Transcript Slide 1

Chapter 22
The Costs of Production
Economic costs:
- the payments a firm must make to attract resources away from their best
alternative production opportunities.
- Payments may be explicit or implicit.
Explicit costs: actual payments of cash (or cash equiv.) to suppliers for their resources
-- cost of labor, raw materials, advertising, freight, etc.
Costs of Production (cont.)
Implicit costs: the value of the resources in their
best alternative employments
- forgone salary / utility
- forgone rental / interest income
(these are opportunity costs)
Two Implicit Costs related to workers:
1. forgone salary (for “labor”) and,
2. normal profit
– opportunity cost of running a company v. doing something else
– conceptual dollar value of an owner’s entrepreneurial ability
– minimum accounting profit required to keep an owner from
changing endeavors
To an economist, normal profit is a cost.
Economic Profits:
Total Revenue
minus
All Costs (explicit and implicit costs – including a normal profit)
Economic Profits
Short run:
- the time period that is too brief for a firm to alter its plant capacity.
- plant size is fixed in the short run.
- short run costs are the wages, raw materials, etc., used for production
The long run:
- a period of time long enough for a company to change resource quantities…
… specifically capital (plant/factory size, machinery, etc.)
Short and long run are conceptual time periods, not calendar time periods.
Short-Run Production Relationships
Total product (TP): the total quantity, or total output,
of a particular good produced.
Marginal product (MP): change in total output from
each add’l resource input.
∆ in Total Product
Marginal Product = ---------------------------1 add’l labor unit
Average product (AP): is the total product divided by
the total number of workers.
THE LAW OF DIMINISHING RETURNS
a.k.a. the law of diminishing marginal product
Assumptions:
- fixed technology and fixed production methods
(i.e. fixed capital but not fixed labor)
-
variable inputs (e.g. labor) are of equal quality
(i.e. MP does not diminish because successive workers are inferior)
The law of diminishing returns:
as successive units of a variable resource
are added to a fixed resource,
beyond some point
the product attributable to each additional resource unit will decline.
-----
cultivation of the fields
revisions to an essay
manufacturing facility
traffic
p435 #4. Complete the following
table by calculating marginal
product and average product from
the data given.
Plot total, marginal, and average
product and explain in detail the
relationship between each pair of
curves.
MP First rises: fixed capital is used more productively
MP is the slope of the TP curve:
Explain why marginal product first
rises, then declines, and ultimately MP declines: Law of DR; traffic/congestion;
· as TP ↑ at a ↑ rate,
becomes negative.
progress made but at aMP
slower
is + rate
and ↑
MP negative: continuation of DR; “more is less”
· as TP ↑ at a ↓ rate,
What bearing does the law of
diminishing returns have on short
MP is + but ↓
run costs? Be specific. “When
· as TP↓,
marginal product is rising,
MP is – and ↓
marginal cost is falling. And when
marginal product is diminishing,
marginal cost is rising.” Illustrate
and explain graphically.
AP ↑ when MP is larger;
AP ↓ when MP is smaller.
p420 #4. Complete the following
table by calculating marginal
product and average product from
the data given.
Plot total, marginal, and average
product and explain in detail the
relationship between each pair of
curves.
Explain why marginal product first
rises, then declines, and ultimately
becomes negative.
What bearing does the law of
diminishing returns have on short
run costs? Be specific. “When
marginal product is rising,
marginal cost is falling. And when
marginal product is diminishing,
marginal cost is rising.” Illustrate
and explain graphically.
Labor is the variable cost (but assume the cost per
unit of labor is constant).
Remember:
∆ in TP
MP = ---------------------------1 add’l labor unit
Therefore:
$ cost of 1 unit labor
MC = ----------------------------MP
As MP is increasing (the denominator is increasing),
MC is decreasing.
As MP is decreasing (the denominator is decreasing),
MC is increasing.
When MP is at its maximum; MC is at its minimum.
Short-Run Production Costs
FIXED COSTS: costs that do not vary with changes in output (TP)
-- rent, interest on debt, depreciation expense, casualty insurance, etc.
Note: the dollar cost of a “fixed cost” may vary (e.g. real estate taxes) but not because
of changes in output.
VARIABLE COSTS: costs that change with a firms level of output (TP)
-- raw materials, sales tax, shipping charges
There is an overlap between fixed and variable costs.
-- labor tends to be a variable cost, but there are fixed components
-- advertising tends to be variable, but the connection with changes
in TP may be strong or weak. Also, the definition of “advertising” can vary.
TOTAL COST: the sum of fixed and variable costs at each level of output.
-- Graphically, the total cost and variable cost curves are “parallel”.
-- The difference between them is fixed cost.
Short-Run Production Costs (cont.)
