ecn 2 q
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2PTheCostsofProducction.pptxThe Costs of Production
Please listen to the audio as you work through the slides.
Creative Commons Attribution 4.0 License, Charles Hackner Houston Community College unless otherwise noted CC BY NC
Where are we going?
Going forward we will bring product demand, product price, and revenue together and explain how firms compare revenues and costs in determining how much to produce (the profit maximizing level of output).
Ultimate goal – to show how those comparisons relate to economic efficiency in various market structures.
Learning objectives
Students should be able to thoroughly and completely explain:
How the long run ATC curve is derived.
How the presence of economies of scale or diseconomies of scale impact the shape of the LR ATC curve.
The Short Run Production Relationships
The Law of Diminishing Returns
Economic Costs
From a general economic perspective
The measure of economic cost, or opportunity cost, of any resource used to produce a good is –
The value or worth the resource would have in its best alternative use.
Economic Costs
From the firm’s point of view
Economic Costs – the payments a firm must make, or the
incomes it must provide, to attract the resources it needs away from
alternative production opportunities
More Specifically we consider:
Explicit Costs – actual (payments to resource suppliers)
Implicit Costs – opportunity costs of using (self-owned or self-employed) resources.
- The money payments those resources could have earned in their best alternative use.
Accounting profit versus Economic profit
An example:
You go from being an employee to a business owner
Formerly Earning $22,000 / yr as sales rep for T-shirt mfr.
Invest $20,000 of savings that were earning $1000 /yr.
Start your own T-shirt company.
Use a store that you have been renting out for $5000 / yr.
Hire a clerk at $18,000 / yr
How successful is this business?
Explicit Costs
Implicit costs
How successful is this business?
Treated as a cost
Required to attract & retain resources -
(entrepreneurial ability)
Economic or Pure Profits
Economic
Profit
Total
Revenue
Economic Cost
Normal Profits
Economic Costs
Economic
Profit
Implicit costs
(including a
normal profit)
Explicit
Costs
Accounting
costs (explicit
costs only)
Accounting
Profit
Economic (opportunity) Costs
T
O
T
A
L
R
E
V
E
N
U
E
Profits to an
Economist
Profits to an
Accountant
Economic Costs
Economic profit = total revenue – economic cost
Economic cost = explicit cost + implicit cost
Just to be clear
Short run and long run: The role of Time
When the demand for a firm’s product changes,
the firm’s profitability may depend on how quickly it can adjust the amounts of the various resources it employs in the production of that product.
Short Run and Long Run
Accounting:
Short and long run is based upon annual chronology.
Economics:
Short run has fixed plant capacity.
Long run all resources are variable
For the industry, the long run includes enough time for firms to enter and exit the industry
12
Short-Run Production Relationships
Firm’s costs of producing a specific output are a function of:
Resource prices and
The quantities of inputs needed to produce a given level of output.
Resource demand and supply determine resource prices.
The production function:
The technological relationship between inputs and output determine the quantities of resources needed: called
(Google this to learn more)
3. Average Product (AP) – output per unit of (labor) input (labor productivity)
1. Total Product (TP) – total output of the good produced.
2. Marginal Product (MP) – the extra output that results from adding a unit of a variable resource.
Example – the marginal product of labor
3 Short-Run Production Relationships
Marginal Product =
Change in Total Product
Change in Labor Input
Average Product =
Total Product
Units of Labor
Concerns of the firm
In the short run, a firm can for a time, increase its output by adding units of labor to its fixed plant.
But by how much will output rise when the firm adds each unit of labor?
How long will the firm be able to get increased output?
Why do we say “for a time”?
Transition to Law of Diminishing Returns
Law of Diminishing Returns
Assumptions:
Technology is fixed
Production techniques do not change.
All units of labor are of equal quality.
Definition:
As successive units of a variable resource are added to a fixed resource, beyond some point the extra, or marginal product that can be attributed to each additional unit of the variable resource will decline.
