Transcript Slide 1

13
The Costs of Production
PRINCIPLES OF
ECONOMICS
FOURTH EDITION
N. G R E G O R Y M A N K I W
PowerPoint® Slides
by Ron Cronovich
© 2007 Thomson South-Western, all rights reserved
ACTIVE LEARNING
Brainstorming
1:
You run General Motors.
 List 3 different costs you have.
 List 3 different
business decisions
that are affected
by your costs.
1
In this chapter, look for the answers to
these questions:
 What is a production function? What is marginal
product? How are they related?
 What are the various costs, and how are they
related to each other and to output?
 How are costs different in the short run vs. the
long run?
 What are “economies of scale”?
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THE COSTS OF PRODUCTION
2
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
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THE COSTS OF PRODUCTION
the market
value of the
inputs a firm
uses in
production
3
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.
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4
Explicit vs. Implicit Costs: An Example
You 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.
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5
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.
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6
Economic Profit versus Accounting Profit
 When total revenue exceeds both explicit and
implicit costs, the firm earns economic profit.
 Economic profit is smaller than accounting profit.
• Economic profit
• Super Normal Profit
• Monopoly Profit
• Producer Surplus
Normal Profit is when total revenue just equals
explicit and implicit cost. (Break even)
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7
Figure 1 Economic versus Accountants
How an Economist
Views a Firm
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
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Explicit
costs
8
THE COSTS OF PRODUCTION
Copyright © 2004 South-Western
2:
Economic profit vs. accounting profit
ACTIVE LEARNING
The equilibrium rent on office space has just
increased by $500/month.
Compare the effects on accounting profit and
economic profit if
a. you rent your office space
b. you own your office space
9
ACTIVE LEARNING
Answers
2:
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.
10
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.
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11
Example 1: Farmer Jack’s Production Function
Q
(no. of (bushels
workers) of wheat)
3,000
Quantity of output
L
2,500
0
0
1
1000
2
1800
3
2400
500
4
2800
0
5
2,000
1,500
1,000
3000
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0
1
2
3
4
5
No. of workers
12
Formulas
 Total Product = total Output
 Average Product = Total Output/ Total Input
 Marginal Product = /\ total Output/ /\ total Input
 /\ = change in
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13
Average product
 The average product is the output per worker.
 The average product will tend to rise initially in
the short run with increasing returns to the
variable factor, but will eventually begin to fall
when diminishing returns set in.
 The marginal product curve will intersect the
average product curve at its peak.
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14
 Marginal product: The addition to output made
by each extra worker
 Total product: Total output.
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15
Marginal Product
 The marginal product of any input is the
increase in output arising from an additional unit
of that input, holding all other inputs constant.
 E.g., if Farmer Jack hires one more worker,
his output rises by the marginal product of labor.
 Notation:
∆ (delta) = “change in…”

Examples:
∆Q = change in output, ∆L = change in labor
∆Q
Marginal product of labor (MPL) =
∆L
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16
EXAMPLE 1: Total & Marginal Product
L
Q
(no. of (bushels
workers) of wheat)
∆L = 1
0
1
∆L = 1
∆L = 1
∆L = 1
∆L = 1
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2
3
4
5
0
MPL
∆Q = 1000
1000
∆Q = 800
800
∆Q = 600
600
∆Q = 400
400
∆Q = 200
200
1000
1800
2400
2800
3000
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17
EXAMPLE 1: MPL = Slope of Prod Function
Q
(no. of (bushels MPL
workers) of wheat)
0
0
1000
1
1000
800
2
1800
600
3
4
5
2400
2800
3000
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400
200
MPL
3,000
Quantity of output
L
equals the
slope of the
2,500
production function.
2,000
Notice that
MPL diminishes
1,500
as L increases.
1,000
This explains why
500 production
the
function
gets flatter
0
as L0 increases.
1
2
3
4
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5
No. of workers
18
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
would benefit from hiring the worker.
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19
Why MPL Diminishes
 Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
E.g., Farmer Jack’s output rises by a smaller and
smaller amount for each additional worker. Why?
 If Jack increases workers but not land,
the average worker has less land to work with,
so will be less productive.
 In general, MPL diminishes as L rises
whether the fixed input is land or capital
(equipment, machines, etc.).
