Production & Cost in the Firm

Production & Cost in the Firm ECO 2013 Chapter 7 Created: M. Mari Fall 2007

Economic Costs • Costs exists because resources are scarce and have alternative uses • When society uses a combination of resources to produce a particular product, it foregoes all alternative opportunities to use those resources for other purposes. • The measure of the economic cost or the opportunity cost of any resource used to produce a good is the value or worth the resource would have in its best alternative.

Economic Costs • (opportunity costs) are those payments a firm must make or income it must provide to resource suppliers to attract the resources away from alternative production.

Costs • Two types of costs • Explicit • Implicit • Total costs = Explicit Costs + Implicit Costs

Explicit Costs • are monetary payments to non-owners of the firm for the resources they supply. • Rent • Labor • Materials • Utilities

Implicit Costs • costs of self-owned, self-employed resources. • Salary of owner not taken • Capital invested by owners • Foregone rent, interest, wages • Not seen in accounting profit analysis

Profits • Accounting profit • A firm’s total revenue minus its explicit costs • Total revenue – explicit costs • Economic profit • A firm’s total revenue minus explicit and implicit costs • Earn more than expected • Normal profit • The accounting profit earned when all resources earn their opportunity costs • What you expect to earn

Production in the Short Run • Long run • A period during which all resources under the firm’s control are variable • Short run • A period during at least one of a firm’s resources is fixed

Short-run Production Relationships • A firm’s costs of producing a specific output depend not only on the price of needed resources but also on the quantities of resources needed to produce that output. • Resource supply and demand determine the resource prices • The technological aspects of production specifically the relationship between inputs and outputs, determine the quantity of resources needed.

Law of Diminishing Marginal Returns • Total product • The total output produced by a firm • Production function • The relationship between the amount of resources employed and a firm’s total product • Marginal product • The change in total product that occurs when the sue of a particular resource increases by one unit

Marginal Returns • Law of diminishing marginal returns • As more of a variable resource is added to a given amount of a fixed resource, marginal product eventually declines and could become negative

Graphical Total product Total product Workers per day Diminishing but positive M P Negative marginal returns Increasing

Costs in the Short run • Fixed costs • Any production cost that is independent of the firm’s rate of output • Depreciation on building • Insurance • Property taxes • Variable costs • An production cost that changes as the rate of output changes • Labor • Materials • utilities

Formula Total Costs = Fixed Costs + Variable Cost Variable costs = Variable cost per unit x units At zero output then: Total costs = Fixed costs

Formula • Average Fixed Costs (AFC) = Total Fixed Costs • Output (Q) • Average Variable Costs (AVC) = Total Variable Costs • Output (Q) • Average Total Costs (ATC) = Total Costs • Output (Q) • Marginal Costs = Change in total cost • Change in quantity

Chart

Curves Total cost Variable costs $200 Fixed Costs Tons per day 0

Curves Marginal cost

Costs in the Long Run • No fixed costs exists • Can increase facility size • Long run Average cost curve • A curve that indicates the lowest average cost of production at each rate of output when the size or scale of the firm varies

Economies of Scale • Explain the downward sloping part of the long run ATC curve • Economies of mass production • Capital intensive firms • As plant size increases, a number of factors will for a time lead to lower average costs of production • Labor specialization • Managerial specialization • Efficient capital

Diseconomies of Scale • Caused by the difficulty of efficiently controlling and coordinating a firm’s operations, as it becomes a large-scale producer. • Alienation of workers

Constant Returns to Scale • Long-run average costs do not change as output changes. • Example: textbooks

Production & Cost in the Firm