Increasing
Marginal
Returns
Law of Diminishing Returns
(1)
Units of the
Variable Resource
(Labor)
(2)
Total Product
(TP)
(3)
Marginal Product
(MP),
Change in (2)/
Change in (1)
(3)
Average
Product
(AP),
(2)/(1)
0
1
2
3
4
5
6
7
8
0
10
25
45
60
70
75
75
70
10
15
20
15
10
5
0
-5
-
10.00
12.50
15.00
15.00
14.00
12.50
10.71
8.75
]
]
]
]
]
]
]
]
Diminishing
Marginal
Returns
Negative
Marginal
Returns
0
10
20
30
Total Product, TP
1
2
3
4
5
6
7
8
9
20
10
Marginal Product, MP
1
2
3
4
5
6
7
8
9
TP
MP
AP
Increasing
Marginal
Returns
Diminishing
Marginal
Returns
Negative
Marginal
Returns
Law of Diminishing Returns
Q
Q
1. Fixed Costs – do not vary with changes in output
Total Fixed Costs – rent, insurance, interest
Average Fixed Costs =
Total Fixed Costs
Quantity of output
2. Variable Costs – change with level of output.
Total Variable Costs – materials, fuel, transportation, labor
Average Variable Costs =
Total Variable Costs
Quantity of output
Short-run Production Costs
3. Total Cost
Total of Fixed and Variable Costs at each level of output
Average Total Cost =
Total Costs
Quantity of output
4. Marginal Cost
The additional cost of inputs required to produce each successive unit of output.
Marginal Cost =
Change in Total Costs
Change in Quantity of output
Short-run Production Costs
Fixed costs and variable costs from the point of view of the business manger
Variable costs can be controlled in the short-run by changing production levels.
Fixed costs are beyond the control of the business manager, in the short run.
Those fixed costs must be paid regardless of output level.
Marginal Cost = MC = change in TC / change in quantity
Total Fixed Costs = TFC
Total Variable Costs = TVC
Average Variable Costs = AVC = TVC / quantity
Total Costs = TC = TFC + TVC
Average Total Costs = ATC = TC / quantity
Average Fixed Costs = AFC = TFC / quantity
Summary of Definitions
Short-run Production Costs
Short-Run Costs Graphically
Quantity
Costs (dollars)
TC
Total
Cost
Fixed Cost
TVC
Variable Cost
TFC
Combining TVC
With TFC to get
Total Cost
Short-Run Costs Graphically
Quantity
Costs (dollars)
AFC = TFC/ output
AVC = TVC/output
ATC=TC/output
MC= change in TC / change in output
Plotting Average and
Marginal Costs
Productivity and Cost Curves
Costs (dollars)
Average product and
marginal product
Quantity of labor
Quantity of output
MP
AP
MC
AVC
If all units of a
Variable resource (labor) are the same price, The MC of each extra unit of output will fall as long as the Marginal product of each additional worker is rising.
Production Relationships - Summary
Marginal cost and diminishing returns
The shape of the MC curve is a consequence of the law of diminishing returns.
Marginal cost and marginal product
As MP increases, MC decreases
Marginal cost and average variable cost
When AVC is falling, MC is rising
Marginal cost and average total cost and AVC
MC curve intersects both at their respective minimum points.
Productivity curves and cost curves
When MP is rising, MC is falling and when MP is falling, MC is rising
Shifts in cost curves
Changes in either resource prices or technology will cause costs to change and cost curves to shift.
Long-Run Production Costs
All such plant capacities
can be plotted.
For every plant capacity size...
there is a short-run ATC curve.
Long-Run Production Costs
Unit Costs
Output
Long-Run Production Costs
Unit Costs
Output
Long-Run Production Costs
The long-run ATC curve just “envelopes”
all of the short-run ATC curves.
