principles of microeconomics - costs of production

8/3/2019 Principles of Microeconomics - Costs of Production

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The Costs of Production

Dr. Katherine Sauer

Principles of Microeconomics

ECO 2020


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Basic economic assumption:

firms attempt to maximize profits

It is possible for firm owners to have different goals.

The one motive that makes the most accuratepredictionabout how firm managers behave is the assumption of

profit maximization.

Analogy: What is the goal of most automobiledrivers?

- to get from point A to point B in the shortest

amount of time


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I. Profit

The goal of a firm is to maximize profit.

Profit = Total Revenue Total Cost

= TR TC

Total Revenue = price x quantity

Total Cost = market value of all inputs used inproduction


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To an economist, the costs of producing an item must

include all of the opportunity costs of inputs used in

production.

Costs include both implicit and explicit costs.

explicit costs: input costs that require an outlay of moneyby the firm

ex: wages, electricity, raw materials

implicit costs: input costs that do not require an outlay of

money by the firm

ex: forgone interest earned on money spent


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Ex: Caroline uses $300,000 of her savings to start her

firm. It was in a savings account paying 5% interest.

When she takes the money out of savings, she no

longer earns interest on it.

($300,000)(0.05) = $15,000 forgone interest

Because Caroline could have earned $15,000 per year

on this savings, we should include this in her total

cost.

$15,000 is an implicit cost

$300,000 is an explicit cost

$315,000 is the total cost


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If Caroline had instead borrowed $200,000 from a bank

at 7% interest and used $100,000 from her savings:

Implicit cost = ($100,000)(0.05) = 5,000 forgone interest

Explicit cost = $100,000 from savings

+ $200,000 borrowed+ ($200,000)(0.07) = $14,000 interest

Payments =

$314,000

Total cost =

$319,000


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The inclusion of all opportunity costs in calculating profits

is the major way in which accountants and economists

differin analyzing the performance of a business.

Accountants focus on explicit costs.

Economists examine both explicit and implicit costs.


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Economic Profit vs Accounting Profit

A = total revenue explicit costs

E = total revenue explicit costs implicit costs

Accounting profit will always exceed economic profit.

(as long as there are implicit costs)


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Ex: Wages $10,000

Supplies $20,000

Forgone interest $1,500

Utilities $2,000

Price of Product $33

Quantity sold 1000

Calculate Accounting profit and Economic profit.Total Revenue =

33,000

Explicit Costs =

32,000

Implicit Costs =1,500

A = 33,000 32,000 = $1,000

E

= 33,000 32,000 1,500 = -$500


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II. Production and Costs in the Short Run

Short Run = one or more inputs are fixed

Long Run = all inputs are variable

A. Production

Production function = the relationshipbetween the quantity

ofinputs used and the quantity ofoutput that results

Total Product = TP = Output = Q


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Ex: Lets grow some rice.

Outside Guilin, China May 2008

- volunteers: 8 farmers to grow rice

- fixed lot of land

- one water buffalo


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Number

of

Workers

Amount

Produced

Average amount

produced per

worker

(average product)

Additional amount

produced from

each extra worker

(marginal product)

0

1

2

3

4

5

6

7

8


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Trends we notice:

As the number of workers rises, what happens to total output?

As the number of workers rises, what happens to average

product?

As the number of workers rises, what happens to marginalproduct?


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Graph the resultingproduction function:

#workers

totalrice

produced

0 1 2 3 4 5 6 7 8 9


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Graph the resulting output per workercurves:

#workers

riceproduced

per

worker

0 1 2 3 4 5 6 7 8 9


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Recap:

Total Product (TP) is the amount produced.

aka output, quantity(Q)

Average Product of Labor = total output = AP# workers

Marginal Product of Labor = change in output = MP

change in labor

In general, marginal product is the increase in output that arises

from an additional unit of input.


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As the amount of labor used increases, the marginal product of

labor falls.

Diminishing marginal product is the property whereby the

marginal product of an input declines as the quantity of the input

increases.

- the more of an input used, output will increase by

less and less

- output increases at a decreasing rate


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Ex: Consider the short-run production of a small firm that makes

sweaters. These sweaters are made using a combination of labor

and knitting machines. In the short run, the firm has signed alease to rent one machine. Therefore, in the short run, the firm

cannot vary the amount of knitting machines it uses. However,

the firm can vary the amount of labor it employs.

Labor Total(#workers) output

0 0

1 4

2 10

3 134 15

5 16

Average MarginalProduct Product

---- ----4 / 1 = 4 (4-0) / (1-0) = 4

10 / 2 = 5 (10-4) / (2-1) = 6

13/ 3 = 4.33 (13-10)/ (3-2) = 315/ 4 = 3.75 (15-13)/ (4-3) = 2

16/ 5 = 3.2 (16-15)/ (5-4) = 1


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Trends we notice:

As the number of workers rises, what happens to total output?

As the number of workers rises, what happens to average

product?

As the number of workers rises, what happens to marginalproduct?


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Here are the shapes of typical Total Product, Average Product, and

Marginal Product curves:

Total

Product(output)

Average

product

Marginalproduct

output output per

input

input input

Marginal Product

intersectsAverage Product at

Average Products

maximum


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Average

product

Marginal

product

output perinput

input

MP = AP

The Average-MarginalRule:

If MP > AP then AP is

rising.

If MP < AP then AP is

falling.

If MP = AP then AP is at

its maximum.

AP

MP

AP

MP


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Example:

Suppose triplets are enrolled in Principles of Microeconomics.

They each had a B average (GPA = 3.0) before taking the class.

Triplet One gets a C in the course. What happens to herGPA?

Triplet Two gets an A in the class. What happens to herGPA?

