Costs of Production AP Microeconomics UHS Barnett.
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Transcript of Costs of Production AP Microeconomics UHS Barnett.
Costs of ProductionAP MicroeconomicsUHSBarnett
Total Revenue, Total Cost, Profit• We assume that the firm’s goal is to maximize profit.
Profit = Total revenue – Total cost
the amount a firm receives from the sale of its output
the market value of the inputs a firm uses in production
Costs: Explicit vs. Implicit• Explicit costs require an outlay of money,
e.g., paying wages to workers.• Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time.• Remember one of the Ten Principles:
The cost of something is what you give up to get it.
• This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.
Explicit vs. Implicit Costs: An ExampleYou need $100,000 to start your business.
The interest rate is 5%. • Case 1: borrow $100,000
• explicit cost = $5000 interest on loan
• Case 2: use $40,000 of your savings, borrow the other $60,000
• explicit cost = $3000 (5%) interest on the loan• implicit cost = $2000 (5%) foregone interest you could have earned on
your $40,000.
In both cases, total (exp + imp) costs are $5000.
Economic Profit vs. Accounting Profit
• Accounting profit
= total revenue minus total explicit costs• Economic profit
= total revenue minus total costs (including explicit and implicit costs)
• Accounting profit ignores implicit costs, so it’s higher than economic profit.
Using the information below, compute the explicit and implicit costs, the accounting and economic profits. Then explain what will happen in this industry and why.Total Revenue $600,000Cost of materials $200,000Wages to employees $250,000Foregone wage $100,000Foregone rent and interest $80,000
The explicit costs would be the out-of-pocket expenses of materials and employee wages: 200,000 + 250,000 = $450,000.
The implicit costs are the foregone opportunities, $100,000 + $80,000 = $180,000.
The accounting profit is $150,000 computed by taking the total revenue $600,000 less the explicit costs $450,000.
Subtracting the additional $180,000 of implicit costs leaves an economic profit of negative $30,000.
Thus if this loss continues, we would anticipate the owner would exit this business.
A C T I V E L E A R N I N G 2
Economic profit vs. accounting profit
The equilibrium rent on office space has just increased by $500/month. Determine the effects on accounting profit and economic profit if
a. you rent your office spaceb. you own your office space
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
A C T I V E L E A R N I N G 2
Answers
The rent on office space increases $500/month. a.You rent your office space.
Explicit costs increase $500/month. Accounting profit & economic profit each fall $500/month.
b.You own your office space.Explicit costs do not change, so accounting profit does not change. Implicit costs increase $500/month (opp. cost of using your space instead of renting it), so economic profit falls by $500/month.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
• Think about an airliner like Southwest Airlines. What are their fixed costs and what are their variable costs in the short run?
• Fixed – Insurance, depreciation of equipment (capital), taxes, interest on loans, contract employees
• Variable – jet fuel, food (peanuts), wages to hourly employees
Using the information below, compute the explicit and implicit costs, the accounting and economic profits. Then explain what will happen in this industry and why.Total Revenue $600,000Cost of materials $200,000Wages to employees $250,000Foregone wage $100,000Foregone rent and interest $80,000
The explicit costs would be the out-of-pocket expenses of materials and employee wages: 200,000 + 250,000 = $450,000.
The implicit costs are the foregone opportunities, $100,000 + $80,000 = $180,000.
The accounting profit is $150,000 computed by taking the total revenue $600,000 less the explicit costs $450,000.
Subtracting the additional $180,000 of implicit costs leaves an economic profit of negative $30,000.
Thus if this loss continues, we would anticipate the owner would exit this business.
The Production Function• A production function shows the relationship between the quantity
of inputs used to produce a good and the quantity of output of that good.
• It can be represented by a table, equation, or graph. • Example 1:
• Farmer Jack grows wheat. • He has 5 acres of land. • He can hire as many workers as he wants.
0
500
1,000
1,500
2,000
2,500
3,000
0 1 2 3 4 5
No. of workers
Qua
ntity
of o
utpu
t
EXAMPLE 1: Farmer Jack’s Production Function
30005
28004
24003
18002
10001
00
Q (bushels of wheat)
L(no. of
workers)
Marginal Product• If Jack hires one more worker, his output rises by the marginal
product of labor. • The marginal product of any input is the increase in output arising
from an additional unit of that input, holding all other inputs constant.