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20
Diminishing returns
 When the addition of a variable factor of
production results in a fall in marginal product.
Diminishing returns refers to a situation where a
firm is trying to expand by using more of its
variable factors, but finds that the extra output
they get each time they add one gets
progressively less and less. This usually arises
because their capacity is limited in the short-run
and the combination of the fixed and variable
factors becomes less than optimal. Diminishing
returns is the main reason why the short-run
supply curve is upward sloping.
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21
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….
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22
EXAMPLE 1: Farmer Jack’s Costs
L
Q
(no. of (bushels
workers) of wheat)
cost of
land
cost of
labor
Total
Cost
0
0
$1,000
$0
$1,000
1
1000
$1,000
$2,000
$3,000
2
1800
$1,000
$4,000
$5,000
3
2400
$1,000
$6,000
$7,000
4
2800
$1,000
$8,000
$9,000
5
3000
$1,000 $10,000
$11,000
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23
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
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24
Short run VS Long run
 The short run is that period of time in
which at least one factor of production is
fixed. All production takes place in the
short run.
 The long run is that period of time in
which all factors of production are variable,
but the state of technology is fixed. All
planning takes place in the long run.
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25
EXAMPLE 2
 Our second example is more general,
applies to any type of firm,
producing any good with any types of inputs.
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26
EXAMPLE 2: Costs
FC
VC
TC
0 $100
$0 $100
1
100
70
170
2
100 120
220
3
100 160
260
4
100 210
310
5
100 280
380
FC
$700
VC
TC
$600
$500
Costs
Q
$800
$400
$300
$200
$100
6
7
100 380
100 520
480
620
$0
0
1
2
3
4
5
6
7
Q
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27
EXAMPLE 1: Farmer Jack’s Total Cost Curve
Q
(bushels
of wheat)
$12,000
Total
Cost
$1,000
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000
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Total cost
0
$10,000
$8,000
$6,000
$4,000
$2,000
$0
0
THE COSTS OF PRODUCTION
1000
2000
3000
Quantity of wheat
28
Marginal costs
 The amount spent on producing one extra unit.
The marginal cost is the increase in total cost
when one more unit is produced.
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29
Marginal Cost
 Marginal Cost (MC)
is the increase in Total Cost from
producing one more unit:
∆TC
MC =
∆Q
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30
EXAMPLE 1: Total and Marginal Cost
Q
(bushels
of wheat)
0
Total
Cost
$1,000
∆Q = 1000
1000
$3,000
∆Q = 800
∆Q = 600
∆Q = 400
∆Q = 200
CHAPTER 13
1800
Marginal
Cost (MC)
$5,000
2400
$7,000
2800
$9,000
3000 $11,000
∆TC = $2000
$2.00
∆TC = $2000
$2.50
∆TC = $2000
$3.33
∆TC = $2000
$5.00
∆TC = $2000
$10.00
THE COSTS OF PRODUCTION
31
EXAMPLE 1: The Marginal Cost Curve
$12
0
TC
MC
$1,000
$2.00
1000
$3,000
$2.50
1800
$5,000
$3.33
2400
$7,000
$10
Marginal Cost ($)
Q
(bushels
of wheat)
$8
MC usually rises
as Q rises,
as in this example.
$6
$4
$2
$5.00
2800
$9,000
3000 $11,000
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$10.00
$0
0
THE COSTS OF PRODUCTION
1,000
2,000
3,000
Q
32
Why MC Is Important
 Farmer Jack is rational and wants to maximize
his profit. To increase profit, should he produce
more wheat, or less?
 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.
(In the next chapter, we will learn more about
how firms choose Q to maximize their profits.)
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33
EXAMPLE 2: Marginal Cost
TC
MC
0 $100
1
2
3
4
5
6
7
170
220
260
310
380
480
620
CHAPTER 13
$70
50
40
50
70
100
140
$200 Marginal Cost (MC)
Recall,
is $175
the change in total cost from
producing
one more unit:
$150
∆TC
MC =
∆Q
$100
Usually,
MC rises as Q rises, due
$75
to diminishing marginal product.
Costs
Q
$125
$50
Sometimes (as here), MC falls
$25
before rising.
