Understanding Production Costs and Decision Making in Business

1. Unit 6 Costs and Decision Making

2. Role of the Firm • Goal • Firms make decisions to maximize profits • Production • Transformation of factors into goods • Production Function • Relationship between the amounts of inputs and quantity of outputs a firm produces • Q = A * fcn(Land, Labor, Capital, Entrepreneurship)

3. Production Decisions Time Frame • Short Run (SR) • Time period where at least one input is fixed • Long Run (LR) • Time period long enough to where all inputs are variable • Very Long Run (VLR) • Allows for technological change to occur

4. Short Run Costs • Fixed Costs (FC) • Costs associated with use of fixed inputs (resources used by a firm that remain constant in the SR) • Example: Property tax, Rental payments, etc. • Variable Costs (VC) • Costs associated with the use of variable inputs (inputs that increase as the level of production increases) • Example: Raw material costs, hourly wages, etc. • Total Costs (TC) = FC + VC • Marginal Costs (MC) • Added cost of an additional unit of output • Change in TC / Change in Q

5. Short Run Average Costs • Average Fixed Costs (AFC) • AFC = FC / Q • Average Variable Costs (AVC) • AVC = VC / Q • Average Total Costs (ATC) • ATC = AVC + AFC

6. Observations of Cost Curves • AFC continually declines as output expands • AVC and ATC decrease at first, then begin to slowly increase • Law of Diminishing Marginal Returns

7. Production Decision Example Simply - a market with only two inputs: Labor and Capital In the Short Run: Capital is fixed Labor is variable Here, the output produced is said to be the product of labor since nothing is produced without workers. Total Product of Labor= total quantity of output produced by the total number of workers. Marginal Product of Labor= additional output (total product) produced from adding an additional worker.

8. Law of Diminishing Returns • When additional units of labor are added to a fixed input, the Marginal Product of labor must eventually decrease. • Why do you think this occurs?

9. Rib Restaurant Example • We have a BBQ Rib Restaurant that hires employees in order to serve dinners to its customers. • Fixed Cost: • Restaurant building, ovens, cooking equipment, plates, etc • Variable Cost • Workers, dinner ingredients, beverages, etc.

10. Rib Restaurant Example • Simplified to only Labor and Capital: • The Fixed Cost of Capital is $100 per hour rent. • The Variable Cost of Labor is $10 an hour per worker. • The Total Product is the number of dinners that the restaurant can serve in an hour.

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27. Typical Short Run Cost Curves