Transcript Mankiw Chapter 13

Chapter 13
The Costs of Production
Ratna K. Shrestha
The Costs of Production
P
The Law of Supply:
Firms are willing to
produce and sell a
greater quantity of a
good when the price
of a good is high.
Supply
Q
Why Study Behavior of Firms?
Gain a better understanding
of the decisions made by
producers.
Study how the behavior of a
firm depends on the
structure of the market.
Purpose Facing A Firm
The economic purpose of the firm is to maximize profit!
Profit = Total Revenue - Total Cost.


Revenue: The amount that the firm receives for the
sale of its product.
Revenue = Market Price x Amount Sold = PxQ
Cost: The amount that the firm spends to buy inputs
such as labor, raw materials and capital (machines and
tools).
Costs of Production

The firm’s costs include Explicit Costs and Implicit
Costs:
– Explicit Costs: costs that involve a direct money
outlay for factors of production. For example:
hiring labor.
– Implicit Costs: costs that do not involve a direct
money outlay (e.g. opportunity costs of the
owner’s own inputs used - implicit wages, implicit
rent).
v When the owner works for his/her own
company and does not get paid then the salary
the owner could have earned by working for
somebody else is the implicit costs.
Costs as Opportunity Costs


Accountants measure the explicit costs but often
ignore the implicit costs.
Economists include all opportunity costs when
measuring costs (such as firm’s own building for
which it doesn’t pay rent).

Accounting Profit = TR - Explicit Costs
Economic Profit = TR - Explicit Costs - Implicit Costs.

Opportunity costs = Explicit + Implicit costs.

Costs as Opportunity Costs


A third, not so obvious cost includes sunk costs.
Sunk costs are costs that have already been committed
and cannot be recovered.
– So sunk costs have no alternative use and hence its
opportunity cost is zero.
– It doesn’t affect the decisions about supplying a
product because its opportunity cost is zero.
– Whereas opportunity cost should be taken into
consideration while making economic decisions.
Quick Quiz



“A farmer has planted corn seeds but has not yet
fertilized the field.”
Is the cost of seed opportunity cost or a sunk cost?
Is the cost of fertilizer an opportunity cost or a sunk
cost?
Which of these two costs is more likely to affect the
decision to continue farming?
A Production Function and
Total Cost
Number of
Workers
Output
0
0
1
50
2
Marginal
Product of
Labor
Cost of
Factory
Cost of
Workers
Total Cost of
Inputs
$30
$0
$30
50
30
10
40
90
40
30
20
50
3
120
30
30
30
60
4
140
20
30
40
70
5
150
10
30
50
80
The Production Function
The production function shows the relationship
between quantity of inputs used to make a good and
the quantity of output that can be produced from the
use of those inputs.
Production function also reflects the technology of
production.
For example out of the two production functions (a) Q
= K L2 and (b) Q = KL, which one reflects better
technology?
A Production Function...
Quantity
(cookies
per hour)
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
Production function
1
2
3
4
5
Number of Workers Hired
Marginal Product (MP)
Marginal
product
=
Additional output
Additional input
The slope of the production function = Marginal
Product (MP) of an input, such as a worker.
 When the MP declines, the production function
becomes flatter.
 As long as MP of a worker is positive, you can add to
your output by hiring more workers. Once MP = 0, an
extra worker adds to no extra output. That means at that
point when MP = 0, you have maximized your output.

Diminishing Marginal Product
Diminishing marginal product is the property whereby
the MP of an input declines as the quantity of the input
such as labor increases.
Example: As more and more workers are hired at a
firm, if each additional worker contributes less and less to
production because the firm has a limited amount of
equipment, then we have diminishing MP in the
production process. If a firm has only 2 computers but
hires 4 people, then 2 workers have to share a computer
and thus the productivity of a worker declines. If there
are only two workers, in that case productivity of each
worker will be higher.
Total-Cost Curve...
Total
Cost
Total-cost
curve
$80
70
60
50
40
30
20
10
0
20
40
60
80
100 120 140
Quantity of Output
(cookies per hour)
Short-Run vs. Long-Run
Two different time horizons are important when
analyzing costs.
Short-Run: Time period over which some inputs are
variable (e.g, labor, materials) and some inputs are
fixed (e.g., plant size).
Long-Run: Time period over which all inputs are
variable, including plant size.
Short-Run Costs
Costs of production may be divided into two categories
in the short-run:
Fixed Costs:
– Those costs that do not vary with the amount of
output produced. For example, if you have rented
an office for your law firm, then the rent of your
office (cost) does not change with how many
clients (Q) you see. So the rent in this case is a
part of fixed cost.
Variable Costs:
– Those costs that do vary with the amount of output
produced. In the law firm example, the cost of
lawyer’s time is variable as it increases with the
number of clients he/she sees
Family of Costs...