$0
(In other0 examples,
1 2 3 MC
4 may
5 6be 7
constant.)
Q
THE COSTS OF PRODUCTION
34
Average fixed cost
 Total fixed cost divided by output. The average
fixed cost will decline as output increases. This
is because as output increases the fixed costs
are spread further and further.
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35
EXAMPLE 2: Average Fixed Cost
FC
0 $100
1
2
100
100
AFC
n.a.
$100
50
3
100 33.33
4
100
25
5
100
20
6
100 16.67
7
100 14.29
CHAPTER 13
$200
Average
fixed cost (AFC)
is$175
fixed cost divided by the
quantity
of output:
$150
Costs
Q
AFC
$125
= FC/Q
$100
Notice
$75 that AFC falls as Q rises:
The firm is spreading its fixed
$50
costs over a larger and larger
$25
number
of units.
$0
0
1
THE COSTS OF PRODUCTION
2
3
4
Q
5
6
7
36
Average variable cost
 The average variable cost is the total variable
cost divided by output. The average variable
cost curve will generally be u-shaped because of
the presence of increasing returns initially in the
short run reducing average variable costs
initially. Eventually, however, diminishing returns
will set in and the average variable cost will start
to rise.
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37
EXAMPLE 2: Average Variable Cost
VC
AVC
0
$0
n.a.
1
70
$70
2
120
60
3
160
53.33
4
210
52.50
5
280
56.00
6
380
63.33
7
520
74.29
CHAPTER 13
$200
Average
variable cost (AVC)
is$175
variable cost divided by the
quantity of output:
$150
Costs
Q
AVC
$125
= VC/Q
$100
As$75
Q rises, AVC may fall initially.
In most cases, AVC will
$50
eventually rise as output rises.
$25
$0
0
1
THE COSTS OF PRODUCTION
2
3
4
Q
5
6
7
38
Average total costs
 The amount spent on producing each unit of
output. The average total cost is calculated by
dividing the total level of cost by the level of
output. The average total cost will be made up of
two elements; the average fixed and average
variable cost. The average total cost curve will
tend to be u-shaped due to the presence of
increasing and then diminishing returns.
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39
EXAMPLE 2: Average Total Cost
Q
TC
0 $100
ATC
AFC
AVC
n.a.
n.a.
n.a.
1
170
$170
$100
$70
2
220
110
50
60
3
260 86.67 33.33
53.33
4
310 77.50
25
52.50
5
380
76
20
56.00
6
480
80 16.67
63.33
7
620 88.57 14.29
74.29
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THE COSTS OF PRODUCTION
Average total cost
(ATC) equals total
cost divided by the
quantity of output:
ATC = TC/Q
Also,
ATC = AFC + AVC
40
EXAMPLE 2: Average Total Cost
TC
0 $100
1
2
170
220
ATC
$200
Usually,
as in this example,
$175
the ATC curve is U-shaped.
n.a.
$150
$170
110
Costs
Q
$125
$100
3
260 86.67
4
310 77.50
5
380
76
$25
6
480
80
$0
7
620 88.57
$75
$50
0
1
2
3
4
5
6
7
Q
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41
EXAMPLE 2: The Various Cost Curves Together
$200
$175
ATC
AVC
AFC
MC
Costs
$150
$125
$100
$75
$50
$25
$0
0
1
2
3
4
5
6
7
Q
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43
ACTIVE LEARNING
Costs
3:
Fill in the blank spaces of this table.
Q
VC
0
1
10
2
30
TC
AFC
AVC
ATC
$50
n.a.
n.a.
n.a.
$10
$60.00
80
3
16.67
4
100
5
150
6
210
150
20
12.50
36.67
8.33
$10
30
37.50
30
260
MC
35
43.33
60
44
ACTIVE LEARNING
Answers
3:
AFC
FC/Q
Use
ATC
= TC/Q
MC
and
First,relationship
AVC
deduce
VC/Q
FCbetween
= $50 and
use
FCTC
+ VC = TC.
Q
VC
TC
AFC
AVC
ATC
0
$0
$50
n.a.
n.a.
n.a.
