Topic 5

1. Topic 5 Business and Costs of Production

2. Definition: Cost and Profit • As consumers maximize utility, Producers maximize profit • Profit is the reward for the entrepreneur for organizing the production process by pooling land, labor and capital and taking risk • Profit is the residual that is left after all resource providers are paid for and goes to the entrepreneur • Profit = Total Revenue – Total Cost

3. Types of Cost Three types of cost: • Explicit costs • Payments for resources • Shows up in the accounting book • Implicit costs • cost of the resources owned by the firm owners • No cash payment is transferred • Opportunity cost Opportunity cost = Explicit cost + Implicit cost

4. Alternative Measures of Profit Since Profit = Total Revenue – Total Cost and there are three types of cost, we have three alternative measures of profit. Accounting profit =Total revenue - Explicit costs Economic Profit = Total Revenue – O.C. Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)

5. Normal Profit • When total revenue is just equal to explicit and implicit cost, the economic profit is zero • In this case, all resource owners are just paid for and no excess profit left. • Including entrepreneur who receives his opportunity cost (highest value forgone) • In this case (economic profit = 0), we say firm is earning a normal profit • When economic profit > 0, firm is earning above normal or excess profit

6. Wheeler Dealer Accounts, 2007

7. Types of Resources • Variable Resources: Resources that must vary with output produced • Raw materials • Labors • Electricity or Energy • Fixed Resources: Resources that remain unchanged regardless of output • Rent • Interest payment for fixed resources

8. Short Run and Long Run • Short Run or Long Run has nothing to do with time. • They are based on how quickly resources can be varied. • Short run: At least one of the resources is fixed or cannot be varied • Long run: None of the resource is fixed or all resources can be varied

9. Production Function • Production function • Describes the relationship between amount of resources employed and total output • Y= f(L,K) Here, Y = total output or total product L = Amount of labor used K = Amount of Capital used • For example, Y=2.L + 5K • Calculate the total product or Y when • L=100 and K=50

10. Total and Marginal Product • Total Product: Cumulative amount of output produced at different levels of inputs (resources) • Marginal product: Additional amount of output produced from an additional unit of input (resource) • Marginal product of labor: • MPL = ∆TP / ∆L • Marginal product of capital: • MPK = ∆TP / ∆K

11. In Class Practice 1 • Compute the MPL

12. In Class Practice 2 • Compute the MPL

13. Law of Diminishing Marginal Returns • When one of the resources is fixed, marginal product of the variables resource fall • When more and more labor (variable resource) is employed to a same grill (fixed resource) to produce hamburger MPL or productivity of each additional worker will rise first (synthesis effect)

14. Law of Diminishing Marginal Returns • However, after a while, the MPL or the labor productivity will fall • This happens due to fixed resource and known as the Law of Diminishing Marginal Returns • Therefore, this is essentially a short run phenomenon

15. Marginal Returns

16. Marginal Returns • Diminishing Marginal Return kicks in at 4th unit labor • But total product keeps rising until 7th unit labor • Total product is rising at a “decreasing rate” from 4th to 7th unit • Total product falls at the 8th unit of labor when MPL is negative

17. TP and MPL TP 15 Total product 10 5 Labor 0 5 7 10 MPL Diminishing but positive marginal returns Increasing marginal returns 5 4 3 Negative marginal returns 2 1 0 Labor 7 Marginal product 5 10

18. Total Product (TP) • 5 labors produce 500 unit does not mean that each worker produce 100 unit • Although this can a possible way, but this is very improbable, why? • Law of diminishing return may be at work, especially when we are in the short run (at least one of the inputs is fixed) • To know the contribution of individual labors into the production process, we need to look at the Marginal Product (MP) information

19. Total Product (TP) • For example, consider the following table: • In all four TP series, TP=500 when L=5 • But, this table says nothing about 3rd worker’s contribution to the production process • Actually, 3rd worker’s contribution is different for different series. We can see it in the associated MP table

20. Marginal Product (MP) • Looking at the associated MP series, we can tell: • TP1 exhibits constant marginal return for labor • TP2 exhibits increasing marginal return for labor • TP3 exhibits both increasing and decreasing marginal return for labor • TP4 exhibits decreasing marginal return for labor • Which TP series you think represents a typical short run production function?

21. Marginal Product (MP) • Looking at the associated MP series, we can tell: • TP1 exhibits constant marginal return for labor • TP2 exhibits increasing marginal return for labor • TP3 exhibits both increasing and decreasing marginal return for labor • TP4 exhibits decreasing marginal return for labor • Which TP series you think represents a typical short run production function?

22. Production Costs • Costs are simply the payments to resource providers • There are three types in short run: • Fixed cost (FC): Payment for the fixed resources. • No fixed cost in the long run (why?) • Variable cost (VC): Payment for variable resources • Total costTC = FC + VC

23. In Class Practice 3 • Marginal Cost: Change in Total Cost to produce one more unit of output. Formula: MC = ∆TC/∆Q • Compute the Marginal Cost

24. MC and MPL • MC and MPL are related • Increasing marginal product (MPL) • Implies that MC must be falling • Diminishing marginal product (MPL) • Implies MC must be rising

25. In Class Practice 4 • Short-run TC and MC data for Smoother Mover For first 3 labors, Increasing marginal returns (MPLrises): MC falls With the 4th labor, Diminishing marginal returns hits (MPLrises): MC rises

26. In Class Practice 4 For first 3 labors, Increasing marginal returns (MPL rises): Therefore, MC is falling Starting with the 4th labor, Diminishing marginal returns kicks in (MPL rises): Therefore, MC is rising