• Notation: ∆ (delta) = “change in…”Examples: ∆Q = change in output, ∆L = change in labor
• Marginal product of labor (MPL) =
∆Q∆L
30005
28004
24003
18002
10001
00
Q (bushels
of wheat)
L(no. of
workers)
EXAMPLE 1: Total & Marginal Product
200
400
600
800
1000
MPL
∆Q = 1000∆L = 1
∆Q = 800∆L = 1
∆Q = 600∆L = 1
∆Q = 400∆L = 1
∆Q = 200∆L = 1
MPL equals the slope of the production function.
Notice that MPL diminishes as L increases.
This explains why the production function gets flatter as L increases.
0
500
1,000
1,500
2,000
2,500
3,000
0 1 2 3 4 5
No. of workers
Qua
ntity
of o
utpu
t
EXAMPLE 1: MPL = Slope of Prod Function
30005200
28004400
24003600
18002800
100011000
00
MPLQ
(bushels of wheat)
L(no. of
workers)
Why MPL Is Important• Recall one of the Ten Principles:
Rational people think at the margin.• When Farmer Jack hires an extra worker,
• his costs rise by the wage he pays the worker• his output rises by MPL
• Comparing them helps Jack decide whether he should hire the worker.
Why MPL Diminishes• Farmer Jack’s output rises by a smaller and smaller amount for each
additional worker. Why? • As Jack adds workers, the average worker has less land to work with
and will be less productive. • In general, MPL diminishes as L rises
whether the fixed input is land or capital (equipment, machines, etc.). • Diminishing marginal product:
the marginal product of an input declines as the quantity of the input increases (other things equa)
EXAMPLE 1: Farmer Jack’s Costs
• Farmer Jack must pay $1000 per month for the land, regardless of how much wheat he grows.
• The market wage for a farm worker is $2000 per month. • So Farmer Jack’s costs are related to how much wheat he
produces….
EXAMPLE 1: Farmer Jack’s Costs
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total Cost
30005
28004
24003
18002
10001
$10,000
$8,000
$6,000
$4,000
$2,000
$0
$1,000
$1,000
$1,000
$1,000
$1,000
$1,00000
Cost of labor
Cost of land
Q(bushels of wheat)
L(no. of
workers)
EXAMPLE 1: Farmer Jack’s Total Cost Curve
Q (bushels of wheat)
Total Cost
0 $1,000
1000 $3,000
1800 $5,000
2400 $7,000
2800 $9,000
3000 $11,000
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
0 1000 2000 3000
Quantity of wheat
To
tal c
ost
Marginal Cost• Marginal Cost (MC)
is the increase in Total Cost from producing one more unit:
∆TC∆Q
MC =
EXAMPLE 1: Total and Marginal Cost
$10.00
$5.00
$3.33
$2.50
$2.00
Marginal Cost (MC)
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total Cost
3000
2800
2400
1800
1000
0
Q(bushels of wheat)
∆Q = 1000 ∆TC = $2000
∆Q = 800 ∆TC = $2000
∆Q = 600 ∆TC = $2000
∆Q = 400 ∆TC = $2000
∆Q = 200 ∆TC = $2000
MC usually rises as Q rises, as in this example.
EXAMPLE 1: The Marginal Cost Curve
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
TC
$10.00
$5.00
$3.33
$2.50
$2.00
MC
3000
2800
2400
1800
1000
0
Q(bushels of wheat)
$0
$2
$4
$6
$8
$10
$12
0 1,000 2,000 3,000Q
Mar
gin
al C
ost
($)
Why MC Is Important
• Farmer Jack is rational and wants to maximize his profit. To increase profit, should he produce more or less wheat?
• To find the answer, Farmer Jack needs to “think at the margin.”
• If the cost of additional wheat (MC) is less than the revenue he would get from selling it, then Jack’s profits rise if he produces more.
Fixed and Variable Costs
• Fixed costs (FC) do not vary with the quantity of output produced. • For Farmer Jack, FC = $1000 for his land• Other examples:
cost of equipment, loan payments, rent
• Variable costs (VC) vary with the quantity produced. • For Farmer Jack, VC = wages he pays workers• Other example: cost of materials
• Total cost (TC) = FC + VC
EXAMPLE 2• Our second example is more general,
applies to any type of firm producing any good with any types of inputs.
