Chapter 13 The costs of production

1. Chapter 13 The costs of production Outline of topics T1 What are costs T2 Production and costs T3 The various measures of cost T4 Costs in the short run and in the long run

2. T1 What are costs • Use Hungry Helen’s Cookie Factory as an example. • Helen, the owner of the firm, buys • flour, sugar, flavourings, and other cookie ingredients. • the mixers and ovens and • hires workers to run equipments T1.1 total revenue (TR), total cost (TC), and Profit TR: the amount a firm receives from the sale of its output TR=P*Q TC: the amount a firm pays to buy the inputs into production TC =FC+VC ; fixed cost (FC), variable cost (VC) Profit: total revenue minus total cost Profit = TR-TC

3. T1.2 Costs as opportunity costs & the cost of capital as an opportunity cost • Explicit costs: input costs that require an outlay of money by the firm • Ex, the wages & the costs of buying ingredients • Implicit costs: input costs that do not require an outlay of money by the firm • Ex 1, the owner’s opportunity costs of being involved with a business. • Ex 2, the opportunity cost of the financial capital that has been invested in the business. • Economic costs = explicit costs + implicit costs • Economic profit: the excess of a business’s total revenue over its economic costs ( = TR – economic costs) • Accounting profit: the excess of a business’s total revenue over its explicit costs ( = TR-explicit costs)

4. See Figure 13-1 on page 274 T2 Production and Costs Use the Hungry Helen’s Cookie Factory as an example. • Assume: • the size of Helen’s factory is fixed & • Helen can vary the quantity of coolies produced only by changing the number of workers. • It is in the short run. • Production function: the relationship between the quantity of inputs used to make a good and the quantity of output of that good. • Marginal product: the increase in output that arises from an additional unit of input

5. Diminishing marginal product: the property whereby the marginal product of an input declines as the quantity of input increases • See Table 13-1 and Figure 13-2 on page 276 From the production function to the total-cost curve • Total-cost curve shows the relationship between the quantity of output produced and the total cost of production. • See Table 13-1 andFigure 13-2 on page 276 & 277 T3 The various measures of cost • Our analysis of Hungry Helen’s Cookie Factory demonstrated how a firm’s total cost reflects it production function. • From data on a firm’s total cost, we can derive several

6. related measures of cost. • Fixed costs (FC): costs that do not vary with the quantity of output produced • Variable costs (VC): costs that do vary with the quantity of output produced. • Average total cost (ATC) = TC/Q • Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced. • Average fixed cost: AFC= FC/Q • Average variable cost: AVC= VC/Q • Marginal cost: the increase in total cost that arises from an extra unit of production • MC = change in total cost (Δ TC) • change in quantity (Δ Q)

7. Marginal cost tells us the increase in total cost that arises from producing an additional unit of output • See Table 13-2 & Figure 13-4 on page 278 & 279 Cost curves and their shapes ( three features) • Rising marginal cost: marginal cost rises with the quantity of output • U-Shaped average total cost • The marginal cost curve crosses the average total cost curve at the minimum of average total cost. • See Figure 13-5 on page 281 • Be aware, in this example, the firm exhibits diminishing marginal product and therefore, rising marginal cost at at all levels of output.

8. The relationship between marginal cost and average total cost: • Whenever marginal cost is less than average total cost, average total cost is falling. • Whenever marginal cost is greater than average total cost, average total cost is rising. • The marginal cost curve crosses the average total cost curve at the efficient scale Typical cost curves • In many actual firms, diminishing marginal product does not start to occur immediately after the first worker is hired. Such firm would first experience increasing marginal product for a while before diminishing MP sets in.

9. See Table 13-3 and Figure 13-6 on page 283 & 284 • Three properties: • Marginal cost eventually rises with the quantity of output • The average-total-cost curve is U-shaped • The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost. T4 Costs in the short run and in the long run • For many firms, the division of total costs between fixed and variable costs depends on the time horizon. • A firm’s long-run cost curves differ from its short-run cost curves because many decisions are fixed in the short-run but variable in the long run.

10. See Figure 13-7 on page 286. • The Figure presents three short-run average-total-cost (SRATC) curves for a small, medium, and large factory. • It also presents the long-run average-total-cost curve (LRATC). • As the firm moves along the long-run curve, it is adjusting the size of the factory to the quantity of production. • It shows how short-run and long-run costs are related. • The LRATC curve is a much flatter U-shape than SRATC. • All the short-run curves lie on or above the long-run curve. • These properties arise because of the greater

11. flexibility firms have in the long run. • In essence, • in the long run, a firm gets to choose which short-run curve it wants to use. • But in the short run, it has to use whatever short-run curve it chose in the past. • See Ford’s case, increasing production from 1000 to 1200 cars per day. • in the short run, ATC increases from $10,000 to $ 12,000. Why? Because of diminishing marginal product. Ford has no choice in the short run but to hire more workers at its existing medium-size factory • in the long run, ATC remains at $10,000 because Ford can expand both the size of the factory and its work force.

12. Economies of scale: the property whereby long-run average total cost falls as the quantity of output increase • Ex: specialization among labour force • Diseconomies of scale: the property whereby long-run average total cost rises as the quantity of output increases • Ex: coordination problems • Constant returns to scale: the property whereby long-run average total cost stays the same as the quantity of output changes.

13. Cited from Parkin & Bade ( Microeconomics Canada in the global environment, the 3rd edition, page 219.) • A firm’s cost curves are linked to its product curves. • Over the range of rising marginal product, marginal cost is falling. • When marginal product is a maximum, marginal cost is a minimum. • Over the range of rising average product, average variable cost is falling. • When average product is a maximum, average variable cost is a minimum/ • Over the range of diminishing marginal product, marginal cost is rising. • Over the range of diminishing average product, average variable cost is rising.