27. Total Cost (TC) • Total Cost (TC) simply means total expenditure on inputs used • Total cost is a function of number of output produced (not inputs used, a common mistake) • We may find that total cost is $500 when 5 units of output is produced • This is an information about total cost • But, this information says nothing about the cost of producing the 3rd unit of output

28. Shapes of TC and MC Curves Total cost FC = $200 at all levels of output Total dollars Variable cost VC starts from origin; increases slowly at first; with diminishing returns, VC increases rapidly Fixed cost $500 TC is the vertical sum of FC and VC 200 Fixed cost Tons per day 0 3 6 9 15 12 MC first declines: TC increasing at decreasing rate [From 0-9] Then after 9, MC increases: • TC increases at an increasing rate • Diminishing marginal returns Cost per ton Marginal cost $50 25 Tons per day 3 6 9 12 15 0

29. Average Cost (AC) • Although MC for each unit varies, sometime it is important to know the per unit cost • Average Cost is calculates this per unit cost • Consider a part of the preceding table

30. Average Cost (AC) • Although MC for each unit varies, sometime it is important to know the per unit cost • Average Cost is calculates this per unit cost • Consider a part of the preceding table

31. Average Cost (AC) • Although MC for each unit varies, sometime it is important to know the per unit cost • Average Cost is calculates this per unit cost • Consider a part of the preceding table

32. Average Cost (AC) • Important question is what do MC and ATC really mean? • MC=$33.33 simply means that the 5th unit costs $50 • ATC=$80 means: • when 5 units are produced, on an average each unit costs $80 • In other words, when Q=5, per unit cost is $80

33. Average Cost (AC) We know, AC= Cost/Quantity There are three types of costs: • Fixed cost (FC) • Variable cost (VC) • Total cost (TC) Consequently, there are three types of Average Costs • Average Fixed Cost (AFC=FC/Q) • Average Variable Cost (AVC=VC/Q) • Average Total Cost (ATC=TC/Q)

34. ATC = AFC +AVC • Total Cost = Fixed Cost + Variable Cost • TC = FC +VC • Show that ATC = AFC +AVC • ATC = TC/Q ………………………….[Definition of ATC] = (FC + VC)/Q = FC/Q +VC/Q = AFC + AVC ………………..[Definition of AFC and AVC] Therefore, ATC = AFC + AVC

35. FC, VC, TC, AFC, AVC and ATC • Short run TC, MC, and AC data for Smoother Mover • Note, ATC = AFC + AVC

36. FC, VC, TC, AFC, AVC and ATC • Short run TC, MC, and AC data for Smoother Mover • Note, ATC = AFC + AVC

37. Relationship Between MC and AC Consider a NBA player with a career average score of 30. • In his next game, if he scores 40. What will happen to his career average? • When MC > AC The marginal pulls his average UP

38. Relationship Between MC and AC Consider a NBA player with a career average score of 30. • Conversely, if he scores 20. What will happen to his career average? • When MC < AC The marginal pulls the average DOWN

39. MC and ATC • Short run TC, MC, and AC data for Smoother Mover • When MC < ATC, the ATC Falls • When MC > ATC, the ATC Rises • This means, when MC=ATC, the ATC does not change • Graphically, this means MC must go through the lowest point of ATC

40. Shape of ATC=TC/Q As Q goes up, ATC falls initially • Because we are dividing by a larger number • Note, Fixed Cost is being distributed across many units However, as Q goes further up ATC rises • Because the Law of diminishing marginal returns reduces labor productivity (MPL) and increases the Total Cost • Therefore, ATC is of U-shape

41. Shape of ATC and AVC Cost ($) $150 125 100 ATC 75 AVC 50 25 0 5 10 15 Q

42. ATC, AVC and MC • When MC is above AVC and ATC, AVC and ATC is increasing • When MC is below AVC (ATC), the AVC and ATC is falling • When MC = AVC (ATC), AVC (ATC) is at its minimum. Cost ($) MC $150 125 100 ATC 75 AVC 50 25 Q 0 5 10 15

43. Costs in the Long Run Definition: It is a time period in which all resources or inputs can be varied • Long is often considered as a Planning Horizon Because, • Firms plan in the long run • But, produce in the short run • Long run is generated by aggregating many possible short run cost curves

44. LRATC curve from SRATC Cost per unit Consider three short run ATC curve: SS’, MM’ and LL’ Long run ATC curve: SabL’ L’ S M’ M L S’ a b Q per period 0 qa q’ qb

45. LRAC is an Envelop of SRAC Long-run average cost ATC10 ATC1 • curve ATC9 ATC2 $11 b ATC8 a 10 ATC3 ATC7 9 • 10 possible plant sizes are shown • Each point of tangency represents the least cost way of producing that level of output in the short run ATC4 ATC6 Cost per unit c ATC5 0 q q’ Output per period • The long run average cost curve is drawn by connecting the lowest point of SRATC. • Therefore, LRATC is an envelop of SRATC

46. Costs in the Long Run U-shaped long-run average cost curve has three components that represent: • Economies of scale (Increasing Returns to Scale) • LRAC falls as output expands • Diseconomies of scale (Increasing Returns to Scale) • LRAC increases as output expands • Constant Returns to Scale • LRAC is constant or horizintal

47. Economies of Scale in Long Run Long-run average cost Cost per unit 0 A B Output per period Economies of scale Constant average cost Diseconomies of scale