Production Cost - Micro Economics

8/6/2019 Production Cost - Micro Economics

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The Production & Costs


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The Production Function The production function specifies the

maximum amount of output that can

be produced with a given quantity ofinputs. It is defined for a given stateof technical knowledge.

The concept of a production function

is a useful way of describing theproductive capabilities of a firm.


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The Production Function Contd. Mathematically, Y = F (x);

where x = level of input

Y = The maximum level of output Or more generally, Y = F (K, L)

This equation states that output is a function ofthe amount of capital and the amount of labor

The production function reflects the availabletechnology for turning capital and labor intooutput


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Production Function

1. The slope of

production functionequals marginal product

2. As moreinput added, MPdeclines

x

YWith the

available

technology

This curve

shows howoutput

depends on

input,

Y = F(x)


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Total, Average and MarginalP

roductTotal Product is the total amount of output produced in physicalunits such as bushels of wheat or number of sneakers.

Marginal Product of an input is the extra product or output

produced by 1 additional unit of that input while other inputsare held constant.For example, assume that we are holding land, machinery andall other inputs constant. Then labors marginal product is theextra output obtained by adding 1 unit of labor.

Average Product is the total output divided by total units ofinput.Average product of labor or APL = Q/LThis is the accounting measure of productivity.


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A numerical exampleUnits oflabor (a)

Total product(b)

Marginalproduct (c)

Averageproduct(d=b/a)

0 0

1 2000 2000 2000

2 3000 1000 1500

3 3500 500 11674 3800 300 950

5 3900 100 780


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Production Function

1

1

1

MPL

MPL

MPL

1. The slope of

production functionequals marginal product

2. As morelabor is added,MPL declines

Labor, L

Output,

Y

This curve

shows

how

output

dependson labor

input,

holding

the

amount of

capitalconstant


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Marginal Product of Labor Marginal product curve is downward slopping.

MPL = DQ/DLMeasures the output produced by the

last worker.Slope of the production function


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Production Function

Diminishing Marginal Product

Diminishing marginal productis the

property whereby the marginal productof an input declines as the quantity ofthe input increases.

Example: As more and more workers arehired at a firm, each additional worker

contributes less and less to productionbecause the firm has a limited amount ofequipment.


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From the Production Function to

the Total-Cost Curve The relationship between the quantity

a firm can produce and its costs

determines pricing decisions. The total-cost curve shows this

relationship graphically.


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Table 1 A Production Function and Total Cost:Hungry Helens Cookie Factory

Copyright2004 South-Western


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Figure : Hungry Helens Total-Cost Curve

Copyright 2004 South-Western

Total

Cost

$80

70

60

50

40

30

20

10

Quantity

of Output(cookies per hour)

0 10 20 30 15013011090705040 1401201008060

Total-costcurve


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THE VARIOUS MEASURES OF COST

Everywhere that production goes, costs follow

close behind like a shadow.

Costs of production may be divided intofixedcosts and variable costs.

Fixed costsFixed costs are those costs that do notvary with the quantity

of output produced.

Variable costsVariable costs are those costs that do vary with the quantity of

output produced


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$ Cost

Q

FC

C(Q) = FC+ VC

Total Cost=Fixed Cost + Variable Cost

VC(Q)

Fixed Cost & Variable Cost

TC


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Figure 4 Thirsty Thelmas Total-Cost Curves


Total Cost

$15.00

14.00

13.00

12.00

11.00

10.00

9.00

8.00

7.00

6.00

5.00

4.003.00

2.00

1.00

Quantity

of Output

(glasses of lemonade per hour)

0 1 432 765 98 10

Total-cost curve


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Average costs can be determined by dividing the

firms costs by the quantity of output it produces.

The average cost is the cost of each typical unitof product.

Average Fixed Costs (AFC)

AverageVariable Costs (AVC)

Average Total Costs (ATC)ATC= AFC+ AVC

Average Costs


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Average CostsAFC

FC

Q! !

Fixed cost

Quantity

AVCVC

Q! !

Variable cost

uantity

ATCTC

Q! !

Total cost

uantity


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Marginal Cost Marginal cost(MC) measures the increase

in total cost that arises from an extra unitof production.