EXAMPLE 2: Costs
7
6
5
4
3
2
1
620
480
380
310
260
220
170
$100
520
380
280
210
160
120
70
$0
100
100
100
100
100
100
100
$1000
TCVCFCQ
$0
$100
$200
$300
$400
$500
$600
$700
$800
0 1 2 3 4 5 6 7
Q
Cost
s
FC
VCTC
Recall, Marginal Cost (MC) is the change in total cost from producing one more unit:
Usually, MC rises as Q rises, due to diminishing marginal product.
Sometimes (as here), MC falls before rising.
(In other examples, MC may be constant.)
EXAMPLE 2: Marginal Cost
6207
4806
3805
3104
2603
2202
1701
$1000
MCTCQ
140
100
70
50
40
50
$70∆TC∆Q
MC =
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
EXAMPLE 2: Average Fixed Cost
1007
1006
1005
1004
1003
1002
1001
14.29
16.67
20
25
33.33
50
$100
n/a$1000
AFCFCQ Average fixed cost (AFC) is fixed cost divided by the quantity of output:
AFC = FC/Q
Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
EXAMPLE 2: Average Variable Cost
5207
3806
2805
2104
1603
1202
701
74.29
63.33
56.00
52.50
53.33
60
$70
n/a$00
AVCVCQ Average variable cost (AVC) is variable cost divided by the quantity of output:
AVC = VC/Q
As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7Q
Co
sts
EXAMPLE 2: Average Total Cost
88.57
80
76
77.50
86.67
110
$170
n/a
ATC
6207
4806
3805
3104
2603
2202
1701
$1000
74.2914.29
63.3316.67
56.0020
52.5025
53.3333.33
6050
$70$100
n/an/a
AVCAFCTCQ Average total cost (ATC) equals total cost divided by the quantity of output:
ATC = TC/Q
Also,
ATC = AFC + AVC
Usually, as in this example, the ATC curve is U-shaped.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Cost
s
EXAMPLE 2: Average Total Cost
88.57
80
76
77.50
86.67
110
$170
n/a
ATC
6207
4806
3805
3104
2603
2202
1701
$1000
TCQ
EXAMPLE 2: The Various Cost Curves Together
AFCAVCATC
MC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Cost
s
A C T I V E L E A R N I N G 3
Calculating costs
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Fill in the blank spaces of this table.
210
150
100
30
10
VC
43.33358.332606
305
37.5012.501504
36.672016.673
802
$60.00$101
n/an/an/a$500
MCATCAVCAFCTCQ
60
30
$10
A C T I V E L E A R N I N G 3
Answers
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Use AFC = FC/QUse AVC = VC/QUse relationship between MC and TCUse ATC = TC/QFirst, deduce FC = $50 and use FC + VC = TC.
210
150
100
60
30
10
$0
VC
43.33358.332606
40.003010.002005
37.502512.501504
36.672016.671103
40.001525.00802
$60.00$10$50.00601
n/an/an/a$500
MCATCAVCAFCTCQ
60
50
40
30
20
$10
EXAMPLE 2: The Various Cost Curves Together
AFCAVCATC
MC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Cost
s
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Cost
s
EXAMPLE 2: Why ATC Is Usually U-Shaped
As Q rises:
Initially, falling AFC pulls ATC down.
Eventually, rising AVC pulls ATC up.
Efficient scale:The quantity that minimizes ATC.
EXAMPLE 2: ATC and MC
ATCMC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Cost
s
When MC < ATC,ATC is falling.
When MC > ATC,ATC is rising.
The MC curve crosses the ATC curve at the ATC curve’s minimum.
Total Cost = ATC*Q = $15*10 = $150Total Variable Cost = AVC*Q = $8*10 = $80The vertical distance between ATC and AVC is AFC, so TFC = AFC*Q = $7*10 = $70If the total fixed cost is $70 then at 20 units of output, the vertical distance between ATC and AVC which is the AFC would be $3.50.
Similar mirror-image relationship between AP & AVC
Costs in the Short Run & Long Run• Short run:
Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC.
• Long run: All inputs are variable (e.g., firms can build more factories, or sell existing ones).
• In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q (e.g., the factory size with the lowest ATC).
