Production and Costs

Supply and demand are the two words that economists use most often.

Supply and demand are the forces that make market economies work.

Modern microeconomics is about supply, demand, and market equilibrium.

According to the Law of Supply: Firms are willing to produce and sell a

greater quantity of a good when the price of the good is high.

This results in a supply curve that slopes upward.

The Firm’s Objective The economic goal of the firm is to maximize profits.

Total Revenue The amount a firm receives for the sale of its output.

Total Cost The market value of the inputs a firm uses in

production.

Profit The firm’s total revenue minus its total cost.

Profit = Total revenue - Total cost

A firm’s cost of production includes all the opportunity costs of making its output of goods and services.

Explicit and Implicit Costs

A firm’s cost of production include explicit costs and implicit costs.

Explicit costs are input costs that require a direct outlay of money by the firm.

Implicit costs are input costs that do not require an outlay of money by the firm.

Example:

Helen uses $300 000 of her savings to buy her cookie factory from the previous owner.

If she had left her money in a savings account that pays an interest at a rate of 5 percent, she would have earned $15 000 a year.

Helen by buying a cookie factory has foregone $15 000 a year in interest income.

This foregone $15 000 is an implicit opportunity cost of Helen’s business.

The accountant will not show this cost.

Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs.

Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.

Accounting profit = TR – total explicit costs

Economic profit = TR – (explicit costs +

implicit costs)

How an

Economist

Views a Firm

Explicit costs

Implicit costs

Economic

profit

Explicit costs

Accounting

profit

How an

Accountant

Views a Firm

Total

Opportunity

Costs

Revenue Revenue

Zero economic profit = normal profit

Define as

the minimum profit to keep a firm in operation. A firm that earns normal profits earns total revenue equal to its total implicit costs + explicit costs.

Useful to categorize firms’ decisions into

Long-run decisions—involves a time horizon long enough for a firm to vary all of its inputs To guide the firm over the next several years (long run lens)

Short-run decisions—involves any time horizon over which at least one of the firm’s inputs cannot be varied To determine what the firm should do next week ( short run

lens)

There is nothing they can do about their fixed inputs Stuck with whatever quantity they have However, can make choices about their variable

inputs Fixed inputs

An input whose quantity must remain constant, regardless of how much output is produced For example: ???????

Variable input An input whose usage can change as the level of

output changes For example: ????????

Total product Maximum quantity of output that can be produced

from a given combination of inputs

Marginal product (MP) is the change in total product (ΔQ) divided by the change in the number of workers hired (ΔL)

ΔL

ΔQMP

– Tells us the rise in output produced when one more worker is hired

30

90

130

161

184 196 Total Product

DQ from hiring fourth worker

DQ from hiring third worker

DQ from hiring second worker

DQ from hiring first worker

increasing marginal returns

diminishing marginal

returns

Units of Output

Number of Workers 6 2 3 4 5 1

As more and more workers are hired

MP first increases

Then decreases

Pattern is believed to be typical at many types of firms

When the marginal product of labor increases as employment rises, we say there are increasing marginal returns to labor

Each time a worker is hired, total output rises by more than it did when the previous worker was hired

When the marginal product of labor is decreasing

There are diminishing marginal returns to labor

Output rises when another worker is added so marginal product is positive

But the rise in output is smaller and smaller with each successive worker

Law of diminishing (marginal) returns states that beyond some point the marginal product decreases as additional units of a variable factor are added to a fixed factor. (holding the other inputs constant)

Its marginal product will eventually decline

Fixed costs

Costs of a firm’s fixed inputs

Variable costs

Costs of obtaining the firm’s variable inputs

Types of total costs Total fixed costs

Cost of all inputs that are fixed in the short run Total variable costs

Cost of all variable inputs used in producing a particular level of output

Total cost

Cost of all inputs—fixed and variable

TC = TFC + TVC

TC

0

Dollars

135

195

255

315

375

$435

30 90 130 161

Units of Output

184 196

TFC

TFC

TVC

Average fixed cost (AFC) Total fixed cost per unit of output produced

• Average variable cost (TVC) – Total variable cost per unit of output produced

• Average total cost (TC) – Total cost per unit of output produced

Q

TFCAFC

Q

TVCAVC

Q

TCATC

Marginal Cost Increase in total cost from producing one more unit or

output

Marginal cost is the change in total cost (ΔTC) divided by the change in output (ΔQ)

ΔQ

ΔTCMC

– Tells us how much cost rises per unit increase in output

– Marginal cost for any change in output is equal to shape of total cost curve along that interval of output

MC

AVC

ATC AFC

Units of Output

Dollars

$4

3

2

1

30 90 130 161 196 0

AFC

When marginal cost is below average cost, average cost falls.