Marginal cost helps answer the followingquestion:

How much does it cost to produce anadditional unit of output?

MCTC

Q! !

(change in total cost)

(change in quantity)

(

(


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Marginal Cost

Quantity TotalCost

MarginalCost

Quantity TotalCost

MarginalCost

0 $3.00

1 3.30 $0.30 6 $7.80 $1.30

2 3.80 0.50 7 9.30 1.503 4.50 0.70 8 11.00 1.70

4 5.40 0.90 9 12.90 1.90

5 6.50 1.10 10 15.00 2.10


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Figure 5 Thirsty Thelmas Average-Cost and Marginal-CostCurves


Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output


0 1 432 765 98 10

MC

ATC

AVC

AFC


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Cost Curves and Their Shapes Marginal cost rises with the amount

of output produced.

This reflects the property ofdiminishingmarginal product.


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Figure 5 : Marginal-Cost Curves


Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output


0 1 432 765 98 10

MC


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Cost Curves and Their Shapes The average totalaverage total--costcost curve is U-

shaped.

At very low levels of output averagetotal cost is high because fixed cost isspread over only a few units.

Average total cost declines as outputincreases.

Average total cost starts risingbecause average variable cost rises

substantially.


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Cost Curves and Their Shapes The bottom of the U-shaped ATC

curve occurs at the quantity that

minimizes average total cost. Thisquantity is sometimes called theefficient scale of the firm.


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Cost Curves and Their Shapes Relationship between Marginal Cost

and Average Total Cost

Whenever marginal cost is less than averagetotal cost, average total cost is falling.

Whenever marginal cost is greater thanaverage total cost, average total cost isrising.

The marginal-cost curve crosses the average-total-cost curve at the efficient scaleefficient scale.

Efficient scale is the quantity that minimizesaverage total cost.


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Figure :Average-Cost and Marginal-Cost Curves


Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output


0 1 432 765 98 10

ATC

MC


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Typical Cost Curves Three Important Properties of Cost Curves

Marginal cost eventually rises with thequantity of output.

The average-total-cost curve is U-shaped.

The marginal-cost curve crosses theaverage-total-cost curve at the minimum ofaverage total cost.


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COSTS IN THE SHORT RUN AND IN

THE

LONG RUN For many firms, the division of total costs

between fixed and variable costs depends onthe time horizon being considered.

In the short run, some costs are fixed. In the long run, fixed costs become variable

costs.

Because many costs are fixed in the short runbut variable in the long run, a firms long-runcost curves differ from its short-run costcurves.


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Figure 7 Average Total Cost in the Short and Long Run


Quantity of

Cars per Day

0

AverageTotal

Cost

1,200

$12,000

ATC in shortrun with

small factory


medium factory


large factory

ATC in long run


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The Firms Objective

The Firms Objective

The economic goal of the firm is tomaximize profits.


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Total Revenue, Total Cost, and Profit Total Revenue

The amount a firm receives for the saleof its output.

TotalCost

The market value of the inputs a firmuses in production.


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Total Revenue, Total Cost, and Profit Profitis the firms total revenue

minus its total cost.

Profit = Total revenueProfit = Total revenue -- TotalTotalcostcost


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Costs as Opportunity Costs

A firms cost of production includes allthe opportunity costs of making its

output of goods and services. Explicit and Implicit Costs

A firms cost of production includeexplicit costs and implicit costs.

Explicitcosts are input costs that require adirect outlay of money by the firm.

Implicitcosts are input costs that do notrequire an outlay of money by the firm.


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Economic Profit versus AccountingProfit

Economists measure a firms economicprofitas total revenue minus total cost,including both explicit and implicit costs.

Accountants measure the accountingprofitas the firms total revenue minus

only the firms explicit costs.

When total revenue exceeds both explicit andimplicit costs, the firm earns economic profit.

Economic profit is smaller than accountingprofit.


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Figure 1 Economic versus Accountants


Revenue

Total

opportunitycosts

How an Economist

Views a Firm

How an Accountant

Views a Firm

Revenue

Economicprofit

Implicitcosts

Explicitcosts

Explicitcosts

Accountingprofit

Production Cost - Micro Economics

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