 2 categoriesfixed
  and variable
• Fixed includes all of the CAPITAL RESOURCESor
  anything that will be reused again later
• Variable includes all of the LAND RESOURCESor
  anything that gets used in the product itself

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Buy once or repeat

• Fixed costs are only purchased once and
  reusedTollhouse can use a factory for years
• Variable costs must be continually purchased to
  allow for increased production
• Based on this concept we could look at the VC,
  FC, TC, AVC, ATC, AFC, and MC of making cookies

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The Key is the Relationship

• MC is the most important onefuture decisions all
  that matters
• Graph will simply be memorized, but there are a
  few LAWS that MUST BE DRAWN CORRECTLY
• MC always intersects ATC and AVC at lowest points
• The graph of these things then looks like this

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Graph Means the World

• I cannot emphasize enough how important this
  single graph is
• You must draw and redraw this graph over and over
  again
• Know it to perfection

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What can you see with it?

• Biggest thing to realize is that the cost curves,
  almost, always go up at the end
• That means that eventually it will cost more to
  produce more (diminishing returns)
• The idea of how much it will cost to produce more
  creates categories

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Last page of new stuff

• Economies of Scalebigger you get, the cheaper
  you produce (Wal-Mart)
• Diseconomies of Scaleget bigger and costs get
  bigger (keep production small)
• Constant Returns to Scaleaverage cost stays the
  same with size (barbers)
• Also known as Increasing, Decreasing, and
  Constant Returns to Scale

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HUGE TECHNICALITY

• Many fail to grasp this single concept and
  therefore struggle unnecessarily
• MP and MC refer to adding or changing ONE SINGLE
  INPUT
• Ie MP of adding one more unit of labor
• RETURNS TO SCALE refers to changing ALL INPUTS in
  the same manner
• Ie adding one more unit of everything

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Monopolies can be good

• Increasing Returns to Scale allow for NATURAL
  MONOPOLIES to arise
• Situation in which costs continually decrease
  when there is one producer, and it doesnt make
  sense to have any competitors
• Public utility companies

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Summary

• Its going to take some time and practice to
  cement these ideas
• The letters will make sense soon
• The graph MUST be memorized very, very soon
• Application will help it to make sense, but also
  accept this stuff as rule and know it
• LIFE GETS EASY IF YOU DO!!!