The Costs of Production

1. The Costs of Production Chapter 6

2. In This Chapter… 6.1. The Production Process 6.2. How Much to Produce? 6.3. The Right Size: Large or Small?

3. 6.1. The Production Process

4. 6.1. The Production Process Factors of Production (Inputs) Final Goods and Services (Output) Production Process

5. 6.1.The Production Process • Factors of production – • Resource inputs used to produce goods and services. • land, labor, capital, entrepreneurship. • It takes some or all factors of production to produce a good or service – no matter what the good; OUTPUT

6. 6.1. The Production Process • Production function : • is the technical relationship that expresses the maximum quantity of a good that can be produced (attainable) from different combinations of factors (inputs). • The technical relationship between the quantities of inputs used in the production process and the maximum output that can be produced.

7. 6.1. The Production Process • The purpose of a production function is to tell us how much output we can produce with varying amounts of factor inputs • Varying Input Levels • During some time period the amount of some inputs that can be employed are fixed or can’t be varied….Fixed Inputs (E.g. Land; Plant Size) • While the amount of some other inputs can be easily changed… Variable Input (E.g., Labor)

8. 6.1. The Production Process Short-Run …. • The time period during which the quantity (and quality) of some inputs cannot be changed. • When there are fixed inputs, we’re dealing with a short run production condition.

9. 6.1. The Production Process • In the Long Run, however, all inputs can be varied • Thus long run is a time period that allows us to sufficiently vary the amount of inputs we can use in the production process. • When we vary the amounts of input we use in the production process it affects productivity

10. 6.1. The Production Process • Productivity - Output per unit of input, for example, output per labor hour. • The productivity of any factor of production depends on the amount of other resources available to it.

11. 6.1. The Production Process: In the Short Run

12. 55 G H F E I 50 D 45 40 35 C 30 Jeans Output (pairs per day) 25 20 B 15 10 5 0 A 1 2 3 4 5 6 7 8 Labor Input (machine operators per day) The Production Function Total output Amount of Output depends on Input levels

13. Marginal Productivity An important Concept

14. Marginal Productivity • Marginal physical product(MPP): • is the change in total output that results from employment of one additional unit of the variable input.

16. G H F E I D C B c d b e g f h A a i Marginal Physical Product Total output 55 50 45 40 + 10 jeans 35 30 Third worker Jeans Output (pairs per day) 25 20 15 MPP 10 5 0 3 4 5 1 2 6 7 8 Labor Input (machine operators per day)

17. MPP:…Important Feature… • When the MPP of labor (MPPL >0), then total output increases. • Improving the ratio of the variable input (labor) to other factors increases the MPP of the variable input (labor). • But there is a limit to which we can do this because the capacity of the fixed resources will be exhausted • This leads to eventual decline in the additional and total output we could produce

18. Diminishing Marginal Returns • I.e., as more labor is hired, each unit of labor will have less capital and land to work with. • Thus output begins to rise more and more slowly as more workers are hired and will eventually fall

19. Law of Diminishing Returns • According to thelaw of diminishing returns, the marginal physical product of a variable input declines as more of it is employed with a given quantity of other (fixed) inputs. • All types of production are subject to this natural law

20. G H F E I D C B c d b e g f h A a i Diminishing Marginal Returns Total output 55 50 45 40 + 10 jeans 35 30 Third worker Jeans Output (pairs per day) 25 20 15 MPP 10 5 0 3 4 5 1 2 6 7 8 Labor Input (machine operators per day)

21. Resource Costs 6.2. The Costs of Production (The components of the Costs of Production)

22. Resource Costs • A production function tells us how much a firm can produce but not how much it should produce. • Goal of a firm: Maximizing profit • Profit: The difference between Total Revenue (PxQ) and Total Cost (TC) • Requires every firm to decide on its most desirable level of output

23. Explicit vs. Implicit Cost • Explicit costs: • are the payments made for the use of a resource. • Implicit costs : • are the value of resources used, even when no direct payment is made.

24. Economic vs. Accounting Profit Accounting Profit • Accountants typically count dollar costs only and ignore any resource use that doesn’t result in an explicit dollar cost. Economic Profit: • Economists consider implicit costs as well as explicit costs to be part of the total costs of production.

25. Economic vs. Accounting profit • I.e., Economic cost represents he value of all resources used to produce a good or service; opportunity cost.