Total Fixed Costs (FC)
Total Variable Costs (VC)
Total Costs (C) = FC + VC
Average Costs:
 Cost / Output Level
Average Fixed Costs (AFC) = FC / Q
 Average Variable Costs (AVC) = VC/Q
 Average Total Costs (ATC) = C / Q

Marginal Cost


Marginal Cost (MC): is the extra
cost of producing one more unit of
output.”
 MC = C/Q
If Ford’s total cost of
producing 4 cars is
$225,000 and its total cost
of producing 5 cars is
$250,000. . . what is the ATC
and MC of producing the
fifth car?
Shape of Short-Run Cost Curves

Short-run cost behavior is based on the productivity
of the inputs.

As the firm continues to expand output, in a fixed
plant-size situation, eventually the marginal product
of each successive worker hired will decrease. This is
because the more workers hired have to share the
limited resources (plant size).

The diminishing marginal product causes the
marginal cost to increase in the short-run.
Shape of Typical Cost Curves
Cost ($)
MC
ATC
AVC
AFC
Quantity of
output
The Shape of Typical Cost Curves
U-Shaped Average Total Cost (ATC):
– At low levels of output, as the firm expands
production, ATC declines.
– At higher production levels, as output is increased,
ATC increases.
– The bottom of the U-Shape occurs at the quantity
that minimizes average total cost.
– This is called the Efficient Size of the firm.
Relationship Between MC &ATC




Why is ATC U - shaped?
When MC < ATC, ATC is falling.
MC < ATC
ATC
When MC > ATC, ATC is rising.
MC > ATC
ATC
At the point where MC = ATC, ATC is minimum.
Why?
Cost ($)
Relationship Between MC & ATC
MC
ATC
The MC curve always
crosses the ATC
curve at the minimum
ATC cost!
Quantity
Long-Run Costs
 How
do per unit costs behave as the firm expands
all inputs, even plant size or scale of operation?
 Then in this case there is no short run fixed cost as
all the factors of inputs are variable.
 The Long-Run Average Total Cost (LRATC)
reflects the lowest possible unit cost related to
different plant sizes and/or scales of operation.
 For each plant size, there is one specific minimum
LRAC.
 The LRATC Curve is U-shaped as shown in the
next slide.
Long-Run Costs
$/Unit
Economies
of scale
LRATC Curve
Constant Returns
to Scale
Short-Run
ATC
Diseconomies
of Scale
Scale of Operation (Q)
Long-Run Costs
There are three typical long-run cost situations:
Economies of Scale: Long run ATC decreases as
the scale of operation (Q) increases. Many
companies especially utilities enjoy economies of
scale.
 For example in the case of Shaw Cable, the cost
of providing service to an additional household is
very small, and so if it can expand the service,
the ATC declines.
Diseconomies of Scale: LRATC increases with the
scale of operation.
Constant Returns to Scale: LRATC stays constant
as the scale of operation increases.
Long-Run Costs
More Formally:
Economies of Scale is measured as a costoutput elasticity.
EC
EC
C / C
MC


Q / Q
AC
= 1, neither economies nor diseconomies of
Scale
EC > 1, diseconomies of scale.
EC < 1, economies of scale. Notice that the firm
enjoys economies scale when MC < ATC.
Long-Run Costs
 Possible
causes of Economies of Scale:
– volume discounts on purchases of inputs such as
raw materials.
– manufacturing, warehousing, transportation, and
promotional economies.
– larger firm can borrow at lower interest rates.
– The most important one is a large fixed cost. For
example if C = 10 + 5Q, then if Q = 10, ATC = $6. But
if Q = 20, then ATC = $5.5. Notice that if FC = 0
(instead of $10) ATC would not change no matter
how much you produce.
 Possible causes of Diseconomies of Scale
– management diseconomies...
The ATM and the Cost of Getting Cash
The lowest average total cost for a human teller
transaction is $1.29. The lowest average total cost for
an ATM transaction is 32 cents.
The ATM and the Cost of Getting Cash
At Q transactions per month, both methods have the
same ATC.
For a credit union that does fewer than Q transactions
per month, its least-cost method is the teller.
For a bank that
does more than
Q transactions
per month, the
least-cost
method is the
ATM.
The ATM and the Cost of Getting Cash
More technology and more capital is not always
efficient.