CHAPTER 23 –Production Costs

1. CHAPTER 23 –Production Costs How much output can a firm produce? How do the costs of production vary with the rate of output Do larger firms have a cost advantage over smaller firms? We are talking about the Production Function…i.e. Costs of Production

2. Next Step for Production Function • How many inputs does it take to arrive at the desired mix of outputs. (from the factors) *How many workers will it take to make the new Board Game… I LOVE ECONOMICS? • Definition of Production Function: Relationship between the maximum quantity of a good attainable from different combinations of factor inputs.

3. Maximum Output/Minimum Inputs Production of goods equates cost! Idea for a firm (large or small) is to minimize the cost while maximizing output. How best to produce? What’s the smallest amount of resources needed to produce a specific product? *What is the least number of workers we can hire to handle the noon counter trade? (McDonalds). Can we lay off another 1,000 workers and still be competitive (IBM) Ford lays off 15,000 workers (Factors of production=land,labor,capital, entrepreneurship

4. Answers to Production Q The Production Function will answer what maximum amount of output is attainable from various combinations of factor inputs. (this is getting the mixing bowl filled with right ingredients) With a fixed amount of capital adding labor inputs can predict outputs---up to a certain point---then more capital needs to be added.

5. Law of Diminishing Returns • *Did you ever fall asleep reading your economics text after a long day at work? Or maybe you just procrastinated on getting that book open.. Of course you have…..… you have experienced • Diminishing returns. • In the short run—Production function defines the limit to output and how much each worker will contribute to that limit.

6. The factor that can be adjusted quickly in the SR is Labor. • Yet… as more labor is hired, each unit of labor has less capital and land to work with… • Things get constrained.. Hence. Marginal Physical Product declines • This refers to how many widgets

7. Example/Build a City game Set up a small factory Fixed factor of production(4 machines) Functions of machines Add variable factors one at a time. • If you keep adding workers- will reach a point where the marginal worker adds nothing to our total output. • A business person must be aware of the law of diminishing returns if he wants to operate efficiently.

9. Bottom Line If we keep adding workers we will reach a Point where--- the Marginal Worker adds nothing to our total output * All the checkout lanes are filled with Tom Thumb Employees… very few people are checking out. (Is this productive for TT?) What happens to their Profit Margin? Cost exceeds any benefits of hiring additional workers.

10. Long run/short run productivity Short run= period in which the quantity (and quality of some inputs) cannot be changed. General assumption: In SR labor can change while capital is held constant Generally, as amount of labor used increases, the output will also increase (with reservations) See diminishing returns*

11. Marginal Productivity • MPP (marginal physical product)= The change in total output that results from employment of one additional unit of input. Formula: MPP = change in total output change in input quantity *same figure as approximate avg output. On diminishing returns chart…

12. MPP and Assembly Lines

13. Employment Dilemmas Sometimes employees don’t measure up *Output does not justify Their negative inputs

14. Marginal Physical Product MPP- • Marginal Productivity • When the MPP of labor (MPPL >0), then total output increases. • Improving the ratio of labor to other factors increases the MPP of labor.

15. MPP = ∆Q ∆ L MPP Chart Marginal Physical Product

16. E I D C B c d b e A a i MPP Graph(actually diminishing marginal physical product. Total output (per day) 50 45 40 + 10 jeans 35 30 Third worker 25 20 Marginal physical product (per worker) 15 10 5 0 3 4 5 1 2 6 7 8

17. Falling MPP implies Rising MC • The MPP actually mirrors the output/worker. • MPP is the additional output obtained by employing one more unit of input.. • If MPP for each additional unit of input is producing less, it ultimately adds more cost to each additional output. • . (i.e. input cost is rising= marginal cost is increasing

18. 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 Diminishing marginal productivity implies . . . Rising marginal cost

19. Reducing output with indivisible inputs • Often the production process is set so that it cannot be minimized. • Machinery all set-up, cannot just make a l/2 widget to reduce outputs • Example: Railway has tracks that run between cities – need both sets to run trains – cannot establish a half a set of tracks and get shipment there.

20. What about Marginal Revenue? The change in total revenue associated with one additional unit of input. • If marginal costs are increasing marginal revenue is decreasing.

21. Productivity- Right Mix of Output

22. REVIEW TERMINOLOGY • Factors of production- Resource inputs used to produce goods and services (land,labor,capital, entrepreneurship) • Productivity-Output per unit of input (output per labor hour) • Efficiency-maximum output of a good from the resources used in production • Opportunity Cost-The MOST DESIRABLE G&S that are forgone in order to obtain something else. • Short Run-The period in which the quantity (and/or quality) of some inputs cannot be changed.

23. Quick quiz • If input prices are rising, will Marginal cost be rising? • If you have a fixed amount of capital and continue to add labor inputs, will marginal product always increase? • What is marginal physical product?

24. Costs, Prices, Output in Competitive Markets • All competition that is not PURE is IMPERFECT • Whether a firm exists in a perfectly competitive market or imperfectly competitive market, it will TRY to • MAXIMIZE PROFITS or MINIMIZE LOSSES.

