Transcript Money & Central Banks

Costs of Production
KW Chapter 8
Costs: Explicit vs. Implicit
• Explicit Costs of Production: Direct
payments for resources not owned by a firm
(raw materials, wages, energy payments,
interest payments).
• Opportunity Cost: (The best alternative to
any action).
• Implicit Costs: Opportunity Costs of assets
owned by firms
– Ex. Owner of barbershop could earn $100 per
hour working as a barber. Implicit cost of the
owners time is $100 per hour.
– Opportunity cost of equity capital is return that
could have been earned elsewhere.
Short-Run vs. Long Run
• Firms typically have several types of
inputs that they can adjust to adjust
production.
• Long-run - When firms are able to adjust
all of their inputs including physical plant.
• Short-run – When firms are able to adjust
only some of their inputs (usually energy,
labor, and raw material costs).
Production in the Short-Run
• Given a set of fixed inputs (like plant and
capital equipment), a firm can vary other
inputs (typically labor) and to vary
production.
• Typically, as you add workers, you get more
output.
• But, diminishing returns sets in, and the
addition of extra workers will generate less
and less extra production.
Labor Productivity Function
Output
Labor
Short Run Production Function
ΔOutput
ΔLabor
ΔOutput
ΔLabor
Output
MPL 
Labor
Marginal Product Function
MPL
Labor
Increasing Marginal Product at Low
Production Levels
• Up to a point each additional worker adds
synergy and adding more workers leads to
more and more extra pay-off.
• When a production plant is operating
below capacity, adding more workers can
generate more output at a relatively
constant rate.
Fixed Costs vs. Variable Costs
• In short-run, we distinguish between the
costs that are adjustable as production is
adjusted (variable costs) and costs that
are unchanged regardless of production
(fixed costs).
– Variable costs (Wages of production workers,
supply and raw materials costs, short-term
finance costs)
– Fixed costs (Depreciation costs, Financial
costs, wages of non-production workers).
Cost Shares
Various 4 Digit Industry
(USA, 1991-1996)
Production
Nonproduction
Industry
Workers
Energy
Materials Workers
Cement
9.02% 17.83% 43.21%
4.23%
Typesetting
28.17%
0.96% 18.96% 13.07%
Oil Refinery
1.65%
2.62% 83.80%
1.07%
Automobiles
5.41%
0.37% 71.97%
1.06%
Furniture
18.03%
1.62% 47.86%
5.56%
Mens Clothes
20.20%
1.23% 40.08%
7.67%
NBER Productivity Database
Labor Intensity
34.00%
51.50%
20.09%
23.38%
46.68%
47.49%
Types of Costs
• Total Fixed Costs – Invariant to the
number of goods produced (in the shortrun)
• Total Variable Costs- Increasing in the
number of goods produced.
• Total Costs: Fixed Costs + Variable Costs
Output
(Loaves)
0.00
Fixed
Costs
1000
Workers
Wheat
0
Bakers
Wages
0
0.00
Variable
Costs
0.00
Total
Costs
1000.00
10.00
1000
10
100
50.00
150.00
1150.00
20.00
1000
40
400
100.00
500.00
1500.00
30.00
1000
90
900
150.00
1050.00
2050.00
40.00
1000
160
1600
200.00
1800.00
2800.00
50.00
1000
250
2500
250.00
2750.00
3750.00
60.00
1000
360
3600
300.00
3900.00
4900.00
Bakery: Wages $10 per Worker, $5 Wheat
per Loaf
Total Variable Costs are increasing at an accelerating rate.
Reason: Diminishing returns to variable inputs.
6000
5000
4000
3000
2000
1000
0
0.00
10.00
20.00
30.00
40.00
50.00
60.00
Output
Fixed Costs
Variable Costs
Total Costs
Costs: Average vs. Marginal
• Total Costs are the sum of all relevant
costs for a firm.
• Average Costs: Costs per unit of output.
• Marginal Cost: Extra Cost per Extra Unit of
Output.
Average and Marginal Costs
Average Fixed Costs
decreases as production
increases
125
105
85
AVC, ATC, MC all
increase as
diminishing returns
kick in
65
45
25
.0
15 0
.0
0
20
.0
25 0
.0
0
30
.0
0
35
.0
40 0
.0
0
45
.0
50 0
.0
0
55
.0
0
60
.0
0
00
10
-15
5.
