Production Costs, Supply and Price Determination

Production Costs, Supply and Price Determination Chapter 6

Identification of Costs • Explicit Costs – those costs that are incurred when money is spent to hire labor, repair machinery, buy seed, fuel, or other things for which cash expenditures are made. • Implicit Costs – costs that are incurred in using any resource for which there was no cash outlay. (one’s own labor)

Opportunity Cost • The value of the benefit foregone • Example: your land is capable of producing corn or wheat and for $100 you can produce $300 worth of corn or $200 worth of wheat per acre. • What is the cost of producing wheat? • Not $100 • The $300 worth of corn you have to give up.

Profit • Accounting Profit: AP = Income – Explicit Costs Explicit Costs include hired labor, rentals and other purchased inputs, taxes, insurance, depreciation and so on.

Profit • Economic Profit: EP = Income – Implicit Costs – Explicit Costs Implicit Costs include the opportunity costs of things such as your own labor, owned and depreciated equipment and land.

Other Cost Concepts • Fixed Costs - Costs that don’t change with the level of output. • Variable Costs - Costs that change with the level of output.

Length of Run • Short Run – A period of time in which at least one input is fixed in the production process. This gives rise to diminishing returns. • Immediate Short Run – meaning right now, a time span so short that no resource changes can be made.

Length of Run • Long Run – A period of time in which all input usage is variable in the production process. • Ultimate Long Run

Total Cost Curves • Total Variable Cost (TVC) is the total spending for the variable input. • Total Fixed Cost (TFC) is the total portion of costs that don’t change with the level of output. Total Cost (TC) = TVC + TFC

Total Revenue • Total revenue is the value of all production achieved and sold by the firm. Total Revenue = Price x Quantity of Output

Short-run Costs, Revenue and Profit $ Total Revenue Max Profit Total Variable Cost Total Fixed Cost Loss Output

Measuring Per Unit Costs and Returns • Average Fixed Cost (AFC), the amount spent on the fixed input per unit of output. AFC = Total Fixed Cost = TFC Output Y

Average Fixed Cost $ AFC Quantity

Measuring Per Unit Costs and Returns • Average Variable Cost (AVC), the amount spent on the variable input per unit of output. AVC = Total Variable Cost = TVC Output Y

Measuring Per Unit Costs and Returns • Average Total Cost (ATC), the amount spent on all inputs per unit of output. ATC = Total Cost = TC or TVC +TFC Output Y Y • ATC is also equal to AFC + AVC

Average Total and Variable Cost $ ATC AVC Quantity

Measuring Per Unit Costs and Returns • Marginal Cost (MC), the change in the total cost from adding an additional unit of output. MC = Marginal Cost = Δ TC ΔY

Marginal Cost $ MC Quantity

ATC AVC and MC MC ATC $ AVC Quantity

MC $ ATC AVC P* MR = D = P Shutdown Point Quantity

Cost Curves and the Output Decision Rule – The Search for an Optimum • How much output does one produce in order to maximize profits? • The output decision rule tells us where. • Output Decision Rule is to produce where Marginal Cost is Equal to Marginal Revenue. (MR=MC)

Output Decision Rule Profit Maximization MR = MC MC $ ATC AVC P* MR = D = P Quantity Q*

Profit Per Unit • Price - ATC = Profit per unit of output • Note: Price > ATC indicates a profit • Total Profit = (Price – ATC) x Q

MC $ ATC P* MR = D = P Quantity Q*

MC $ ATC P* Economic Profit MR = D = P Quantity Q*

Average Total Cost and Profit • Price - ATC = Profit per unit of output • Note: Price < ATC indicates a loss

$ Quantity

$ How the Firm Sees Its Demand Curve P* MR = D = P Quantity

MC $ P* MR = D = P Quantity

MC $ ATC P* MR = D = P Quantity

MC $ ATC P* MR = D = P Q* Quantity

MC $ ATC MR = D = P P* Economic Loss Q* Quantity

Firm’s Short Run Supply Curve MC $ MC Curve Above AVC AVC P* MR = D = P Quantity

Production Costs, Supply and Price Determination