Chapter 11 Production and Costs

1. Chapter 11Production and Costs

2. What is a basic assumption in economics?Why are firms in business? To do what? • The motivation for business decisions is profit maximization • Opportunity cost is the highest-valued alternative forgone when a choice/decision is made by the firm.

3. What are Fixed Costs? • Fixed Costs • Sunk Costs • Q = 0 ……….FC ….. + (Positive) • As Q (increases) FC remains the same • Examples • Rent • insurance

4. Taxes; Interest rates • Example:Renting a class (Maximum 25 students) • Q=0 …FC = $1000 ….AFC = $1000 • Q=5 …FC = $1000 …. AFC = $200 • Q=10…FC = $1000 ….AFC = $100 • Q=15 …FC = $1000 …AFC = $66 • Q=20 ….FC = $1000…AFC = $50 • Q=25 ….FC = $1000…AFC = $40

5. Fix costs for renting a class $`1000  $200 $200 $`150 Average fix cost = fix cost/units $100  $`100 $66  $50  $50  $40 5 10 15 20 25 Quantity of units (Students)

6. What are Variable Costs? • Variable Costs Q = 0 ……….VC ….. 0 (zero) • As Q (increases) VC  • Examples • wages • Utility • Raw materials

7. What are Variable Costs? • Variable costs per student = $1 • Q=0 …FC = $1000 ….TVC = 0 • Q=5 …FC = $1000 …. TVC = $5 • Q=10…FC = $1000 ….TVC = $10 • Q=15 …FC …$1000….TVC = $15 • Q=20 ….FC = $1000….TVC = $20 • Q=25 ….FC = $1000….TVC = $50

8. Fix costs for renting a class $`1000 Total Variable costs per student  $20  $`15  $`10 $5  5 10 15 20 25 Quantity of units (Students)

9. AFC = TFC/TQ • AVC=TVC/TQ • ATC=TC/TQ=FC+VC/TQ • MC = TC/ Q • MC = cost of producing one additional unit of a product • MC = • (+) or (– ) or ( )

10. To understand Profit, what is necessary? To distinguish between the way economists measure costs and the way accountants measure costs

11. Total costs • Fixed costs + Variable costs • Profit = Total Revenue – Total costs • Profit = Sales – (TFC + TVC) • Profit = Total Revenue – Total costs • Profit = P * Q – (TFC + TVC) • Increase TR (PQ  ) • Decrease costs ()

12. What are Explicit Costs? • A cost paid in money • Payments to nonowners of a firm for their resources • Accounting costs • Direct costs • Cash payment

13. Example of Explicit Costs • Wages • Raw materials • Interest rates to the bank and bond holders • Utility • Other direct payments

14. What are Implicit Costs? • The opportunity cost incurred by a firm when it uses a factor of production for which it does not make a direct money payment. • The opportunity cost of using resources owned by the firm • Indirect costs • Hidden costs • Non-payment costs • Owners costs

15. Example of Implicit Costs? • Forgone salary • Forgone rent • Forgone interest on investment. • Economic depreciation (change in market value of capital over time)

16. Accounting profits = • Total revenue – Total costs (FC + VC) • Accounting profits are always greater than economic profits

17. Economic profits = • Total revenue - (Explicit+Implicit) • Accounting profits are always greater than economic profits

18. What is Normal Profit? • The minimum profit necessary to keep a firm in operation • Covering all costs • Direct costs (explicit) (FC+VC) • Indirect costs (implicit) • Zero economic profit is good. Why?

19. Item Accounting Profit Economic Profit Computech’s Accounting Versus Economic Profit Total Revenue Less Explicit costs: Wages & salariesMaterialsInterest paidOther payments Less implicit costs:Foregone salaryEconomic Dep. Foregone interest Equals profit $500,000 $300,000$100,000$10,000$10,000 000 $80,000 $500,000 $300,000$100,000$10,000$10,000 80,00030,0005,000 -$35,000 Exhibit 1

20. Item Accounting Profit Economic Profit Computech’s Accounting Versus Economic Profit Total Revenue Less Explicit costs: Wages & salariesMaterialsInterest paidOther payments Less implicit costs:Foregone salaryEconomic DepForegone interest Zero economic profit $535,000 $300,000$100,000$10,000$10,000 000 $115,000 $535,000 $300,000$100,000$10,000$10,000 80,00030,0005,000 $0 Exhibit 1

21. Short and Long run • The short run is a time frame in which the quantities of some resources are fixed. • The long run is a time frame in which the quantities of all resources can be varied.

