Costs of Production

Costs of Production Chapter 20

Economic Costs • Economic costs are the costs faced when deciding how to use resources • They can be obvious costs like wages or rents – explicit costs • Or hidden – such as interest income lost when money from savings is used – implicit costs

Profits • Accounting Profits are the monies received from revenue after all explicit costs have been paid • Economic profit is the monies received from revenue after all explicit and implicit costs have been covered

Short and Long Run • Firms profits often depend upon how quickly they respond to changes in demand • Depends upon how fast resource use can be adjusted • Variable resources are easy to adjust – work labor longer, buy more materials • Fixed resources are much harder to adjust and take time – size of the building, machinery available

Short Run • Short Run is a time period to small to adjust size of capital resources but long enough to adjust how it is used • Example – machines can be worked longer, more workers can be added to shifts, more materials used in the plant • In the short run plant capacity is fixed

Long Run • Long run is the time period where firms can adjust plant capacity – all resources can be adjusted now • Build a new plant, buy more equipment • Firms can also arrange to leave or enter the industry as needed • Known as a variable plant period

Short Run Production • Production costs depend upon the prices of resources and the amount of resources needed to produce the desired quantity of goods • Labor output relationship – how much is produced per worker • Total Product – total quantity produced • Marginal Product – additional output produced when an extra unit of a VARIABLE resource is added to the production process • change in total product/change in labor input • Average Product – measures labor productivity – output per unit of labor • Total product/units of labor

Law of Diminishing Marginal Returns • Assumes technology is fixed so methods of production do not change • As additional units of variable resources are added to fixed resource, at some point the additional (marginal) product (output) from that extra variable resource will decline • In other words: as you add more labor to a fixed resource, the output rises by smaller and smaller amounts

WHY? • The logic is simple – overcrowding will eventually take place • At first, adding an additional worker to a plant can help – they can help create division of labor and specialization • Each worker becomes more efficient as they focus on one task • Eventually though too many workers create delays and people have to wait to use equipment which causes slow downs in production • Slow downs mean the additional workers create less additional production than the people before them did

Total, Marginal and Average Product • The law of diminishing marginal returns affects total, marginal and average product • Total product goes through 3 stages based on the changes in marginal product • Marginal product is the slope of total product • Total will increase, at an increasing rate, when marginal is rising • Total will increase, but at a decreasing rate, when marginal is positive but falling • Total will be maximized when marginal is zero • Total will fall when marginal goes negative

Average product will follow the same tendencies (given it is simply total divided by quantity) • It will increase, reach a maximum and then begin to fall as more variable inputs are added • If marginal exceeds average, average product rises • If marginal is less than average, average product will fall • Because of this, marginal and average intersect where average is at it’s maximum • You must look at the math to understand this – if you add a number larger than average to the average, average will rise. If you add a number smaller than average to the average, average falls.

Production AP Ouput MP

Production Costs • Fixed Costs – cost that do not change with output so exist even if production is 0 • Rent, interest payments, depreciation of equipment • Variable Costs – cost that changes with production due to increased use of variable inputs • Wages, material costs, utility payments • As production increases, variable will increase as well • At first it will increase in decreasing amounts, then it will begin to increase in increasing amounts

Variable – why? • This change in variable costs is due to the shape of the marginal product curve • As marginal product rises, it does not take much of an increase in variable resources to increase production • One additional worker can increase production by a lot if they contribute to specialization and efficient use of resources • Small units of additional variable resources mean small increases in costs • As marginal product begins to fall, it will take more and more variable resources to produce increasing quantities • As overcrowding takes place, it will take larger amounts workers just to see an increase in production

Total Cost: sum of fixed and variable costs • At 0 production there will still be a total cost equal to fixed cost • As production increases and variable resources are added, total will increase by the amount of variable costs

Average Costs: per unit cost of production • Useful in making comparisons with price per unit for a good • Average fixed cost: total fixed cost / quantity • AFC declines as quantity rises since it never changes and is spread over larger production numbers • Average Variable Cost: total variable cost / quantity • AVC declines initially, reaches a minimum and then increases again because VC originally increase by smaller amounts, then begin to increase by increasing amounts

Again this is due to diminishing marginal returns • AVC will decline initially because it does not take much additional variable resources to increase production • Firms are inefficient and costly at first but as output increases specialization makes it more efficient and cheaper to run • It will hit its minimum point when marginal product is at its maximum • After that as overcrowding takes place, larger numbers of variable resources are needed to increase production so variable costs (total and average) begin to rise

Average Total Cost: total cost / quantity • Graphically it is the AFC and AVC curves added together so the distance between ATC and AVC represents the AFC ATC Costs AVC AFC Q

Marginal Cost • The additional cost of producing one more unit of output • Reflection of changes in VARIABLE costs • Change in total cost / change in quantity • These are the costs that can be controlled immediately – should we produce another unit? YES – costs are incurred. NO – costs are not incurred