1
10
60
$50.00
$10
$60.00
2
30
80
25.00
15
40.00
3
60
110
16.67
20
36.67
4
100
150
12.50
25
37.50
5
150
200
10.00
30
40.00
6
210
260
8.33
35
43.33
MC
$10
20
30
40
50
60
45
EXAMPLE 2: Why ATC Is Usually U-Shaped
As Q rises:
$200
Initially,
falling AFC
pulls ATC down.
$175
Costs
Eventually,
rising AVC
pulls ATC up.
$150
$125
$100
$75
$50
$25
$0
0
1
2
3
4
5
6
7
Q
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46
EXAMPLE 2: ATC and MC
When MC < ATC,
ATC is falling.
$175
$150
ATC is rising.
$125
Costs
When MC > ATC,
The MC curve
crosses the
ATC curve at
the ATC curve’s
minimum.
ATC
MC
$200
$100
$75
$50
$25
$0
0
1
2
3
4
5
6
7
Q
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47
Efficient Scale
 The bottom of the U-shaped ATC curve occurs
at the quantity that minimizes average total cost.
This quantity is sometimes called the efficient
scale of the firm.
efficient scale , MC = ATC
 Efficient scale is the quantity that minimizes
average total cost.
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48
Cost Curves and Their Shapes
Average Marginal Rule
 Relationship between Marginal Cost and
Average Total Cost
• Whenever marginal cost is less than average
total cost, average total cost is falling.
• Whenever marginal cost is greater than
average total cost, average total cost is rising.
• Thus, MC will always intersect the ATC at its
minimum.
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49
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).
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50
EXAMPLE 3: LRATC with 3 factory Sizes
Firm can choose
from 3 factory
sizes: S, M, L.
Avg
Total
Cost
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.
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THE COSTS OF PRODUCTION
ATCS
ATCM
ATCL
Q
51
EXAMPLE 3: LRATC with 3 factory Sizes
To produce less
than QA, firm will
choose size S
in the long run.
Avg
Total
Cost
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.
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THE COSTS OF PRODUCTION
ATCS
ATCM
ATCL
LRATC
QA
QB
Q
52
A Typical LRATC Curve
In the real world,
factories come in
many sizes,
each with its own
SRATC curve.
ATC
LRATC
So a typical
LRATC curve
looks like this:
Q
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53
How ATC Changes As
the Scale of Production Changes
Economies of
scale: ATC falls
as Q increases.
ATC
LRATC
Constant returns
to scale: ATC
stays the same
as Q increases.
Diseconomies of
scale: ATC rises
as Q increases.
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THE COSTS OF PRODUCTION
Q
54
Long Run Average Cost Curve
 Brief description: The long run average cost
curve shows the least-cost method of production
of any given level of output.
 It is often drawn U-shaped (though in practice
will vary) to show that initially there may be
economies of scale which reduce the cost per
unit. Subsequently there may be constant
returns to scale where the cost per unit remains
the same and eventually the cost per unit may
begin to rise as diseconomies of scale set in.
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55
Long Run Average Cost Curve
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56
Economies of scale
 EOS are any decrease in long-run average costs
that come about when a firm alters all of its
factors of production in order to increase its
scale of output. Ex:
• Specialization
• Division of labor
• Bulk buying
• Financial economies
• Transportation economies
• Large machines
• Promotional economies
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57
Diseconomies of scale
 DOS are any increase in long-run average costs
that comes about when a firm alters all of its
factors of production in order to increase its
scale of output.
• Control and communication problems
• Alienation and loss of identity
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58
 Long Run Average Total Cost (LRATC)
 ATC of producing a given level of output when
all input can vary.
 LRATC curve is constructed as the least cost of
all possible short run cost curves.
 (NOTE) No AFC in the long-run. In the long run
all inputs are variable, so no fixed costs.
 LRATC is equal to long run AVC (since all costs
are variable).
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59
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.
 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.
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THE COSTS OF PRODUCTION
60
CONCLUSION
 Costs are critically important to many business
decisions, including production, pricing, and
hiring.
 This chapter has introduced the various cost
concepts.
 The following chapters will show how firms use
these concepts to maximize profits in various
market structures.
CHAPTER 13
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61
CHAPTER SUMMARY
 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.
CHAPTER 13
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62
CHAPTER SUMMARY
 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.
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CHAPTER SUMMARY
 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.
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CHAPTER SUMMARY
 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.
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