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P R I N C I P L E S O F

P R I N C I P L E S O F. F O U R T H E D I T I O N. The Costs of Production. 13. In studying costs in this chapter, look for the answers to these questions:. What do we mean by “economic costs”? What is a production function? What is marginal product? How are they related?

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P R I N C I P L E S O F

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  1. P R I N C I P L E S O F FOURTH EDITION The Costs of Production 13

  2. In studying costs in this chapter, look for the answers to these questions: • What do we mean by “economic costs”? • What is a production function? What is marginal product? How are they related? • What types of costs do businesses incur, and how are they related to each other and to output? • How are costs different in the short run vs. the long run? • What are “economies of scale”? CHAPTER 13 THE COSTS OF PRODUCTION

  3. What are costs of a professional services firm that designs and sells websites? • The firm (Ec200web.Inc) designs custom web sites for businesses, and guarantees service for one year. Both are included in the purchase price. • The firm requires office space, a computer system, workers (programmers and marketing), an owner/manager, and financial capital (money to pay bills until customers pay for the service). • What are its economic costs? CHAPTER 13 THE COSTS OF PRODUCTION

  4. Costs: Explicit vs. Implicit 0 • Explicit costs – require an outlay of money,e.g. paying wages to workers, rent, etc. • Implicit costs – do not require a cash outlay,e.g. the opportunity cost of the owner/manager’s time. e.g. financial capital • Remember one of the Ten Principles:The cost of something is what you give up to get it. • This is true whether the costs are implicit or explicit. Both matter for firms’ decisions. CHAPTER 13 THE COSTS OF PRODUCTION

  5. Explicit vs. Implicit Costs: An Example 0 You need $100,000 to start this business. The interest rate is 5%. • Case 1: borrow $100,000 • explicit cost = $5000 interest on loan • Case 2: use $40,000 of your savings, borrow the other $60,000 • explicit cost = $3000 (5%) interest on the loan • implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000. In both cases, total (exp+ imp) costs are $5000. CHAPTER 13 THE COSTS OF PRODUCTION

  6. Economic Profit vs. Accounting Profit 0 • Accounting profit = total revenue minus total explicit costs • Economic profit = total revenue minus total costs (including explicit and implicit costs) • Accounting profit ignores implicit costs, so it’s higher than economic profit. CHAPTER 13 THE COSTS OF PRODUCTION

  7. ACTIVE LEARNING 2: Economic profit vs. accounting profit The equilibrium rent for office space has just increased by $500/month. Compare the effects on accounting profit and economic profit if a. you rent your office space b. you own your office space 6

  8. ACTIVE LEARNING 2: Answers The rent on office space increases $500/month. a. You rent your office space. Explicit costs increase $500/month. Accounting profit & economic profit each fall $500/month. b. You own your office space. Explicit costs do not change, so accounting profit does not change. Implicit costs increase $500/month (opp. cost of using your space instead of renting it), so economic profit falls by $500/month. 7

  9. We Assume profit maximization: why? … and are there any exceptions? • Profit = Total Revenue – Total (economic) Cost • The firm’s owner (with invested capital) is motivated to maximize profits. Many owners participate only by their investment, and derive no pleasure from running the firm. • A principal exception -- how employees are treated: keeping employees who are friends or family, out of a sense of loyalty or compassion, or employing people you “like to work with”. Most applicable for small businesses. • It can be difficult for owners of large corporations (stockholders) to control the management. CHAPTER 13 THE COSTS OF PRODUCTION

  10. Discipline Imposed by Capital Markets • Corporations with publicly traded stock operate in a world where profits/losses are more visible than privately held businesses. Quarterly earnings reports are very public, especially with CNBC (business cable network!). • Rising profits cause a firm’s stock price to rise, and many executives own stock in their firm. Stock prices can fall sharply when profits do not meet expectations! • Poor management can be punished: • executives fired, • firm acquired by and previous managers fired. CHAPTER 13 THE COSTS OF PRODUCTION

  11. Costs and the Production Function 0 • A production function shows the relationship between the quantity of inputs used to produce a good, and the quantity of output of that good. Q = (inputs) • We classify inputs as “fixed” or “variable” – “Fixed” inputs can not be altered in the “short run” while “Variable” inputs can be altered. -- eg. adding another worker. • The Marginal Product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. CHAPTER 13 THE COSTS OF PRODUCTION

