Industrial Organization Part 1: Costs of Production

1. Industrial Organization Part 1: Costs of Production MicroMod5

2. Objectives • By the end of this module, SWBAT • Explain the difference between accounting and economic profits and explicit vs. implicit costs • Describe the relationship between the production function and total cost curve • Draw and describe the “big three” average cost curves and then show how marginal cost fits in • Explain the benefits of economies of scale in the long run applications of costs of production

3. SLOs • Corporations routinely focus on decreasing the costs of production for goods and services in order to maximize profit • Understanding costs is a lifelong learning skill in the field of economics that explains much firm behavior • Also, important to understand the externalities of minimizing costs • Layoffs • Tax shelters • Undocumented laborers, migrant laborers, etc.

4. Recap on Profit • Profit = Total Revenue - Total Cost • Costs come in two flavors • Explicit - costs that require expenditures by business (accountant’s cost) • Implicit - costs that do not require expenditures by businesses (i.e. time, energy, other opportunity costs) • Explicit + implicit costs = total costs

5. Recap on Profit • in similar fashion, accounting profit = TR - total explicit costs • economic profit = TR - total cost • total cost figure forms the basis for a whole series of curves that provides a detailed picture of supplier behavior

6. Production Function • relationship between quantity of inputs used to produce and quantity of output • looks like left half of Laffer Curve • diminishing marginal product - as amount of inputs increases, becomes less productive • common sense tells you this is true - “too many cooks in the kitchen” adage

7. Total Cost Curve • other way to express the same notion as production function • diminishing marginal product due to rising marginal cost

8. Total Cost Curve Production Function Total Cost Curve

9. The Big Three • Fixed costs - costs that don’t vary with quantity of goods, services produced • Variable costs - costs that DO vary with quantity of goods, services produced • Marginal cost - increase in total cost that arises from the next unit of good, service

10. The Big Three - Salon Example • Fixed costs - rent for hair salon • Variable costs - hair product in terms of gel, relaxer, mousse, etc. • Marginal cost - how much the next dye job you do will cost you in terms of materials

11. Average Total Cost • U-shaped graph • mathematically, it is average fixed cost plus average variable cost • AFC graph shaped like an L, AVC graph shaped like very elastic supply curve • resulting sum in ATC graph becomes a flattened U

12. Average Total Cost

13. Marginal Cost • steepest rise of all cost curves • initially falls with ATC but then quickly rises • whenever MC < ATC, ATC is decreasing • whenever MC > ATC, ATC is increasing • MC always, always, always intersects ATC at ATC’s lowest point • this region called “efficient scale” - place where business operates at lowest cost margin

14. Marginal Cost

15. Long Run vs. Short Run • Long run curves differ from short run curves • recall that even though demander usually more flexible in economic decisions than supplier, fixed short run costs can become variable • (i.e. new production facility, invention of new production techniques)

16. Long Run vs. Short Run • As a result, long run curves much flatter than short run cost curves in the same way supply and demand curves are more elastic in the long run • three distinct phases • economies of scale (production up, costs down) • constant returns to scale (production up, costs level) • diseconomies of scale (production up, costs up)

17. Long Run vs. Short Run