Determining Fixed v. Variable:
how strong is the correlation between output and a given cost?
For example, does output vary directly with changes in:
• number of employees hired?
-
number of machinists?
Number of administrative assistants?
Number of managers/executives?
• raw materials purchased?
• property taxes paid?
p420 #1. Distinguish between explicit and implicit costs, giving examples of each.
Explicit costs:
payments the firm must make for inputs to nonowners of the firm to attract them
away from other employment. (e.g. wages and salaries to its employees).
Implicit costs:
nonexpenditure costs that occur through the use of self owned, self employed
resources. (e.g. the salary the owner of a firm forgoes by operating his or her own
firm and not working for someone else).
What are the explicit and implicit costs of attending college?
The explicit costs of going to college are the tuition, books, and the extra costs of living
away from home (if applicable). Implicit costs are the income forgone.
Why does the economist classify normal profits as a cost?
Normal profits are costs since the owner of a firm would close it down if a normal
profit were not being earned. A normal profit is required to keep the owner operating
the firm, so a normal profit is a cost.
Are economic profits a cost of production?
Economic profits are not costs of production since the entrepreneur does not require
the gaining of an economic profit to keep the firm operating. In economics, costs are
whatever is required to keep a firm operating.
p420 #2. Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual
rent of $5,000 for his shop, and materials cost $20,000 per year. Gomez has $40,000 of his own
funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $4,000 per
year if alternatively invested. Gomez has been offered $15,000 per year to work as a potter for a
competitor. He estimates his entrepreneurial talents are worth $3,000 per year. Total annual
revenue from pottery sales is $72,000. Calculate accounting profits and economic profits for
Gomez’s pottery.
Explicit costs: $37,000
($12K for the helper + $5K of rent + $20 of materials)
Implicit costs: $22,000 ($4K of forgone interest + $15K of forgone salary + $3K “normal profit”)
Accounting profit = $35,000
($72K revenue – $37K of explicit costs)
Economic profit = $13,000 ( $72K – $37K of explicit costs – $22K of implicit costs)
p420 #3.
Which of the following are short run and which are long run adjustments?
(a) Wendy’s builds a new restaurant;
(a) Long run
(b) Acme Steel Corporation hires 200 more production workers;
(b) Short run
(c) A farmer increases the amount of fertilizer used on his corn crop; and
(c) Short run
(d) An Alcoa plant adds a third shift of workers.
(d) Short run
P435 #5. Why can the distinction between fixed and variable costs be made in the short run?
• Some costs do not vary with total output; these are fixed costs.
• Fixed costs are related to the scale or size of the plant.
• In the short run, the scale of the plant cannot change: technology and production
capacity is fixed.
• Costs related to the fixed plant (e.g. rent, real estate taxes, the CEOs salary) continue
to be incurred irrespective of the firm’s output.
• Other costs vary with total output; these are variable costs.
• A firm can increase its output by using its fixed plant more intensively (e.g. by hiring
more labor, using more materials).
• With the increase in output, there is an increase in costs (variable costs).
p420 #5. cont.
“There are no fixed costs in the long
run; all costs are variable.” Explain.
In the long run, all short term fixed
costs can be eliminated, avoided, or
re-negotiated.
e.g. Insurance policy/ lease runs
out, CEO can be fired, etc.
In the long run, a firm may:
1. continue at current scale,
maintaining level of fixed costs
2. increase operations, increasing
fixed costs
3. decrease operations,
decreasing fixed costs
Short-Run Production Costs:
Per-Unit (Average) Costs
average
A firm has fixed costs of $60 and variable costs as indicated. Complete the table.
Graph total fixed cost, total variable cost, and total cost. Explain how the law of diminishing
returns influences the shapes of the total variable-cost and total cost curves.
As marginal cost decreases from outputs 1 through 4, total cost and total variable cost
increase at a decreasing rate. (During this time, marginal returns are increasing.)
As marginal cost increases (due to the occurrence of diminishing marginal returns;
outputs 5 to 10), TC and TVC increase at an increasing rate.
Graph AFC, AVC, ATC, and MC. Explain the derivation and shape of each of these four curves
and their relationships to one another. Specifically, explain in nontechnical terms why the MC
curve intersects both the AVC and ATC curves at their minimum points.
Average Fixed Cost falls continuously since a fixed amount of capital cost is spread over
more units of output.
The Marginal Cost, Average Variable Cost, and Average Total Cost curves are U-shaped,
reflecting the influence of first increasing and then diminishing returns.
The ATC curve is the sum of the AFC and AVC curves.
The ATC and AVC curves fall when the MC curve is below; ATC/AVC rise when the MC
curve is above it. This means the MC curve must intersect the ATC/AVC curves at its
lowest point.