  12. ∆Q ∆L Marginal Product 0 • The marginal productof any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. • Notation: ∆ (delta) = “change in…” Examples: ∆Q = change in output, ∆L = change in labor • Marginal product of labor (MPL) = CHAPTER 13 THE COSTS OF PRODUCTION

  13. Why MPL Diminishes • Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal, i.e. other inputs held constant) E.g., each worker increases the output of websites by a smaller and smaller amount for each additional worker. Why? • Ec200web has a small office and a given computer investment. As more workers try to use these inputs, they reduce the productivity of everyone – noise and “congestion” arises at the worksite!) • This decline in marginal product typically occurs whenever there are fixed inputs. CHAPTER 13 THE COSTS OF PRODUCTION

  14. 3,000 2,500 2,000 Quantity of output 1,500 1,000 500 0 0 1 2 3 4 5 No. of workers A Simple Example: A production function with diminishing marginal productivity 0 L(no. of workers) Q MPL MPL equals the slope of the production function. Notice that MPL diminishes as L increases. This explains why the production function gets flatter as L increases. 0 0 1000 1 1000 800 2 1800 600 3 2400 400 4 2800 200 5 3000 CHAPTER 13 THE COSTS OF PRODUCTION

  15. Ec200web, Inc. • A firm’s cost structure reflects two key factors: the nature of its production function and the role of fixed vs. variable costs. • The firm has fixed costs of $100/day, which covers rent, the computer network, and the opportunity cost of the owner/manager and his/her financial capital. • It has only one variable input, labor, which it pays $70/day. (I agree – unrealistically low! Imagine this rate per hour.) CHAPTER 13 THE COSTS OF PRODUCTION

  16. The Production Function for this Firm • Labor Output (websites) Marginal Product • 0 0 0 • 1 1 1.0 • 2 2.45 1.45 (… rising) • 3 4.0 1.55 • 4 5.0 1.0 (… declining) • 5 5.7 .7 • 6 6.2 .5 • 7 6.6 .4 • 8 6.7 .3 CHAPTER 13 THE COSTS OF PRODUCTION

  17. A Closer Look: How Marginal Productivity Changes • One worker can produce one website a day. • Adding a second worker allows them to share some tasks, and together they produce 2.45 websites per day. They specialize in what they do best. The marginal product to the firm of hiring a second worker is greater (1.45 websites) than that of the first worker (1.0 websites). • But the marginal product of each additional worker eventually declines as the firm hires more and more workers. The firm’s costs rise because it is “capacity constrained” by its fixed inputs. CHAPTER 13 THE COSTS OF PRODUCTION

  18. Fixed and Variable Costs 0 • Fixed costs(FC) – do not vary with the quantity of output produced. • For Ec200web, FC = $100 for rent, computers, manager, and financial capital • Variable costs (VC) – vary with the quantity produced. • For Ec200web, VC = wages paid to workers • Each worker is paid $70. Variable costs will depend on worker wage and worker output. • Total cost (TC) = FC + VC CHAPTER 13 THE COSTS OF PRODUCTION

  19. $100 $0 $100 100 70 170 100 120 220 100 160 260 100 210 310 100 280 380 100 380 480 100 520 620 EXAMPLE: Costs 0 $800 FC FC VC TC Q VC $700 TC 0 $600 1 $500 2 Costs $400 3 $300 4 $200 5 $100 6 $0 7 0 1 2 3 4 5 6 7 Q CHAPTER 13 THE COSTS OF PRODUCTION

  20. Cost function is derived from the shape of the Production Function. • The production function tells how inputs are translated into output. In this example, Total Cost initially increases at a lower rate, then eventually appears to increase at a faster rate. • This result reflects rising marginal productivity of labor at lower levels of output, for the first few three workers hired, which translates into lower increases in unit cost. • But at higher output levels, marginal product of labor is rising less, hence unit costs rise more. CHAPTER 13 THE COSTS OF PRODUCTION

  21. MC = ∆TC ∆Q Marginal Cost • Marginal Cost (MC) is the increase in Total Cost from producing one more unit: CHAPTER 13 THE COSTS OF PRODUCTION