26. Dollar Costs (Economic Costs) • The dollar costs of production are directly related to the underlying production function. 1. Total Fixed Costs (TFC) 2. Total Variable Costs (TVC) 3. Total Costs (TC)

27. Costs of Production

28. $1,200 1,100 1,000 900 800 700 600 Production Costs (dollars per day) 500 400 300 200 100 0 15 30 45 60 75 Rate of Output (pairs of jeans per day) Fixed Cost • Fixed costs are the costs of production that do not change when the rate of output is altered, such as the cost of basic plant and equipment. TFC=$120

29. $1,200 1,100 1,000 900 800 700 600 Production Costs (dollars per day) 500 400 300 200 100 0 15 30 45 60 75 Rate of Output (pairs of jeans per day) Variable Cost • Variable costs are the costs of production that change when the rate of output is altered, such as labor and material costs. TVC

30. $1,200 1,100 1,000 900 800 700 G 600 Production Costs (dollars per day) 500 400 B 300 A 200 100 0 15 30 45 60 75 Rate of Output (pairs of jeans per day) Total Cost • Total cost is the market value of all the resources used to produce a good or service. Total cost Variable costs Fixed costs

31. Total Cost • How fast total costs rise depends on variable costs only. • Total cost is equal to the fixed costs when output is zero. • There is no way to avoid fixed costs in the short run.

32. $1,200 1,100 1,000 900 800 700 G 600 Production Costs (dollars per day) 500 400 B 300 A 200 100 0 15 30 45 60 75 Rate of Output (pairs of jeans per day) The Cost of Jeans Production Total cost include variable and fixed costs Total cost Variable costs Variable costs Fixed costs

33. Average Costs • One of the most common cost is average, or per-unit, cost. 4. Average Fixed Cost (AFC) 5. Average Variable Cost (AVC) 6. Average Total Cost (ATC)

34. Average Costs • Average fixed cost(AFC) is total fixed cost divided by the quantity produced in a given time period.

35. Average Costs • Average variable cost(AVC) is total variable cost divided by the quantity produced in a given time period.

36. Average Costs • Average total cost(ATC) is total cost divided by the quantity produced in a given time period.

37. Average Costs • Average total cost is the sum of average fixed and average variable cost. ATC = AFC + AVC

38. Average Costs

39. $24 I 20 ATC J 16 O K N L M Costs (dollars per pair) 12 8 AVC 4 AFC 0 10 20 30 40 50 Rate of Output (pairs per day) Average Costs

40. Characteristic of Average Costs • Falling AFC • As the rate of output increases, AFC decreases as the fixed cost is spread over more output. • Any increase in output lowers average fixed cost.

41. Characteristic of Average Costs • Falling and then Rising AVC • AVC will eventually rise as the rate of output increases. • AVC rises because of diminishing returns in the production process.

42. Characteristic of Average Costs • U-Shaped ATC • The initial dominance of falling AFC, combined with the later resurgence of rising AVC, is what gives the ATC curve its characteristic U shape.

43. Minimum Point of the Average Total Cost • The bottom of the U-shaped average total cost curve represents the minimum average total costs. • It identifies the lowest possible opportunity costs to produce the product. • Note: Profit aren’t necessarily maximized where average total costs are minimized.

44. 7. Marginal Cost (MC)

45. Marginal Cost • Marginal cost refers to the change in total costs associated with one more unit of output.

46. Marginal Cost

47. v u t s q r p Marginal Cost $35 30 Higher output level becomes increasingly expensive 25 20 15 10 5 10 20 30 40 50 Rate of Output (pairs per day)

48. Relationship between MPP and MC • Whenever MPP is increasing, the marginal cost of producing a good must be falling. • If marginal physical product declines, marginal cost increases. • Diminishing returns in production cause marginal costs to increase as the rate of output is expanded.

49. 24 1.20 c 1/g 1.00 20 16 0.80 b Diminishing marginal physical product Rising marginal cost 12 0.60 Marginal Physical Product Additional Labor Cost d 1/f 8 0.40 1/e e 4 0.20 1/d f 1/b 1/c g h 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 i Labor Input Labor Input Falling MPP Implies Rising Marginal Cost Diminishing marginal productivity implies . . . Rising marginal cost

50. Summarizing the Relationship between different types of Costs of Production and their Implication