Chapter 20: Production and Costs

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Chapter 20 Production and Costs

• economic costs profits
• short run
• long run

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big picture

• understand behavior of firm
• understand measure
• production
• costs

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I. economic costs profits

• firms goal
• maximize profit
• look at factors that affect firms decision

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economic costs

• opportunity cost of resources used
• explicit costs
• paid in money
• wages, rent, material, etc.
• implicit costs
• opportunity cost of resources used

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example smoothie shop

• explicit costs
• wages
• interest on loan
• rent on store
• fruit, blenders

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• implicit costs
• forgone interest on funds used to buy capital
• owners forgone wages
• owners forgone profit from other venture

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accounting profit

• total revenue explicit costs
• ignores opportunity cost

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economic profit

• includes opp. costs
• total revenue - total costs
• (price)(quantity)
• - (explicit implicit costs)

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normal profit

• occurs when
• amount of accounting profit
• opportunity costs of resources
• if earning a normal profit,
• economic profit 0

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Short Run vs. Long Run

• Short Run (SR)
• time frame where some resources are fixed
• -- plants, equipment
• some inputs variable
• -- labor
• SR decisions are reversible

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• Long Run (LR)
• time frame where all inputs are variable
• --build a bigger plant
• LR decisions are hard to reverse
• -- cannot easily get rid of capital
• -- sunk cost

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II. SR Production

• measures of output
• total product
• marginal product
• average product

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total product (TP)

• total quantity of good produced
• in a given period
• at first, increases with labor,
• then falls

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TP gal. of smoothies per hour
workers
TP
0 1 2 3 4 5 6 7
0 1 3 6 8 9 9 8
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TP
workers
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marginal product (MP)

• change in TP due to one more worker

change in TP

change in labor
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At first MP rises with workers

• add more workers
• greater specialization
• MP of each worker added is larger
• than previous worker
• increasing marginal returns

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then, MP falls with more workers

• keep adding workers
• but same amount of capital
• so eventually get in the way
• MP of more workers smaller than
• MP of previous workers
• decreasing marginal returns

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TP, MP gal. of smoothies
workers
TP
MP
0 1 2 3 4 5 6 7
0 1 3 6 8 9 9 8
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MP
Q workers
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law of decreasing returns

• As firm uses more labor
• with capital fixed,
• MP of labor will eventually fall

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Average Product (AP)
TP

labor
productivity
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AP
workers
TP
MP
0 1 2 3 4 5 6 7
0 1 3 6 8 9 9 8
1 1.5 2 2 1.8 1.5 1.1
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MP
AP
workers
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MP AP

• MP intersects AP at max of AP
• why?
• MP gt AP
• AP is rising
• MP lt AP
• AP is falling

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III. SR cost

• measure cost 3 ways
• total cost
• marginal cost
• average cost

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Total Cost (TC)

• cost of all factors used
• total fixed cost (TFC)
• cost of land, capital, etc.
• does not change in SR
• total variable cost (TVC)
• cost of labor
• changes in SR
• TC TFC TVC

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example yogurt

• labor 6/ hour
• TFC 10/ hour

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0 0 10 0
10
1 1 10 6
16
1.6 2 10 9.6
19.6
2 3 10 12
22
10 10
4 5
8 9
24 30
34 40
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Marginal Cost

• change in TC due to one-unit increase in output
  (Q)

change in TC

change in Q
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MC
0 10 0 10
1 10 6 16
2 10 9.6 19.6
3 10 12 22
10 10
8 9
24 30
34 40
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Average Cost (ATC)

• TC/Q
• average fixed cost (AFC)
• (TFC/Q)
• average variable cost (AVC)
• (TVC/Q)
• ATC AFC AVC

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AFC AVC AC
0 10 0 10
1 10 6 16
10 6 16
2 10 9.6 19.6
5 4.8 9.8
3 10 12 22
3.33 4 7.33
10 10
1.25 3 4.25
8 9
24 30
34 40
1.11 3.33 4.44
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MC AC

• MC intersects AC at its minimum
• MC lt AC
• AC is falling
• MC gt AC
• AC is rising

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AC is U-shaped

• why?
• AFC falls with Q
• AVC falls then rises
• decreasing marginal returns
• so ATC falls, then rises

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cost product curves

• when MP is at maximum,
• MC is at minimum
• when AP is at maximum,
• AVC is at minimum

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what shifts cost curves?

• technology
• make more with same inputs
• shifts TP, MP, AP up
• changes ATC curve

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• changes in factor prices
• increase fixed costs
• -- TFC, AFC shift up
• -- TC shift up
• increase wages (variable)
• -- TVC, AVC, MC shift up
• -- TC shift up

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IV. LR costs

• all inputs (and costs) are variable
• what happens if increase plant
• AND labor by 10?
• ATC fall?
• ATC rise?
• ATC stay same?

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Economies of scale

• increase inputs 10
• output increase gt 10
• ATC falls
• why?
• gains from specialization
• -- labor
• -- capital

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Diseconomies of scale

• increase inputs 10
• output increase lt 10
• ATC rises
• why?
• too hard to control large firm

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Constant returns to scale

• increase inputs 10
• output increase 10
• ATC stays same

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LR Average Cost (LRAC)

• lowest average cost when all inputs are variable
• SRAC curves from different plant sizes

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LRAC
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diseconomies of scale
economies of scale
constant returns to scale
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summary

• costs implicit explicit
• SR, only labor variable
• LR, all inputs variable
• Production costs
• total, marginal, average
• fixed, variable