  22. MC = ∆TC ∆Q EXAMPLE: Marginal Cost Recall, Marginal Cost (MC)is the change in total cost from producing one more unit: Q TC MC 0 $100 $70 1 170 50 2 220 40 3 260 Usually, MC rises as Q rises, due to diminishing marginal product. Sometimes (as here), MC falls before rising. (In other examples, MC may be constant.) 50 4 310 70 5 380 100 6 480 140 7 620 CHAPTER 13 THE COSTS OF PRODUCTION

  23. n.a. $100 50 33.33 25 20 16.67 14.29 EXAMPLE: Average Fixed Cost AFC=FC/Q 0 Average fixed cost (AFC)is fixed cost divided by the quantity of output: AFC = FC/Q Q FC AFC 0 $100 1 100 2 100 3 100 Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units. 4 100 5 100 6 100 7 100 CHAPTER 13 THE COSTS OF PRODUCTION

  24. n.a. $70 60 53.33 52.50 56.00 63.33 74.29 EXAMPLE: Average Variable Cost 0 Average variable cost (AVC)is variable cost divided by the quantity of output: AVC = VC/Q Q VC AVC 0 $0 1 70 2 120 3 160 As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises. 4 210 5 280 6 380 7 520 CHAPTER 13 THE COSTS OF PRODUCTION

  25. AFC AVC n.a. n.a. n.a. $170 $100 $70 110 50 60 86.67 33.33 53.33 77.50 25 52.50 76 20 56.00 80 16.67 63.33 88.57 14.29 74.29 EXAMPLE: Average Total Cost 0 Average total cost (ATC) equals total cost divided by the quantity of output: ATC = TC/Q Q TC ATC 0 $100 1 170 2 220 3 260 Also, ATC = AFC + AVC 4 310 5 380 6 480 7 620 CHAPTER 13 THE COSTS OF PRODUCTION

  26. $200 $175 $150 $125 Costs $100 $75 $50 $25 $0 0 1 2 3 4 5 6 7 Q EXAMPLE: Average Total Cost 0 Q TC ATC Usually, as in this example, the ATC curve is U-shaped. 0 $100 n.a. 1 170 $170 2 220 110 3 260 86.67 4 310 77.50 5 380 76 6 480 80 7 620 88.57 CHAPTER 13 THE COSTS OF PRODUCTION

  27. $200 $175 $150 AFC $125 AVC Costs $100 ATC $75 MC $50 $25 $0 0 1 2 3 4 5 6 7 Q EXAMPLE:The Various Cost Curves Together 0 CHAPTER 13 THE COSTS OF PRODUCTION

  28. ACTIVE LEARNING 3: Costs Fill in the blank spaces of this table. Q VC TC AFC AVC ATC MC 0 $50 n.a. n.a. n.a. $10 1 10 $10 $60.00 2 30 80 30 3 16.67 20 36.67 4 100 150 12.50 37.50 5 150 30 60 6 210 260 8.33 35 43.33 28

  29. ACTIVE LEARNING 3: Answers First, deduce FC = $50 and use FC + VC = TC. Use AFC = FC/Q Use ATC = TC/Q Use relationship between MC and TC Use AVC = VC/Q Q VC TC AFC AVC ATC MC 0 $0 $50 n.a. n.a. n.a. $10 1 10 60 $50.00 $10 $60.00 20 2 30 80 25.00 15 40.00 30 3 60 110 16.67 20 36.67 40 4 100 150 12.50 25 37.50 50 5 150 200 10.00 30 40.00 60 6 210 260 8.33 35 43.33 29

  30. $200 $175 $150 $125 Costs $100 $75 $50 $25 $0 0 1 2 3 4 5 6 7 Q EXAMPLE: Why ATC Is Usually U-shaped 0 As Q rises: Initially, falling AFCpulls ATC down. Eventually, rising AVCpulls ATC up. ** It is declining marginal product of variable inputs that causes rising variable costs. CHAPTER 13 THE COSTS OF PRODUCTION

  31. $200 $175 $150 $125 Costs $100 ATC $75 MC $50 $25 $0 0 1 2 3 4 5 6 7 Q EXAMPLE:ATC and MC 0 When MC < ATC, ATC is falling. When MC > ATC, ATC is rising. The MC curve crosses the ATC curve at the ATC curve’s minimum. CHAPTER 13 THE COSTS OF PRODUCTION