Explain how the locations of each of the four curves graphed in question 7b would be altered
if (1) total fixed cost had been $100 rather than $60…
• the AFC and ATC curves would have the general same shape but would be higher (by
$40 divided by the specific output).
• the AVC and MC curves are not affected by changes in fixed costs.
…and (2) total variable cost had been $10 less at each level of output*.
• MC would be $10 lower for the first unit of output but remain the same for the
remaining output (*somewhat unlikely scenario).
• The AVC and ATC curves would have the same general shape but be lower (by $10
divided by the specific output).
• The AFC curve would not be affected by the change in variable costs.
p436 #8. Indicate how each of the following would shift the (a) marginal-cost curve, (b)
average-variable cost curve, (c) average-fixed-cost curve, and (d) average-total-cost
curve of a manufacturing firm. In each case specify the direction of the shift.
a.
A reduction in business property taxes
decrease in fixed costs
(a) MC no change; AVC no change; AFC shift down; ATC shift down.
b.
An increase in the nominal wages of production workers
increase in variable costs
(b) MC shift up; AVC shift up; AFC no change; ATC shift up.
c.
A decrease in the price of electricity
primarily a decrease in variable costs
(c) MC shift down; AVC shift down; AFC no/tiny change; ATC shift down.
d.
An increase in the insurance rates on plant and equipment
increase in fixed costs
(d) MC no change; AVC no change; AFC shift up; ATC shift up.
e.
An increase in transportation costs
increase in variable costs
(e) MC shift up; AVC shift up; AFC no change; ATC shift up.
Shifts to the Cost Curve (summary)
Changes in technology and resource prices may
cause cost curves to shift.
TFC, TVC, TC, AFC, AVC, ATC, MC
If fixed costs increase (or decrease):
(property taxes, interest payments on debt, etc.)
• the TFC, TC, AFC, and ATC would shift upward (or
downward).
• the TVC, AVC, and MC curves would not change.
If variable costs increase (or decrease):
(wage rates, raw materials, shipping, etc.)
• the TVC, TC, AVC, ATC, and MC would shift
upward (or downward).
• the TFC and AFC curves would not change.
Long-Run Production Costs
1. Short run Average Total Cost curves for five possible plant sizes.
2. Short run Average Total Cost curves for “unlimited” plant sizes.
3. Long Run Average Total Cost curve
Economies and Diseconomies of Scale
Economies of scale:
• downward sloping portion of the long-run ATC curve
– specialization (labor/management)
– efficient capital (e.g. machinery)
– spreading of costs (start-up costs, advertising, etc.)
Diseconomies of scale:
• upward sloping portion of the long-run ATC curve
– management and coordination of large-scale operations
– opportunity to shirk
Constant returns to scale:
• period of output where long-run ATC may not change (would be horizontal)
Sunk Costs (and Prospective Costs)
Sunk costs: costs which have already been incurred; cannot be recovered.
-- guaranteed salary of fired coach (when hiring replacement)
-- prepay for swimming lessons (when deciding whether to “skip”)
Traditional economics teaches that sunk costs should not affect the rational decision
maker's best choice.
Economic Thinking is Marginal Thinking…
…rational decisions weigh the marginal benefit v. the marginal cost
Prospective costs are future costs that may be incurred or changed if an action is taken.
-- contract terms of new coach?
-- sign up for another set of swimming lessons?
Prospective costs are avoidable future costs and should be included
in any decision making processes.
22-10
(Key Question) Use the concepts of economies and diseconomies of scale to explain the
shape of a firm’s long-run ATC curve.
The U-shaped LR ATC curve falls as the realizes economies of scale during expansion:
• labor and managerial specialization.
• use of more efficient capital.
The LR ATC curve turns upward as the enlarged firm experiences diseconomies of scale:
• managerial inefficiencies.
• opportunity to shirk.
What is the concept of minimum efficient scale?
MES (Minimum Efficient Scale): is the smallest level of output needed to attain all
economies of scale and minimize long-run ATC.
What bearing may the exact shape of the LR ATC curve have on the structure of an industry?
A. If long-run ATC descends slowly to its minimum cost over a long range of output,
the industry will likely be composed of a few large firms.
B. If long-run ATC drops quickly to its minimum cost which then extends over a long
range of output, the industry will likely be composed of both large and small firms.
C. If long-run ATC drops quickly to its minimum point and then rises abruptly, the
industry will likely be composed of many small firms.
p436 #9. Suppose a firm has only three possible plant-size options represented by the
ATC curves shown in the accompanying figure. What plant size will the firm choose in
producing (a) 50, (b) 130, (c) 160, and (d) 250 units of output?
(a) Plant #1
(b) Plant #2
(c) Plant #2
(d) Plant #3
Draw the firm’s long run average cost curve on the diagram.