Costs of Production

1. Costs of Production 4 Nov 2010

2. Costs of Production • Costs are a critical concept • Costs represent a burden sustained to carry out activities • Carry out production • Meet certain goals • Costs determine production and pricing • Understand costs and you will understand the supply curve

3. Review • Profit = Total Revenue – Total Cost • Total Revenue = Price x Quantity • Total Costs = Explicit Costs + Implicit Costs • Implicit Costs • Value of owner’s time (entrepreneurial value) • Difficult to quantify • Opportunity cost of invested capital • Interest rates foregone • Economic Profit= Total Revenue – Opportunity Costs • Opportunity Costs = Implicit + Explicit Costs

4. Production and Costs Examination of Production Process and the Total Cost

5. Production Function (Starbucks)

6. Output Number of Drinks Number of workers

7. Marginal Product of Labor

8. Total Cost Curve Total Cost Output

9. Behavior of Total Costs and Variable Costs

10. Measures of Costs • Fixed Costs • Costs that do not vary with the quantity of output • Variable Costs • Costs that vary with the quantity of output produced • In our previous example • Fixed Cost: $50 per hour for the Starbucks facility • Variable Cost: $10 per hour wage

11. Average and Marginal Costs • How do costs vary as the level of production varies? • How much does it cost to run the store? • How much does it cost when I increase the number of drinks/output?

12. Average and Marginal Costs • Average Total Cost • Total cost / output • Average Fixed Cost • Fixed cost/output • Average Variable Cost • Variable cost/output • Marginal Cost • Increase in total cost that arises from one more unit • MC = (TC2-TC1) / (Q2-Q1)

13. Average and Marginal Costs (Starbucks)

14. COST CURVES FOR STARBUCKS

15. Economies of Scale • The increase in efficiency of production as the number of goods being produced increases. • Typically, a company that achieves economies of scale lowers the average cost per unit through increased production • fixed costs are shared over an increased number of goods. 

16. Economies of Scale

17. Competitive Markets Decisions Behind the Supply Curve

18. Conditions of Competitive Markets • Many buyers and sellers - individual firms have little effect on the price. • Goods offered are very similar - demand is very elastic for individual firms. • Firms can freely enter or exit the industry - no substantial barriers to entry.

19. Revenue in a Competitive Market • Market Price (P) is given • Firms are “Price Takers” • Profit = Total Revenue (TR) – Total Cost (TC) • How much does the Firm receive for a “typical unit”? • AVERAGE REVENUE • Total Revenue / Quantity Sold

20. Average Revenue • TR/Q = (P x Q)/Q = Price • TR/Q = PRICE

21. Economists Think at the Margin • How much additional revenue does the firm get if it sells one more unit? • MARGINAL REVENUE • Change in Total Revenue/ Change in Quantity • MARGINAL REVENUE IS ALSO EQUAL TO PRICE!! • SEE NEXT SLIDE

22. Michelin HydroEdge Tires

23. Tim’s Tire Store

24. Profit Maximization • Profit is Maximized where Marginal Revenue is equal to Marginal Cost • Marginal Cost is always rising • When MR > MC • Revenue is increasing faster than costs • Firm should increase production • When MR < MC • revenue from the additional unit is less than additional cost • the firm should decrease production.

25. Profit Maximization • A firm maximizes profits when MR = MC.

26. Profit Maximization MC Costs/ Rev ATC P=AR=MR Q* Quantity

27. Tim’s Tire Store

28. Marginal Cost Curve is the Supply Curve? • Since MC is upward sloping, as price increases, quantity produced will increase too. • As price falls, quantity produced falls. • In each case, the marginal cost curve determines how much the firm is willing to produce at each price • So it translates into the supply curve

29. Shutting Down (Temporary) Total Costs = Variable Costs + Fixed Costs If a business shuts down it will only incur FIXED COSTS (it will not have any revenue either)

30. Shutting Down (Temporary) • Company should produce if it can cover its variable costs • Total Revenue > Total Variable Costs • Or how about….AR > AVC • It means the same thing, we are just adjusting the inequality for quantity • Shut down would occur if/when Price falls below the level of the Average Variable Cost • Rember: PRICE is also AVERAGE REVENUE

31. Short Run Supply MC COSTS ATC AVC Shut down: P < AVC QUANTITY

32. Long Run Decisions • In the long run, all costs are variable • If Total Revenue is less than Total Costs • Or if Average Revenue is less than Average Total Cost • Firm will shut down

33. Long Run Supply Curve MC COSTS ATC P = AR QUANTITY

34. Parting Thoughts • In the long run, a firm will enter or exit the market until profit is zero • Profit = TR – TC • Total Cost includes all the opportunity costs of the firm • ZERO PROFIT is EQUILIBRIUM CONDITION • Even if profit is zero, the firm has met satisfaction of opportunity costs

35. Monopoly Monopolistic Competition

36. What is a monopoly? • One and only one firm that produces a good (or offers a unique service) • Characteristics • Barriers to entry • No close substitutes

37. Monopolies are… • PRICE MAKERS! • Recall from our previous discussion that competitive firms are price takers

38. Examples • DeBeers Diamonds • ALCOA (Aluminum) • The cable company • Utilities (gas, electric, etc) • Morton Salt

39. Monopoly Quirks • Monopoly’s power exists in its power to sell • In other words, its profits depend upon DEMAND • The market demand and company demand curve are one and the same • Like a competitive firm, a monopoly’s profits are maximized where • MR = MC • However, monopoly price will be well above the point where MR = MC

40. Monopoly Example MC PROFIT MAX ATC DEMAND MR

41. Antitrust • Government regulation to attack efficiency loss of monopoly • Break up monopolies • AT&T • Prevent mergers? • Fining companies that collude or price discriminate • Walmart

42. Monopolistic Competition • More than one buyer/sellers (several…could be numerous) • Differentiated products (substitutes) • Firms have sufficient knowledge (do not act as if in a vacuum) • Free entry and exit

43. Monopolistic Competition (Short Run) • Limited competition at first • Products that are in the market are close, but not exact substitutes • “Every firm has a monopoly of its own product” (British Economist Joan Robinson) • Example: Portable Media PLayer • iPOD AAC mP4 • 80% market share

44. Monopolistic Competition (Short Run) MC Costs ATC D = AR MR Quantity

45. Monopolisitically Competitive (Long Run) • Firms that produce close substitutes enter market • There is a profit to be made • As long as: • P > MR=MC • P > ATC!

46. Monopolistic Competition (Long Run) MC ATC D = AR MR ZERO ECONOMIC PROFIT P = ATC

47. Problems with Monopolistic Competition • Inefficiency • Price is always greater than marginal cost • Excess capacity • Firm not producing at bottom of ATC • Underserving market • Advertising/non-Price Competition • Advertises to attract customers rather than cutting price • Advertising is seen as wasteful

48. Oligopoly Few Sellers/Similar or Identical Products

49. At the Heart • Game Theory • Psychologists call it theory of social situations • After all, Economics is a social science • Cooperative Game Theory • Non-Cooperative Game Theory

50. Cooperative Game • Rules are enforced within the group • Groups of firms form coalitions and collude • Ever watch “Survivor”?