Production decisions are usually marginally based • Combined with marginal revenue (additional revenue received from one more sale) it tells firms if they should produce the additional unit – will it be profitable? • Marginal cost curves decline sharply, reach a minimum and then begin rising rapidly • Reflects the fact that variable costs increase by decreasing amounts, reach a minimum and then begin rising

MC and MP • MC curve shape is reflection of law of diminishing marginal returns • As MP is rising, MC of labor is falling (remember don’t need a lot of extra labor to get that additional output so costs rise at a decreasing rate) • Can see this if you divide the constant cost (assume all workers are hired at same wage rate) of a worker by their marginal product • Once diminishing returns kicks in, MP begins to fall and MC begins to rise • MC and MP are opposites – when MP is rising, MC is falling; when MP is at it’s peak, MC is at it’s minimum; when MP begins to fall, MC is rising

MC, ATC and AVC • MC will intersect ATC and AVC at their minimum points • When the marginal cost added is less than the average, average will fall • When the marginal cost added is greater than the average, average will rise • MC and ATC intersect where ATC has ceased to fall but has not yet begin rising – the minimum point on the ATC curve (MC reacts faster and more sharply than ATC) • MC also crosses AVC at the minimum point for the same reason • MC is not affected by AFC because marginal is a reflection of change and TFC do not change

MC AVC Costs Production AP MP Q of labor Q of output Comparing Curves

What causes the curves to shift? • Changes in resource prices or technology • Changes in costs will change the curves • If fixed costs increase, AFC will shift up and ATC will move up – AVC and MC will NOT move because both are based on variable resources • If variable costs increase, AVC, ATC and MC will all shift upward • More efficient technology that increases productivity will lower costs

Long Run Production Costs • In the long run ALL resources can be adjusted • Different amounts of variable resources can be used, more/equipment can be owned, plant size can change • Therefore, in the long run, ALL costs become variable so we only really look at TOTAL costs

Firm Size and Costs • What is the relationship between the plant size of a firm and the costs they face? • At first, larger plant sizes may actually result in falling ATC but eventually, larger and larger plants will result in rising ATC

ATC-4 ATC-1 ATC-2 ATC-5 ATC-3 LRATC Dashed lines tell you where a firm needs to move to a new plant size. At this point, a new larger plant can produce at lower ATC than the existing plant Average Total Costs 20 30 50 60 Output

At outputs of 20 or less, plant size 1 is best. • At 21 – 30 it gets lower ATC with plant size 2 • At 31 – 50 plant size 3 is best • 51 – 60 plant size 4 • 61+ plant size 5 is best • Each plant will have higher total costs than the one before it BUT ATC (per unit costs) will be lower • Each individual curve represents a short run production for different plants. Together they make up the Long Run ATC curve for the firm • LRATC shows the lowest ATC at which any output level can be produced as firms have time to make adjustments in plant size

Economies of Scale • Why is LRATC u-shaped? • NOT due to law of diminishing marginal returns – it does is short run only; does not apply in the long run • Economies of Scale (economies of mass production): reductions in the average total cost of production as a firm expands plant size in the long run

Why Economies of Scale lead to downsloping long run ATC curves • Labor Specialization: as plants increase in size labor is able to become more specific and specialized in their job • There is more room and ability to divide workers up into single specific tasks • Focusing on one task makes a worker better and more efficient at their job • No more production time loss from switching jobs

Managerial Specialization: greater specialization of managers • Individual group managers who can work with certain tasks and small groups rather than a single plant manager who has to supervise multiple tasks and hundreds of workers • Leads to greater efficiency • Efficient Capital: more efficient equipment, more efficient use of current equipment • Other Factors: per unit design and development costs, advertising costs fall as production increases, experience and therefore efficiency rises as production rises • As inputs rise, production rises by large amounts, ATC falls

Diseconomies of Scale • Rising ATC as firms increase expands production in the long run • Mainly due to difficulty in controlling and managing a large operation • As plant size increases, personnel size increases and more managers get involved. • Key executives move further away from hands on understanding and more people are needed to understand and absorb all details of production. • Delegation leads communication and cooperation problems. Efficiency falls and costs rise. • Also easier for workers to slack off and drop in efficiency as workers feel more isolated. More management is needed to watch them and so costs rise. • Increases in inputs lead to a small increase in production so ATC rises

Constant Returns to Scale • Production range where ATC does not change as production increases • Increases in inputs have a proportionate increase in production size

Minimum Efficient Scale • Lowest level of output at which a firm can minimize long run average costs • Some industries can only support one or a few firms who can produce efficiently to meet consumer demand – these industries lead to natural monopolies or oligopolies • LRATC shape is determined by technology and economies/diseconomies of scale • Industries can have firms of different plant sizes who all operate on the same portion of a LRATC curve • The shape of the ATC curve determines the number of firms in an industry

Costs of Production