Triplet Three gets a B in the class. What happens to herGPA?

When the additional grade (marginal grade) is higher the

overall GPA (average grade) goes up.

When the additional grade (marginal grade) is lower the overall

GPA (average grade) falls.

When the additional grade (marginal grade) is the same the

overall GPA (average grade) doesnt change.


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B. Costs

Inputs are not free. The more output a firm produces, the

more inputs it needs to acquire.

Intuitively, we understand that as total output rises, so do

total costs of production.


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There are two types of costs:1. fixed costs: costs that do not vary with the

quantity of output produced.

ex: warehouse lease, payments on a loan

2. variable costs: costs that do vary with the

quantity of output produced.

ex: raw materials, electricity


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Consider the sweater manufacturer again. Suppose the

firm is currently renting one machine for $25 per day.

Each worker is also paid $25 per day.


0 0

1 4

2 10

3 13

4 155 16

Fixed Variable TotalCost Cost Cost

0 2525 50

50 75

75 100

100 125125 150

25

25

25

25

2525


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Trends we notice:

What happens to fixed costs as output increases?

What happens to variable costs as output increases?

What happens to total cost as output increases?


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total cost = fixed costs + variable costs.

TC = FC + VC

Total Cost

Output

Fixed Cost

Because fixed costs

dont vary with the

amount produced, the

fixed cost curve is ahorizontal line at the

value of the fixed cost.

Even if the firmproduces nothing, it will

incur the fixed cost.


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Total Cost

Output

Fixed Cost

Variable costs increase

as output increases, so

the variable cost curve

is upward sloping.

If the firm produces

nothing, then it incurs

no variable cost.- curve starts at

zero

Variable Cost


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Cost

Output

Fixed Cost

Since total cost is the

sum of fixed cost and

variable cost, it slopes

up and has an interceptequal to the value of

fixed cost.

Variable Cost

Total Cost


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In addition to total costs, firms are interested in the cost

per unit of output produced:

average total cost: total cost divided by the quantity of

output

ATC = TC

Q

average fixed cost: fixed costs divided by the quantity of

output

AFC = TFCQ


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average variable cost: variable costs divided by thequantity of output

AVC = TVC

Q

marginal cost: the increase in total cost that arises from

an extra unit of production

MC = change in TC = change in TVC

change in Q change in Q


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0 0

1 4

2 10

3 134 15

5 16

Fixed Variable TotalCost Cost Cost

0 2525 50

50 75

75 100100 125

125 150

25

25

25

2525

25

Average Average Average

Fixed Variable Total Marginal

Cost Cost Cost Cost---

6.25

2.50

1.921.67

1.56

---

6.25

5.00

5.776.67

7.81

---

12.50

7.50

7.698.33

9.38

---

6.25

4.17

8.3312.50

25.00


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Trends we notice:

What happens to Average Fixed Cost as output increases?

What happens to Average Variable Cost as output increases?

What happens to Average Total Cost as output increases?

What happens to Marginal Cost as output increases?


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Here are the shapes of typical average fixed cost, average

variable cost, average total cost, and marginal cost curves.

Average Total Cost

Marginal

Cost

cost perinput

output

Average Variable Cost

Average Fixed Cost


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Focus for a moment on the relationship between average

cost and marginal cost:

Marginal

Cost

cost perinput

output

Average Cost

The Average-MarginalRule applies here:

If MC > AC then AC

rising.

If MC < AC then AC

falling.

If MC = AC then AC is at

its minimum.

MC = AC

AC

MC

AC

MC


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Marginal

Cost

cost perinput

output

Average Total

Cost

The quantity that

corresponds to the

minimum of AverageTotal Cost has a

special name:

efficient scale

qE


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Note the relationship between marginal product and

marginal cost:

Marginal

Cost

cost perinput

output

Marginal

product

output perinput

input


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III. Production and Cost in the Long Run

A. Production

In the long run, all inputs are variable.

B. Costs

In the long run, there are no fixed costs.


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The Long Run Average Cost Curve is found by tracing out

the minimums of all of the Short Run Average Total Cost

curves.

output

Average

Cost

ATC for firm

of size 1ATC for firm

of size 5

LRAC


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For a given firm, its LRAC is usually a flat u-shape.- range of output where average costs are falling as output rises

- range of output where average costs are rising as output rises

output

Average

Cost

LRAC

Economies of Scale Diseconomies of Scale

qE


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Economies of Scale often occur when a firm has high

overhead and large fixed costs.

- automobile manufacturer needs to make a highvolume of vehicles to make up for the factory

costs

Diseconomies of Scale often occur when a firm is so bigthat it is experiencing coordination and communication

issues.

- different branches of Sony have sued each other

not realizing they were both part of Sony

Constant Returns to Scale = average costs stay constant

as output increases.


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Chapter Summary:

The goal of firms is to maximize profit (total revenue

minus total cost).

When calculating profits, it is important to include all

the opportunity costs of production.

A firms costs reflect its production process.- diminishing marginal product

- total-cost curve gets steeper as the quantity

rises


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A firms total costs can be divided between fixed costs

and variable costs.

- Fixed costs are costs that do not change whenthe firm alters the quantity of output produced.

- Variable costs are costs that do change when the

firm alters the quantity of output produced.

Average total cost is total cost divided by the quantity

of output.

Marginal cost is the amount by which total cost rises if

output increases by one unit.


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For a typical firm, marginal cost rises with the quantity

of output.

Average total cost first falls as output increases and then

rises as output increases further.

The marginal-cost curve always crosses the average

total cost curve at the minimum of average total cost.


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A firms costs often depend on the time horizon being

considered.

- many costs are fixed in the short run but

variable in the long run

principles of microeconomics - costs of production

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