The Costs of Production

1. 13 The Costs of Production

2. What Does a Firm Do? • Firm’s Objective • Firms seek to maximize profits • Profits = Total Revenues minus Total Costs • Choose Q such that Max {TR(Q*) –TC{Q*} • Total revenue • Revenue received fromsale of its output • Total cost • Market value of the inputs a firm uses in production

3. Why Are Costs Important to a Firm? • Primary economic objective of a firm • Maximize profits • Total revenues depend on customer demand • Tot Rev(Q) = Price(Qd) x Qd • Price-taker (competitive world) • Initially assume: firm is a Price-taker (competitive world) • Competitors numerous and perfect substitutes • Demand is perfectly elastic • Tot Rev is not controllable by firm • Costs {can controlled by p-taking firm} • Depend on amount supplied (Q*) by the firm • prices of and amounts used of inputs

4. What are Costs? • Costs as opportunity costs • Explicit costs • Input costs that require an outlay of money by the firm • Reflect value of input used by other producers/markets – price willing to pay • Implicit costs • Input costs that do not require an outlay of money by the firm • Opportunity costs of time; alternative investment

5. What are Implicit Costs? • The cost of capital as an opportunity cost • Implicit cost of investment in firm • Interest income not earned • Invested in business • Not shown as cost by an accountant • But is an opportunity cost to an economist; the foregone investment/return • Key difference between economists/accountants and treatment of what costs are and how they affect economic versus accounting profits

6. What are Implicit Costs? • The cost of your labor as an opportunity cost • Implicit cost of your labor (owner) • Wages not earned/paid by someone else • Do you pay yourself a wage if you own the business? • If not, then not shown as cost by an accountant • But is an opportunity cost to an economist; the foregone salary • Another example key difference between how costs are recognized by economists/accountants

7. What are Costs? • Economic profit • Total revenue minus total cost • Including both explicit and implicit costs • Accounting profit • Total revenue minus total explicit cost

8. 1 Economists versus accountants Economists include all opportunity costs when analyzing a firm, whereas accountants measure only explicit costs. Therefore, economic profit is smaller than accounting profit

9. Production and Costs • Production function • Relationship between • Quantity of inputs used to make a good • And the quantity of output of that good • Gets flatter as production rises • Diminishing marginal returns to inputs (e.g., K, L) • Marginal product • Increase (change) in output arising from an additional unit of input (ΔQ/ΔL)

10. 1 A production function and total cost: Caroline’s cookie factory

11. 2 Caroline’s production function and total-cost curve Quantity of Output (cookies per hour) Total Cost (a) Production function (b) Total-cost curve Production function Total-cost curve $90 30 20 10 40 50 60 70 80 100 160 140 120 40 20 80 60 160 140 120 100 20 40 60 80 1 2 3 4 5 6 Number of Workers Hired Quantity of Output (cookies per hour) 0 0 The production function in panel (a) shows the relationship between the number of workers hired and the quantity of output produced. Here the number of workers hired (on the horizontal axis) is from the first column in Table 1, and the quantity of output produced (on the vertical axis) is from the second column. The production function gets flatter as the number of workers increases, which reflects diminishing marginal product. The total-cost curve in panel (b) shows the relationship between the quantity of output produced and total cost of production. Here the quantity of output produced (on the horizontal axis) is from the second column in Table 1, and the total cost (on the vertical axis) is from the sixth column. The total-cost curve gets steeper as the quantity of output increases because of diminishing marginal product.

12. The Various Measures of Cost • Fixed costs • Do not vary with the quantity of output produced • Variable costs • Vary with the quantity of output produced • Average fixed cost (AFC) • Fixed cost divided by the quantity of output • Average variable cost (AVC) • Variable cost divided by the quantity of output

13. 2 The various measures of cost: Conrad’s coffee shop

14. 3 Total Cost Conrad’s total-cost curve Total-cost curve $15.00 14.00 13.00 10.00 11.00 12.00 1.00 3.00 4.00 2.00 5.00 6.00 7.00 8.00 9.00 10 1 7 5 3 4 8 6 9 2 Quantity of Output (cups of coffee per hour) 0 Here the quantity of output produced (on the horizontal axis) is from the first column in Table 2, and the total cost (on the vertical axis) is from the second column. As in Figure 2, the total-cost curve gets steeper as the quantity of output increases because of diminishing marginal product.

15. The Various Measures of Cost • Average total cost (ATC) • Total cost divided by the quantity of output • Average total cost = Total cost / Quantity ATC = TC / Q • Marginal cost (MC) • Increase in total cost • Arising from an extra unit of production • Marginal cost = Change in total cost / Change in quantity MC = ΔTC / ΔQ

16. The Various Measures of Cost • Average total cost • Cost of a typical unit of output • If total cost is divided evenly over all the units produced • Average Fixed Costs = Total Fixed Costs ÷ Q • Average Variable Costs = Total Var Costs ÷ Q • Marginal cost = ΔTC(Q+1 – Q)/ΔQ • Increase in total cost from producing an additional unit of output

17. EXHIBIT 5.1Daily Costs of Manufacturing Pine Lumber 5-17

18. EXHIBIT 5.2The Marginal Cost of Manufacturing Pine Lumber 5-18

19. EXHIBIT 5.1Daily Costs of Manufacturing Pine Lumber 5-19

20. EXHIBIT 5.3The Cost Curves 5-20

21. The Various Measures of Cost • Cost curves and their shapes • U-shaped average total cost: ATC = AVC + AFC • AFC – always declines as output rises • AVC – typically rises as output increases • Diminishing marginal product • The bottom of the U-shape • At quantity that minimizes average Rising marginal cost • Because of diminishing marginal product • total cost

22. The Various Measures of Cost • Cost curves and their shapes • Efficient scale • Quantity of output that minimizes average total cost • Relationship between MC and ATC • When MC < ATC: average total cost is falling • When MC > ATC: average total cost is rising • The marginal-cost curve crosses the average-total-cost curve at its minimum

23. 5 Costs Cost curves for a typical firm MC 1.50 2.00 1.00 0.50 2.50 $3.00 ATC 10 4 8 6 2 14 12 AFC AVC 0 Quantity of Output Many firms experience increasing marginal product before diminishing marginal product. As a result, they have cost curves shaped like those in this figure. Notice that marginal cost and average variable cost fall for a while before starting to rise.

24. Costs in Short Run and in Long Run • Many decisions • Fixed in the short run • Variable in the long run, • Firms – greater flexibility in the long-run • Long-run cost curves • Differ from short-run cost curves • Much flatter than short-run cost curves • Short-run cost curves • Lie on or above the long-run cost curves

25. 6 Average Total Cost Average total cost in the short and long runs ATC in short run with medium factory ATC in long run ATC in short run with large factory ATC in short run with small factory $12,000 Constant returns to scale 10,000 Diseconomies of scale Economies of scale 0 Quantity of Cars per Day 1,000 1,200 Because fixed costs are variable in the long run, the average-total-cost curve in the short run differs from the average-total-cost curve in the long run.

26. Costs in Short Run and in Long Run • Economies of scale • Long-run average total cost falls as the quantity of output increases • Increasing specialization • Constant returns to scale • Long-run average total cost stays the same as the quantity of output changes

27. Costs in Short Run and in Long Run • Diseconomies of scale • Long-run average total cost rises as the quantity of output increases • Increasing coordination problems

28. 3 The many types of cost: A summary