EXAMPLE 3: LRATC with 3 factory sizes
ATCSATCM ATCL
Q
AvgTotalCost
Firm can choose from three factory sizes: S, M, L.
Each size has its own SRATC curve.
The firm can change to a different factory size in the long run, but not in the short run.
EXAMPLE 3: LRATC with 3 factory sizes
ATCSATCM ATCL
Q
AvgTotalCost
QA QB
LRATC
To produce less than QA, firm will choose size S in the long run. To produce between QA and QB, firm will choose size M in the long run. To produce more than QB, firm will choose size L in the long run.
Long run average cost curve (LRATC) shows the minimum average cost of producing any given level of output
A Typical LRATC Curve
Q
ATCIn the real world, factories come in many sizes, each with its own SRATC curve.
So a typical LRATC curve looks like this:
Different industries have different shaped LRATC’s
LRATC
How ATC Changes as the Scale of Production Changes
Economies of scale: ATC falls as Q increases.
Constant returns to scale: ATC stays the same as Q increases.
Diseconomies of scale: ATC rises as Q increases.
LRATC
Q
ATC
The AC curve is broken into three areas
Increasing Returns to Scale (economies of scale) - For instance doubling the inputs leads to a more than doubling of output
Constant Returns to Scale - Doubling of inputs leads to a doubling of output
Decreasing Returns to Scale (diseconomies of scale) - Doubling of inputs leads to less than doubling of output.
How ATC Changes as the Scale of Production Changes
• Economies of scale occur when increasing production allows greater specialization: workers more efficient when focusing on a narrow task.• More common when Q is low. • Spreading out of design and development costs (Movie Industry)• Purchasing inputs in bulk – lower per unit cost (railway industry)• more intensive use of highly skilled personnel• more intensive use of capital (for instance, with shifts)• ability to utilize by-products rather than discard them.
How ATC Changes as the Scale of Production Changes
• Diseconomies of scale are due to coordination problems in large organizations. E.g., management becomes stretched, can’t control costs. • More common when Q is high.• - difficulties in control and supervision,
- slow decision making due to excessive size of administration,- lack of employee motivation.
The minimum efficient scale: is the smallest output that a plant (or firm) can produce such that its long run average costs are minimized.
Beyond this level of production, as this firm continues to grow, it will see no further cost benefits
The minimum efficient scale: is smallest output that a plant (or firm) can produce such that its long run average costs are minimized.
Beyond this level of production, as this firm continues to grow, it will see no further cost benefits
Difference between short-run ATC & LRATC curves
Economies of Scope: Lower the per unit cost as the range of products produced increases
Discussion Questions:1. What does it mean that a firm can become “too big for its own good”? Can you think of any other organizations (economic or otherwise) that have gotten so big that they’ve failed?
2. Why does your hometown have only one electricity company? Why aren’t utility industries such as water, natural gas, and garbage collection more competitive? How does the concept of economies of scale lead to certain industries being “natural monopolies”?
3. Why don’t more companies make jumbo jets?
S U M M A R Y
• Implicit costs do not involve a cash outlay, yet are just as important as explicit costs to firms’ decisions.
• Accounting profit is revenue minus explicit costs. Economic profit is revenue minus total (explicit + implicit) costs.
• The production function shows the relationship between output and inputs.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
S U M M A R Y
• The marginal product of labor is the increase in output from a one-unit increase in labor, holding other inputs constant. The marginal products of other inputs are defined similarly.
• Marginal product usually diminishes as the input increases. Thus, as output rises, the production function becomes flatter, and the total cost curve becomes steeper.
• Variable costs vary with output; fixed costs do not.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
S U M M A R Y
• Marginal cost is the increase in total cost from an extra unit of production. The MC curve is usually upward-sloping.
• Average variable cost is variable cost divided by output. • Average fixed cost is fixed cost divided by output. AFC always falls
as output increases. • Average total cost (sometimes called “cost per unit”) is total cost
divided by the quantity of output. The ATC curve is usually U-shaped.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
S U M M A R Y
• The MC curve intersects the ATC curve at minimum average total cost. When MC < ATC, ATC falls as Q rises. When MC > ATC, ATC rises as Q rises.
• In the long run, all costs are variable. • Economies of scale: ATC falls as Q rises. Diseconomies of scale:
ATC rises as Q rises. Constant returns to scale: ATC remains constant as Q rises.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.