25. Fixed, Variable, Total Costs What is a definition of profit? What economic conditions might exist for this scenario?

26. ANSWER! WHAT IS PROFIT? • TR-TC=PROFIT • How much money am I taking in? (TR) • How much is it costing me to produce my output? (TC)

27. Economic Profit vs Accounting Profit(the difference lies in how cost is defined) Economic Cost = Explicit Cost + Implicit Cost Accounting Costs are all the costs that have an explicit dollar cost attached to it. TR-TC • Economic cost represents in addition to explicit cost the opportunity cost of resources used. • You start a business- you own the building – you earn $50,000 in revenue- costs are $20,000. (what could you have rented the building for if you were not using it?

28. Accounting, Economic and Normal Profit II

29. Suppose a company incurs the following costs: labor, $400; equipment, $300; and materials, $100. The company owns the building so it doesn’t have to pay the usual $800 in rent. • What is the total accounting cost? • What is the total economic cost? • How would accounting and economic costs change if the company sold the building and then leased it back?

30. Fixed Costs: • All costs are classified as fixed or variable. In the short run, the firm can only use its existing facilities to increase its output. During the short-run, there are several important costs that are fixed. • Fixed costs do not change when the firm changes its level of output • Name some— • -interest on debts of the firm, payments for rent, insurance premiums, taxes on real property, salaries.

31. Average Fixed Cost AFC • Average fixed cost, AFC declines as the firm increases its output. • Divide TFC by Q = AFC TFC/Q = AFC

32. Graph 2 3 4 5 6 7 8 9 10 c O S T S AFC Quantity

33. Graph explanation If a firm had nothing but fixed costs, the more it produced the lower its unit cost (AFC) However, the firm is also confronted by variable costs. What are Variable Costs? Variable Costs increase as the firm increases its output. All costs that are not fixed---are variable!

34. Continued Variable Costs When a firm increases its output, it must acquire more productive resources. Examples: More laborers Wages Electricity Paint, sugar, plastic, steel, etc. ***Variable costs: any costs that rises as the firm produces more; and costs that fall as the firm produces less. ****This is the cost that producers have control over.

35. Quick QuizIdentify which is Fixed or Variable Cost • Mortgage payments on a factory • Electric bills at a print shop • The cost of a new robot at General Motors plant • Premiums on liability insurance at the XYZ Corporation • Wages paid to auto workers • Contract paid to top management at GE

36. Bottom Line--- The bottom line is productivity whether it is a worker on an assembly line or a CEO. “Whenever you are asked if you can do a job, tell 'em, 'Certainly I can!' Then get busy and find out how to do it.” ― Theodore Roosevelt Why is productivity measured by the federal government?

37. Total Variable Cost and Average Variable Cost AVC is found by dividing TVC by Q TVC/Q = AVC Although Average fixed cost declines continually, average variable cost does not. At first AVC usually declines as the firm’s output increases. After reaching a minimum, then AVC begins to rise.

38. AVC and Diminishing Returns The AVC curve will have the general shape of the letter U. This is explained by the Law of diminishing returns. Law says: as more and more units of a variable factor of production are added to a fixed factor of production (such as capital equipment) eventually a point will be reached at which the output accounted for by each additional unit of the variable factor will start to decline.

39. Total Cost Total Cost is the sum of total fixed cost and total variable cost. When a firm increases its output, total cost tends to rise Fixed cost remains unchanged, naturally, but total cost will be pulled up by the rise intotal variable cost with the rise in output. ATC= TC/Q or adding AFC + AVC

40. Marginal Cost- controllable cost • Marginal Resource Cost • Marginal cost (MC) is the increase in total costs associated with a one unit increase in production.

42. $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) Graph ATC/AVC/AFC

43. Minimum Average Cost • The bottom of the U-shaped average total cost curve represents the minimum average total costs. • It identifies the lowest possible opportunitycosts to produce the product.******

44. A Cost Summary • The output decision has to be based not only on the capacity to produce (the production function) but also on the costsof production (the cost functions).

45. A Cost Summary • The marginal cost curve always intersects the ATC curve at its lowest point. mc ATC

46. $32 28 24 20 16 Cost (dollars per unit) 12 8 4 0 1 2 3 4 5 6 7 8 9 Rate of Output (units per time period) Basic Cost Curves MC ATC AVC m AFC n

47. Mathematical Rule • Whenever a number added to a series of numbers is less than their average, the average must decline………. • When a number added to a series of numbers is larger than their average, the average must rise….. • Marginal Cost helps a firm decide whether to increase or decrease output. • Marginal cost is the cost that the firm can control most directly.

48. Adding numbers

49. A Cost Summary If MC > ATC, ATC is increasing If MC < ATC, ATC is decreasing If MC = ATC, ATC at minimum

50. $32 28 24 20 16 Cost (dollars per unit) 12 8 4 0 1 2 3 4 5 6 7 8 9 Rate of Output (units per time period) Identify these curves!