  32. Illustrating Fixed and Variable Costs – how important are ‘fixed’ costs? • Traditional manufacturing firms: fixed costs are large, and fixed and variable inputs are combined in relatively ‘fixed proportions’ – i.e. only so many variable inputs can be added. • Professional service firms: people, computers, and office space comprise a large fraction of total inputs. Many fixed inputs become variable costs with a relatively short time horizon. CHAPTER 13 THE COSTS OF PRODUCTION

  33. What Explains Long Run Costs? (Short Run vs Long Run Costs) • Short run: Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC. • Long run: all inputs are variable (e.g., firms can build more factories, or sell existing ones) • In the long run, the firm MUST CHOOSE THE EFFICIENT FACTORY SIZE!. ATC at any Q is cost per unit using the most efficient mix of inputs for that Q (e.g., the factory size with the lowest ATC). CHAPTER 13 THE COSTS OF PRODUCTION

  34. AvgTotalCost ATCM ATCS ATCL Q EXAMPLE 3: LRATC with 3 Factory Sizes (Look like factories with sizeable fixed costs). Firm can choose from 3 factory sizes: S, M, L. Each size has its own SRATC curve. The firm can change to a different factory size in the long run. WHICH FACTORY WILL IT CHOOSE? CHAPTER 13 THE COSTS OF PRODUCTION

  35. AvgTotalCost ATCM ATCS ATCL Q QA QB EXAMPLE 3: LRATC with 3 Factory Sizes To produce less than QA, firm will choose size Sin the long run. To produce between QAand QB, firm will choose size Min the long run. To produce more than QB, firm will choose size Lin the long run. LRATC CHAPTER 13 THE COSTS OF PRODUCTION

  36. ATC LRATC Q A Typical LRATC Curve In the real world, factories come in many sizes, each with its own SRATC curve. So a typical LRATC curve looks like this: CHAPTER 13 THE COSTS OF PRODUCTION

  37. ATC LRATC Q How ATC Changes as the Scale of Production Changes Economies of scale: ATC falls as Q increases. Constant returns to scale: ATC stays the same as Q increases. Diseconomies of scale: ATC rises as Q increases. CHAPTER 13 THE COSTS OF PRODUCTION

  38. How ATC Changes with Output: the sources of economies of scale • Economies of scale occur when increasing production allows greater specialization: workers more efficient when focusing on a narrow task. • More common when Q is low. • Economies of scale is also traceable to spreading ‘fixed’ inputs across more units of output: patents and technologies, marketing advantages created from advertising and reputation of products, management communication and control processes, large scale purchasing. CHAPTER 13 THE COSTS OF PRODUCTION

  39. Economies of scale? Why/why not? What do you think is the efficient size of such firms (where avg. costs lowest)? • Fitness facility • Major retail chain (Walmart, Best Buy) • Car repair shop • Hospital • Anheuser Busch • Fancy restaurant • Airline CHAPTER 13 THE COSTS OF PRODUCTION

  40. How ATC Changes with Output: what explains diseconomies of scale? • Why can’t a firm ‘duplicate’ itself ten times over and maintain the same average cost level? • Diseconomies of scale are due to coordination problems in large organizations. E.g., management becomes stretched, can’t control costs, can’t coordinate activities of its component parts/divisions, can’t measure performance of its component parts. CHAPTER 13 THE COSTS OF PRODUCTION

  41. Conglomerates: do they yield “management economies” (or reverse!)? • Conglomerates – companies comprised of many disparate businesses – offer the promise of economies of management and finance. • General Electric: 300,000 employees, $164 billion in sales, tax return is 24,000 pages. Businesses include NBC, Universal Pictures, jet engines, consumer finance, lighting, medical imaging equipment, plastics, motors, etc. • Is GE ‘unmanageably large’? Some wonder! Stock price: $60 in 2001; now $35. CHAPTER 13 THE COSTS OF PRODUCTION

  42. CHAPTER SUMMARY: Key Insights • Economic costs include explicit and implicit costs. • The production function shows the relationship between output and inputs and affects cost functions. Decreasing marginal product in the short run results in the short run average and marginal cost curves steepening. • Variable costs vary with output in the short run, while fixed costs do not. In the long run, all costs are variable. The shape of the long run cost curve depends on economies of scale. CHAPTER 13 THE COSTS OF PRODUCTION

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