When marginal cost is above average cost, average cost rises.

When marginal cost is equals average cost, average cost is at its minimum point.

Add marginal cost to the table

Total

Input

(L) Q MP

TVC

(wL) MC

0 0 0

1 1,000 1,000 500 0.50

2 3,000 2,000 1,000 0.25

3 6,000 3,000 1,500 0.17

4 8,000 2,000 2,000 0.25

5 9,000 1,000 2,500 0.50

6 9,500 500 3,000 1.00

7 9,850 350 3,500 1.43

8 10,000 150 4,000 3.33

9 9,850 -150 4,500

Important Map Observations

AFC declines steadily over the range of production. Why?

In general, ATC is u-shaped. Why?

MC intersects the minimum point (q*) on ATC. Why?

Goal: earn the highest possible profit

To do this, it must follow the least cost rule To produce any given level of output the firm will

choose the input mix with the lowest cost

Firm must decide what combination of inputs to use in producing any level of output

Long-run total cost (LRTC)

The cost of producing each quantity of output when the least-cost input mix is chosen in the long run

Long-run average total cost (LRATC)

The cost per unit of output in the long run, when all inputs are variable

Q

LRTCLRATC

ATC curve tells us how average cost behaves in the short run, given plant size fixed moving along the current ATC curve

To produce any level of output in the long run, the firm will always choose that ATC curve with lowest ATC —among all of the ATC curves available move from one ATC curve to another by varying

the size of its plant Will also be moving along its LRATC curve This insight tells us how we can graph the firm’s

LRATC curve

Plant - collection of fixed inputs at a firm’s disposal

Can distinguish between the long run and the short run

In the long run, the firm can change the size of its plant

In the short run, it is stuck with its current plant size

LRATC ATC1

Use 0 automated

lines

ATC3 ATC0

C

B A

ATC2

D

E

175 196 184

Dollars

1.00

2.00

3.00

$4.00

Units of Output

30 90 130 161 250 300 0

Use 1 automated

lines

Use 2 automated

lines

Use 3 automated

lines

For some output levels, LRTC is smaller than TC

Long-run total cost of producing a given level of output can be less than or equal to, but never greater than, short-run total cost (LRTC ≤ TC)

Long-run average cost of producing a given level of output can be less than or equal to, but never greater than, short–run average total cost (LRATC ≤ ATC)

According to whether the LRATC decreases / does not change / increase as output increases, there are three types of issues: Economies of scale (decreasing LRATC) at relatively

low levels of output

Constant returns to scale (constant LRATC) at some intermediate levels of output

Diseconomies of scale (increasing LRATC) at relatively high levels of output

LRATC curves are typically U-shaped

Units of Output

LRATC

Economies of Scale Constant Returns to

Scale

Diseconomies of Scale

Dollars

1.00

2.00

3.00

$4.00

130 184 0

An increase in output causes LRATC to decrease

The more output produced, the lower the cost per unit

LRATC curve slopes downward

Long-run total cost rises proportionately less than output

Increasing return to scale

Gains from specialization Labour Managerial

Efficiency of capital Some types of inputs cannot be increased in tiny

increments, but rather must be increased in large jumps, therefore must be purchased in large lumps Low cost per unit is achieved only at high levels of

output

More efficient use of lumpy inputs will have more impact on LRATC at low levels of outputs

An increase in output causes LRATC to remain

The more output produced but the cost per unit is not change

LRATC curve remains flat

Long-run total cost rises proportionately with output

constant return to scale

LRATC increases as output increases

LRATC curve slopes upward

LRTC rises more than in proportion to output

More likely at higher output levels

As output continues to increase, most firms will reach a point where bigness begins to cause problems

As a firm become large beyond

some level

~increasing bureaucratic and red

tape (financial/accounting)

~management coordination

problems

~out of control situations