Econ 2420

Ch.11: Technology, Production, and Costs

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A. Introduction

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1.The Objective of any business firm is to maximize economic profits. Profits = Revenue - Costs

2.To maximize profit, firms must use an optimal mix of resources to produce goods and services at the least possible costs.

Firms have to use better and new techniques of production in order to be efficient and reduce costs.

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3.Costs of production arise from the production of goods and services using resources (labor, capital, land, managers, etc).

Payments to factors of production (labor cost, capital, rent, etc.) represent costs.

4.Inefficient firms experience loss of customers because their products are relatively more expensive than for efficient firms.

B. The Production Function

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1. A production function - the relationship between output and inputs (labor, capital, etc.)

2.Examples Qshirts = f(labor, machine, building, etc.) Education = f(faculty, administration, facilities, etc.) Dry cleaning = f(labor, machine, chemicals, hangers, others)

3. Measures of Productivity

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Average productAverage product (AP = Q/L) - output per worker which is a measure of productive efficiency. *It depends on the skill of workers *It depends on the machinery and equipment available to them

Marginal productMarginal product (MP =Change in Output/Change in Variable Input) =ΔQ/ ΔL *additional output associated with an additional unit of the variable input (labor).

Short-Run vs Long-Run

4.a. Short-run production refers to a time horizon during which at least one of the inputs is fixed.

b. Long-run refers to a time horizon long enough for a firm to vary all of its inputs.

Example: Production of Pizza ==> What inputs are fixed in the short-run?

Can we change all the inputs in the long-run ?

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Short-run production function of JeansLabor

Input/day(L) Output(Q) AP=Q/L MP=ΔQ/ΔL

0 0 - -

1 15 15 15

2 34 17 19

3 44 14.7 10

4 48 12 4

5 50 10 2

6 50 8.3 0

7 47 6.7 -3

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What happens to total output as the unit of labor employed increases ? Q increases as L increases

At what unit of labor does the total output reach maximum ? At L=6; Why not at L=5?

What happens to MPL when the total output is maximum ? MPL = 0

Why do AP and MP initially increase and eventually decrease as labor units increase ?

Due to division of labor and congestion effectWhat happens to AP and MP as the use of labor

continues to increase? They will eventually decrease due Law Diminishing Returns

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5. The law of diminishing (marginal) returns states that as we continue to add more of one input (holding other inputs constant), its marginal product will eventually decline.

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C. Short run Costs of Production

1.(a) Costs - payments for the use of hired and owned resources

(b) Costs = Explicit costs + Implicit costs

Explicit costs (Accounting costs, or out-of-pocket cost) -direct cash payments for the use of hired resources (labor, materials)

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Implicit costs (Opportunity costs) -payments for the use of owned resources which do not entail direct payments

Example:(The OC of an owner operator who invests own capital, time, and assets into business)Normal profit is the OC of the resources

supplied by the firm’s owners.A firm realizes a normal profit when economic profit is zero.

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2. Accounting costs = explicit costs(historical costs)Economic costs= Accounting (explicit costs)

+ implicit costs(opportunity costs

3. SR Total Costs of Production

a.Total fixed costs(TFC) - costs which do not vary with the level of output Example: insurance premium, property tax. These costs are unavoidable costs and .

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b.Total Variable Costs (TVC) - costs which vary with the level of output.

.These costs are incurred only when production takes place (labor costs, material costs, etc).

.Variable costs determine whether a firm should stay in business or go out of business.

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c. SR Total Costs (TC) = TFC + TVC (Economic costs) of Producing Jeans

Q TFC TVC TC (TFC+TVC) 0 120 0 $120 15 120 125 245 30 120 240 360 45 120 360 480

Note : TFC= TC-TVC TVC= TC-TFC

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Costs

Q

120

0

TFC

TC

TVCTFC

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4. SR per unit costs of production

• Average fixed cost (AFC = TFC/Q) -per unit fixed cost

• Average Variable Cost (AVC = TVC/Q) -per unit variable cost

5a.It is used to make the closing of operation decision when compared with the product price.

Price < AVC represents the shutdown point.

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Average Total Cost (ATC = TC/Q ) - per unit total cost. ATC= AFC + AVC

5b.It is used to determine the per unit or total profit (loss) when compared with product price.

Per unit Profit = Price - ATC

Total profit = (Price - ATC) Q

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Marginal Cost (MC = TC/ Q)

- An additional cost associated with an additional unit produced.

5c. It is used to determine the profit maximizing rate of output when compared to the marginal revenue (MR)

Note: The profit maximizing rate of output is obtained when MR = MC .

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Q AFC AVC ATC MC

0 - - - - 15 $8.00 $8.33 $16.33 $8.33

30 4.00 8.00 12.00 7.6745 2.67 8.00 10.67 8.00

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Graph of Short-run Per unit Curves

Per unit costs

0 QQ

AFC

MCATC

AVC

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6. The relation of per unit costs to per unit products is inverse.

AVC = TVC/Q = (W . L)/Q = W/AP

MC = ΔTC = Δ(W . L) = W ΔQ Δ Q MP

MC=W/MP

AVC= W/AP

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Costs

AP,MP

0

0 Q1 Q2

Output (Q)

Labor

MCAVC

MP

AP

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Long Run Costs

1.In the SR, a business firm has limited or no options to reduce fixed costs.

In the LR, businesses have a significant flexibility to make investment decisions which could reduce the per unit costs of production.

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2.Long-run costs are important for planning and making investment decisions.

Firms can alter their production capacity as is desirable by building plants (factories) of varying sizes depending on the market demand..

Each plant size is represented by the short run Average total cost (SAC).

The plant size which a company wants to operate depends on the market demand for company’s product.

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3a. The most widely used planning or investment decision criterion is based on the long run average cost

LRAC = LRTC/Q

LRAC - represents the least possible per unit cost to produce a given level of output

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b. Derivation of LRAC=LAC Graph

Table

What is the shape of the LRAC?

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4. The U-Shape of the LRAC curve is explained by economies and diseconomies of scale.

a. Economies of scale - refer to reductions in per unit costs as the scale of operation expands (represent the declining portion of the LRAC curve).

b. Diseconomies of Scale - refer to increases in per unit costs as the scale of operation significantly rises.

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5.(a) Factors which contribute to economies of scale are:

.Specialization and division of labor

.Effective utilization of existing facilities and services

.Better utilization of by-products

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b. A factor contributing to diseconomies of scale is management inefficiency which arises as the scale of operation becomes large (Army, post office)