00
5
0.
MC equals AVC and ATC
when each of the latter are
at their minimum level.
Output
Average Fixed Costs
Average Variable Costs
Average Total Costs
Average Marginal Costs
Cost Schedules
Output
(Loaves)
0.00
Total
Costs
1000.00
Average
Fixed
Costs
Average
Variable
Costs
Average
Total
Costs
Marginal
Costs
15.00
10.00
1150.00
100
15
115
35.00
20.00
1500.00
50
25
75
55.00
30.00
2050.00
33.33333
35
68
75.00
40.00
2800.00
25
45
70
95.00
50.00
3750.00
20
55
75
115.00
60.00
4900.00
16.66667
65
82
Costs in the Long Run
• In the short-run, the size of a firms physical
plant is a fixed factor.
• Over-time, the plant size can adjust.
• In the bakery example, extra ovens can be
added.
Minimizing Costs in the Long Run
• Consider average total cost schedules at
different numbers of ovens.
• Each oven will have a production level that
generates the minimum average total cost.
• To minimize average costs in the long-run,
choose the number of ovens which will
have the lowest, minimum average total
cost.
Average Total Cost Schedules at Different
Scales of Production
228
208
1 Oven
188
2 Ovens
168
3 Ovens
148
4 Ovens
128
5 Ovens
108
6 Ovens
7 Ovens
88
8 Ovens
68
Output
120
110
100
90
80
70
60
50
40
30
20
10
48
Minimum of the different cost
Schedules
228
208
1 Oven
188
2 Ovens
168
3 Ovens
148
4 Ovens
128
5 Ovens
108
6 Ovens
7 Ovens
88
8 Ovens
68
Output
120
110
100
90
80
70
60
50
40
30
20
10
48
Connect the Dots
Long Run Average Total Costs
228
208
1 Oven
188
2 Ovens
168
3 Ovens
148
4 Ovens
128
5 Ovens
108
6 Ovens
7 Ovens
88
8 Ovens
68
Output
120
110
100
90
80
70
60
50
40
30
20
10
48
If we adjust capital scale continuously,
the collection of minimum points is the
Long Run Average Total cost cuve
Short-run ATC
LR ATC
Economies of Scale
• When firms are able to adjust all of their inputs,
they can choose a size that will minimize costs.
• If a firm is able to achieve some economies of
scale, increasing size will reduce the average total
cost.
• Sources of Economies of Scale
– Production requires major expenditure on items needed
to produce even zero products
• Ex. Software, pharmaceuticals
– Production requires many specific steps which can be
most efficiently done through specialization
• Ex. Airplanes, automobiles
Long Run ATC increasing returns to
scale.
LR ATC
Costs
Economies of Scale
Output
Returns to Scale
• Scale Economies is not always likely to
characterize production.
• If each production unit can act autonomously
with identical costs then we may experience
constant returns to scale.
• Firms at some point experience diseconomies of
scale or increasing long run average total costs.
• Sources of diseconomies of scale
– Limits of managerial invention.
– Limits of some other fixed resource.
Long Run ATC decreasing returns
to scale.
LR ATC
Costs
Constant Returns
Scale
Diseconomies
Output
Overall Cost Function
LR ATC
Minimum Efficient
Scale
MES and Market Structure
• If MES is relatively large in comparison
with the market demand:
$
The market is most
efficiently served by a
single firm---natural
monopoly!
D
LRAC
Q
MES and Market Structure
• If MES is relatively small in comparison
with market demand:
Many “small” firms
in the market.
$
Q
Typical Scale varies across sectors
in USA
Sales per Establishment
25000
20000
15000
10000
5000
0
Mining
Utilities
Construction Manufacturing Retail trade
2002 Census of Manufactures
Professional,
scientific, &
technical
services
Learning Outcomes
Students should be able to
• Define and calculate various types of economic
costs.
– Explicit, implicit, fixed, variable, total, average,
marginal, economic, accounting.
• Describe the shape of various relevant cost
curves
– Average Total (in LR and SR), Average Fixed,
Marginal Costs
• Describe the relationship between production,
productivity (marginal and average) and the law
of diminishing returns.