The Costs of Production

Mr. Raposo

What is a business?

• Business: An enterprise that brings individuals, financial and economic resources to produce goods or

• services.• Sole Proprietorship: A business owned by a single

person.• Partnership: A business owned by two or more people.• Corporation: A company given legal status apart from its

owners. Ownership in a corporation is gained (loss) by buying (selling) shares.

What is Production?

• Production: The process of transforming our resources (inputs) into a good or service with economic value (output).

• Inputs: Resources used in production

• Output: The quantity of a good or service that results from production

Labour Intensive vs. Capital Intensive Processes

• Labour-intensive process: Employs more labour less capital in its production process

• Capital-intensive process: Employs more capital and less labour in its production process.

Example of Productive Efficiencyfig. 4.2

Process Workers (labour)

Sewing Machines (capital)

Total T-shirts Produced per

day

A 4 2 250

B 3 3 250Capital Intensive

Labour Intensive

Productive Efficiency

• Productive Efficiency: Producing a certain quantity of output at the lowest cost.

• Example: Worker in previous example costs $100/day. The cost of the machine is $25 day. Which production process is more efficient?

Exercise: Measure Productive Efficiency

Process Workers (labour)

$100/day

Sewing Machines (capital)

$25/day

Cost per day for labour

Cost per day for

machines

Total Cost

A 4 2

B 3 3

Answer: Measuring Productive Efficiency

Process Workers (labour)

$100/day

Sewing Machines (capital)

$25/day

Cost per day for labour

Cost per day for

machines

Total Cost

A 4 2 $400 $50 $450

B 3 3 $300 $75 $375

Economic Costs vs. Accounting Costs

• Economic Costs: Include both Explicit and Implicit costs

• Explicit Costs: Expenses such as payment for material, wages, rent, etc. These costs appear on a business firm's accounting records.

• Implicit Costs: These costs not included among expenses on the accounting records of a business firm. They are estimates of what the owner’s “give up” by being involved in the business.

Economic Profit

Economic Profit = Total revenue – economic costs

Remember,

Total Revenue (TR) = Price (P) x Quantity(Q)

Accounting Profit

• Excludes implicit costs

• Accounting Profit = Total revenue-Explicit

Costs

Example:• Widget company has total revenue of

$200,000. Accountants determine explicit costs to be $150,000. The owner, Mr. R, of widget co. has invested $80,000 of his own money that could earn 10% on $80,000 if invested. Mr. R could also be earning at least $45,000 as a manager at his previous work. Calculate accounting and economic profit.

Exercise

• Calculate Accounting and Economic Profit

Example:• Widget company has total revenue of

$200,000. Accountants determine explicit costs to be $150,000. The owner, Mr. R, of widget co. has invested $80,000 of his own money that could earn 10% on $80,000 if invested. Mr. R could also be earning at least $45,000 as a manager at his previous work. Calculate accounting and economic profit.

Accounting Profit

= Total Revenue – Explicit Costs

= $200,000 - $150,000

= $50,000

Economic Profit

= Total Revenue – Economic Costs

= Total Revenue – (Explicit + Implicit Costs)

= $200,000 – ($150,000+$8,000+$45,000)

= $200,000 – $203,000

= -$3,000 (a loss)

(Interest Calculated as: $80,000 x 10% = $8,000)

Homework: p. 121#1-5

Production in the Short-Run

• Short-run: A period of time too short for a business to alter its plant capacity, but long enough to vary the degree to which this capacity is utilized.

• Long-run: A period of time long enough to permit a firm to vary the capacity of the plant as well as the degree of its use.

Using Resources

• Fixed Inputs: Inputs that cannot be adjusted in the short run. (ex: Size of machine or factory)

• Variable Inputs: Inputs that can be adjusted in the short run. (ex: labour and materials)

Total, Average and Marginal Product

• Total product = q (quantity of output)

• Average product = total product (q)

(AP) # of workers (L)

• Marginal product = q L

Calculate and Graph

• Calculate and total, marginal and average product

• Graph total product on a separate graph

• Graph marginal and average product together on a separate graph below the total product graph

• Refer to text fig.4.4 p. 106

Fig. 4.3 Production in the Short RunLabour Total

ProductMarginal Product

Average Product

0 0

1 80

2 200

3 250

4 270

5 280

6 270

Fig. 4.3 Production in the Short Run

Labour Total Product

Marginal Product

Average Product

0 0 -

1 80 80 80

2 200 120 100

3 250 50 83.3

4 270 20 67.5

5 280 10 56

6 270 -10 45

The Costs of Production

• Fixed, Variable & Total Costs

• Per Unit Costs (or Average Costs)

• Marginal Costs

Law of Diminishing Marginal Returns

• Law of diminishing marginal returns: At a certain point, the addition of a variable input to a fixed input causes the marginal product to decrease.

Law of Diminishing Marginal Returns

• Example: Class activity for Mr. R’s widget co.

Short Run & Long Run

• Short Run- a period in which at least one of a firm’s resources is fixed (plant capacity)

• Output can be varied by increasing labour, materials & other resources but plant capacity is fixed

• Long Run- a period in which all resources are variable, including plant capacity

Fixed, Variable & Total Costs

• Fixed Costs = Costs that do not vary with output

• Variable Costs = Costs that vary with output

• Total Costs = Fixed + Variable Costs

Per Unit or Average Costs

• Average Fixed Costs (AFC) = TFC

Q

• Average Variable Costs (AVC) = TVC

Q

• Average Total Costs (ATC) = TFC+TVC

Q

Marginal Cost

• Marginal Cost (MC): the additional cost of producing one more unit of output.

• Marginal Cost = Change in Total CostChange in Q

Application

• Calculate and graph marginal cost, average cost, average variable costs and average fixed costs

• Refer to text p. 111

Short-run costs: Enter formula in first row

Labour Total Product

Marginal Product

Fixed Costs

Variable Costs

Total Costs

Change in Total Costs

Marginal Costs

Average Fixed Costs

Average Variable Costs

Average Cost

0 0

1 80

2 200

3 250

4 270

5 280