Unit Costs
Output
Long-Run Production Costs
Unit Costs
Output
long-run ATC
Economies of Scale
Reductions in the average total cost of producing a product, as the firm expands the size of its plant (its output) in the long run;
The economies of mass production
Factors that influence Economies of Scale
Labor specialization
Managerial specialization
Efficient use of capital
Declining start-up costs
Learning by doing
All lead to lower long run ATC as the firm expands
Diseconomies of Scale
Increases in the average total cost of producing a product as the firm expands the size of its plant (its output) in the long run.
Factors that influence Diseconomies of Scale
Increasing levels of complexity.
Increasing # of management levels
Worker alienation
Constant Returns to Scale
The range over which long – run average total cost does not change
Long-Run ATC Shapes
Output
Long-run ATC curve where economies
of scale exist
Average Total Costs
Long-Run
ATC
Economies
Of Scale
Constant Returns
To Scale
Diseconomies
Of Scale
q1
q2
8-36
Output
Long-run ATC curve where costs are lowest
only when high levels of output are achieved
Average Total Costs
Economies
Of Scale
Diseconomies
Of Scale
Long-Run
ATC
Long-Run ATC Shapes
Output
Long-run ATC curve where economies of scale exist, are exhausted quickly, and become dis-economies of scale.
Average Total Costs
Long-Run
ATC
Economies
Of Scale
Diseconomies
Of Scale
Long-Run ATC Shapes
8-38
Minimum Efficient Scale and Industry Structure
Minimum Efficient Scale - MES
The lowest level of output at which a
firm can minimize long – run average total costs.
Why would this be a good level of output to achieve?
Economies and
Diseconomies of Scale
Unit Costs
Output
long-run ATC
Economies
of scale
Unit Costs
Output
long-run ATC
Economies
of scale
Constant returns
to scale
Economies and
Diseconomies of Scale
Unit Costs
Output
long-run ATC
Where economies
of scale are
quickly exhausted
Case for many
Small firms in
An industry
MES achieved quickly
Many retail trades, some farming
Economies and
Diseconomies of Scale
Minimum Efficient Scale and Industry Structure
Natural Monopoly
A relatively rare situation in which average total cost is minimized when only one firm produces the particular good or service
Example: electricity generation
The shape of the long-run ATC curve
Determined by:
Technology – how?
Economies of scale – how?
Diseconomies of scale – how?
Applications & Illustrations
Rising Cost of Insurance and Security, the 9/11 case
In the short run they are fixed – independent of output levels. Short-run ATC shifted upward.
Successful Start-Up Firms
Specialization, new technology
Short-run cost curves shift downward with output expansion.
Economies of scale
The Verson Stamping Machine
large firm size leads to achievement of economies of scale
Aircraft and Concrete Plants
MES radically different in the two industries
Economies of scale extensive in aircraft manufacture
Economies of scale exhausted quickly in cement plants
Different geographic market sizes
KEY TERMS
Total Sales Revenue 120000
Cost of T-shirts40000
Clerk's salary18000
Utilities5000
Total Explicit Costs63000
Accounting Profit57000
Foregone Interest1000
foregone rent5000
foregone wages22000
Total implicit costs 28000
Total Economic Cost91000
Economic profit29000
Sheet1
| Total Sales Revenue | 120000 | ||
| Cost of T-shirts | 40000 | ||
| Clerk's salary | 18000 | ||
| Utilities | 5000 | ||
| Total Explicit Costs | 63000 | ||
| Accounting Profit | 57000 |
Sheet2
Sheet3
Sheet1
| Total Salels Revenue | 120000 | ||
| Cost of T-shirts | 40000 | ||
| Clerk's salary | 18000 | ||
| Utilities | 5000 | ||
| Total Explicit Costs | 63000 | ||
| Accounting Profit | 57000 | ||
| Accounting Profit | 57000 | ||
| Foregone Interest | 1000 | ||
| foregone rent | 5000 | ||
| foregone wages | 22000 | ||
| Total implicit costs | 28000 | ||
| Total Economic Cost | 91000 | ||
| Economic profit | 29000 |
