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The Costs of Production Chapter 8 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Economic Costs Equal to opportunity costs Explicit + implicit costs Explicit costs Monetary payments Implicit costs Value of next best use Self-owned resources Self-employed resources 8-* Profit Accounting profit Total revenue less explicit cost Normal profit Equal to implicit cost Economic or pure profit Total revenue less economic cost 8-* Profits Compared Economic Profit Accounting Costs (Explicit Costs Only) Accounting Profit Explicit Costs Implicit Costs (Including a Normal Profit) Economic (Opportunity) Costs Total Revenue Economic Accounting 8-* Economic Profit Economic Profit = Total Revenue ? (Explicit Costs + Implicit Costs) When Economic Profit = 0, it means the firm is not only covering its explicit costs but also its implicit costs (or opportunity costs). The firm is making a normal profit. Normal profit is an implicit costs and is the minimum payment that entrepreneurs much receive for running the firm. The Production Function It takes factors of production to produce a good or service ? no matter what the good is. Factors of production ? Resource inputs used to produce goods and services, such as land, labor, capital, entrepreneurship. The Production Function The production function is the technological relationship expressing the maximum quantity of a good attainable from different combinations of factor inputs. Short and Long Run The short run Fixed plant capacity Variable intensity of plant use Variable output The long run Variable plant capacity Firms enter and exit 8-* Short-Run Constraints When there are fixed inputs, we?re dealing with a short run production condition. The short-run is the period in which the quantity (and quality) of some inputs cannot be changed. Short-Run Constraints Labor is the variable input that determines how much output we get from our fixed inputs (land and capital). In general, as the amount of labor used increases, output also increases. Short-Run Production Function 0 1 2 3 4 5 6 7 8 Labor Input (machine operators per day) Jeans Output (pairs per day) 5 10 15 20 25 30 35 40 45 50 55 Total output (per day) A B C D E F H I G Output rates depend on input levels Production Relationships Total product (TP) Marginal product (MP) Average product (AP) Average Product Total Product Units of Labor = Marginal Product Change in Total Product Change in Labor Input = 8-* Law of Diminishing Returns Fixed technology Add variable resource to fixed resource Marginal product will decline Beyond some point Rationale 8-* Increasing Marginal Returns Law of Diminishing Returns (1) Units of the Variable Resource (Labor) (2) Total Product (TP) (3) Marginal Product (MP), Change in (2)/ Change in (1) (3) Average Product (AP), (2)/(1) 0 1 2 3 4 5 6 7 8 0 10 25 45 60 70 75 75 70 10 15 20 15 10 5 0 -5 - 10.00 12.50 15.00 15.00 14.00 12.50 10.71 8.75 ] ] ] ] ] ] ] ] Diminishing Marginal Returns Negative Marginal Returns 8-* 0 10 20 30 Total Product, TP 1 2 3 4 5 6 7 8 9 20 10 Marginal Product, MP 1 2 3 4 5 6 7 8 9 TP MP AP Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns Law of Diminishing Returns 8-* Resource Costs A production function tells us how much a firm can produce but not how much it should produce. The most desirable rate of output is the one that maximizes total profit. Profit - The difference between total revenue and total cost. Short-Run Production Costs Fixed Costs Do not vary with output Variable Costs Materials, most labor Total Cost TC = TFC + TVC 8-* Total Cost Short-Run Production Costs Costs 1 2 3 4 5 6 7 8 9 10 0 Q 100 200 300 400 500 600 700 800 900 1000 $1100 TFC TC TVC Total Cost Variable Cost Fixed Cost 8-* Per-Unit Production Costs Average fixed cost AFC = TFC/Q Average variable cost AVC = TVC/Q Average total cost ATC = TC/Q = TFC/Q + TVC/Q ATC = AFC+AVC Marginal cost MC = change in TC/change in Q 8-* Average Costs Short-Run Production Costs Costs 1 2 3 4 5 6 7 8 9 10 0 Q 50 100 150 $200 AFC MC ATC AVC AVC AFC 8-* Production Relationships Marginal cost and diminishing returns Marginal cost and marginal product Marginal cost and average variable cost Marginal cost and average total cost Production curves and cost curves Shifts in cost curves 8-* Marginal Cost Marginal cost refers to the change in total costs associated with one more unit of output. Marginal Cost Average Product and Marginal Product Cost (Dollars) Graphical Relationships MP AP MC AVC Quantity of Output Quantity of Labor Production Curves Cost Curves 8-* A Cost Summary The marginal cost curve always intersects the ATC curve at its lowest point. If MC > ATC, ATC is increasing If MC < ATC, ATC is decreasing If MC = ATC, ATC at minimum Basic Cost Curves $32 28 24 20 16 12 8 4 0 1 2 3 4 5 6 7 8 Cost (dollars per unit) Rate of Output (units per time period) 9 ATC n m AVC AFC MC Long-Run Costs The short-run is characterized by costs that cannot be changed (fixed costs). There are no fixed costs in the long-run. The long run is a period of time long enough for all inputs to be varied (no fixed costs). Long-Run Average Costs The long-run cost curve is a summary of our best short-run cost possibilities. Long-Run Production Costs Choose your plant size Minimize ATC Different ATC curves Short run Long run ATC Envelope of short run ATC 8-* Long-Run ATC Curve Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output Any number of short-run optimum size cost curves can be constructed 8-* Long-Run ATC Curve Long-Run ATC Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output The long-run ATC curve just ?envelopes? the short run ATCs 8-* Economies of Scale There are many optional plant sizes available in long-run production. A firm can decide to use one large plant or several smaller plants to produce a given amount of output. Economies of Scale Economies of scale are reductions in minimum average costs that come about through increases in the size (scale) of plant and equipment. Long Run Production Cost Economies of Scale Labor specialization Managerial specialization Efficient capital Diseconomies of Scale Constant Returns to Scale 8-* Long-Run ATC Shapes Output Long-run ATC curve where economies of scale exist Average Total Costs Long-Run ATC Economies Of Scale Constant Returns To Scale Diseconomies Of Scale q1 q2 8-* Economies of Scale Economies of scale are reductions in minimum average costs that come about through increases in the size (scale) of plant and equipment. Output Long-run ATC curve where costs are lowest only when large numbers are participating Average Total Costs Economies Of Scale Diseconomies Of Scale Long-Run ATC Long-Run ATC Shapes 8-* Economies of Scale Efficiency and size do not necessarily go hand in hand. Diseconomies of scale occur when an increase in plant size results in reducing operating efficiency. Output Long-run ATC curve where economies of scale exist, are exhausted quickly, and turn back up substantially Average Total Costs Long-Run ATC Economies Of Scale Diseconomies Of Scale Long-Run ATC Shapes 8-* Minimum Efficiency Scale (MES) The smallest level of output at which a firm can minimize long-run average costs. When there is an extended range of constant returns to scale, relatively large and small firms co-exist. If economies of scale extend beyond the market size, the conditions for a Natural Monopoly are produced. If MES is reached at a low level of output, there will be many firms in an industry. Sunk Costs Irrelevant in decision making Cannot be recovered Do not affect marginal benefit and marginal cost Firm example: R&D costs 8-*
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