22. L TP MP 0 0 1 1 2 3 3 6 4 8 5 9 6 9 AP A 1 1 B 2 1.5 C D 2 3 E 2 2 F 1 1.8 1.5 0 G H -1 1.14 7 8

23. Total Product   9 9 9  8  8 8 7  6 6 5 Marginal Product 4  3 3 Average Product  2 1 1 1 2 3 4 5 6 7 8 9 B F

24. Increasing marginal returnsDecreasing marginal returns • Specialization • Division of labor • Learning curve • Same work space • limited equipment • bureaucracy • command and control • specialization but decreasing importance

25. What is the Marginal-product rule? When MP < AP, AP falls When MP > AP, AP rises If MP = AP, AP MAX example grade point average

28. 950 640 775 550 525 566.6 425 400 400 350 325 400 306 300 280 300 220

29. SHORT-RUN COST A firm’s average variable cost curve is linked to its average product curve. If average product rises, average variable cost falls. If average product is a maximum, average variable cost is a minimum.

30. SHORT-RUN COST At low outputs, MP and AP rise and MC and AVC fall. At intermediate outputs, MP falls and MC rises; and AP rises and AVC falls. At high outputs, MP and AP fall and MC and AVC rise.

31. Shifts in cost curve • Technology • Product curve • Cost curve down • Prices of factors of production • Product curve • Cost curve down 

32. Businesses face three options • Operate • Maximize profits & Minimize losses • Shut down • Q = 0; Only costs are = FC • Go out of business • Q=0; No costs; FC = 0

33. Example 1 • TR = SALES = $7 mil • FC = $5 mil • VC = $6 mil • Solution • TC = FC + VC = $5mil + $6mil = $11mil • Profit = TR-TC=

34. Choice 1 operate • Profit = $7mil - $11mil=loss of $4mil : • Choice 2 Shut down • Q=0 only FC = $5 mil • Loss $5 mil • Decision: Operate because … • Operating loss($4mil) < shut down loss ($5mil)

35. Example 2 • TR = SALES = $8 mil • FC = $10 mil • VC = $9 mil • Solution • TC = FC + VC = $10mil + $9mil = $19 mil • Profit = TR-TC=

36. Choice 1 operate • Profit = $8mil - $19mil=loss of $11mil : • Choice 2 Shut down • Q=0 only FC = $10 mil • Loss $10 mil • Decision: Shut down because. • Operating loss($11mil) > shut down loss ($10mil)

37. Rule: If you are covering all your VCSR Operate • TR(SALES)  VC • Rule: If you are NOT covering all your VCSR Shut down • TR(SALES) < VC • VC > TR

38. Golden rule for profit maximization or loss minimization • Always produce where MC = MR. Why ? • MR = TR/ Q • How is the price determined in the market?

41. 950 640 775 550 525 566.6 425 400 400 350 325 400 306 300 280 300 220

42. What is the Marginal-Average Rule? When MC < AC, AC falls When MC > AC, AC rises If MC = AC, AC at minimum

43. Price is determined by the market • If P = $575 • If P = $450 • If P = $300 • If P = $200 • Calculate profit/loss

44. 950 640 775 550 525 566.6 425 400 400 350 325 400 306 300 280 300 220

45. Price = $575 • Step 1 : Q = MR = MC (GOLDEN RULE) • Step 2 : TR = P X Q = • Step 3 : TC = P (COST) X Q = • Step 4 : PROFIT = TR -TC

46. Price = $575 • Step 1 : Q = MR = MC (GOLDEN RULE) = 5.5 units • Step 2 : TR = P X Q = • 575 x 5.5 = $3,162.5 • Step 3 : TC = P (COST) X Q = • 540 x 5.5 = $2,970 • Step 4 : PROFIT = TR –TC • $3,162.5 - $2,970 = +$192.5

48. Price is determined by the market • If P = $700 • If P = $1,100 • Use four steps to calculate profit/loss

49. What is the relationship between the minimum and maximum points of the MR and MP curves? The maximum point of the MP curve corresponds to the minimum point of the MC curve

50. Plant Size and Cost ( Q ) • Economies of scale • specialization, division, learning curve, overhead spread, market power, • Diseconomies of scale • Diseconomies of scale arise from the difficulty of coordinating and controlling a large enterprise. • Eventually, management complexity brings rising average total cost. • Constant returns to scale • Constant returns to scale occur when a firm is able to replicate its existing production facility including its management system.